Market Overreacts to Menthol Risk

The U.S. Food and Drug Administration has announced three policy proposals that will ban menthol in cigarettes, limit the marketing of flavors in vaping liquids, and ban flavored cigars. This represents the most concerted attempt to clamp down on the tobacco industry in 20 years. Tobacco stocks moved sharply downward after the November announcement, particularly in reaction to the potential for menthol prohibition. We still believe the probability of a menthol ban is less than 50% because the path to legislation requires the FDA prove the net public health benefit of the proposed ban. This is a fairly heavy burden of proof.

Even if the FDA does bring into force a menthol ban, we think the effects of such a development are already more than priced in. Our analysis shows that the market reaction is proportionate to an unlikely outcome whereby all industry menthol volume is lost immediately after prohibition. We expect a less extreme outcome, with some volume decline but some volume migration to nonmenthol variants within brand families. In this scenario, we believe the market has overreacted to the news and has dragged down some already undervalued stocks to very attractive levels. Having said that, the potential menthol ban will now act as a new overhang over the stocks, and it may take more than a rebound in heated tobacco to deliver the upside we believe is on offer at today’s prices. Investors will have to be patient and have the stomach for further fat-tail risk, but we think

There are three main regulatory proposals in FDA Commissioner Scott Gottlieb’s statement:

• Prohibition of menthol in combustible tobacco products.
• Restrictions on the sale of all flavored electronic nicotine products to age-restricted in-person locations, and where the products are sold online, tightening the age verification processes.
• Prohibition on all flavors in cigars.

The FDA has considered banning menthol several times in the past. In 2009, it banned other flavors, including clove, but stopped short of a menthol ban. Following a 2013 Advance Notice of Proposed Rulemaking, the FDA again stopped short of restrictive measures on menthol, in part because it stated that the weight of evidence did not demonstrate that menthol use was associated with greater exposure to toxins, nor did it contribute to higher disease risk in comparison with nonmenthol cigarettes. It did at that time conclude, however, that menthol cigarettes are likely to be a greater public health risk than nonmenthol cigarettes because they are likely to encourage initiation and display reduced cessation rates among smokers.

It is the ease of initiation that the FDA now appears to be targeting, and all three proposals are being framed around initiation, particularly among youth. Menthol cigarettes, Gottlieb argues, are more likely to encourage initiation because of the smoothness of the draw relative to nonmenthol products. Similarly, he argues, flavored vaping liquids may encourage consumption by nonusers.

Menthol Ban Would Have Most Impact, but Long Road to Implementation

Of the FDA’s proposals, the menthol ban is the most surprising and is arguably the most draconian measure taken against the tobacco industry since the Master Settlement Agreement in the late 1990s. It also has the greatest potential impact on the cash flows of the businesses. Menthol represents around one third of the roughly 250 billion-stick U.S. cigarette industry. Following the consolidation of Reynolds American in July 2017, the category is dominated by British American Tobacco, whose menthol variant of the Newport brand commands a volume market share of around 13% of U.S. cigarettes, as well as Camel Menthol and Camel Crush, which represent approximately a further 3% market share. Imperial, through Kool and Salem Menthol, and

Although the ANPRM represents the most resolute attempt yet by the U.S. regulator to ban menthol, implementation and execution will be fraught with difficulties, and we still peg the probability of successful legislation at less than 50%. One of the difficulties will be the path to implementation. The Family Smoking Prevention and Tobacco Control Act of 2009, which handed regulatory oversight of tobacco to the FDA, stated that the organization could ban menthol cigarettes only if it could demonstrate that doing so would be a net benefit to public health after taking account of potential knock-on effects, such as the growth of an underground market for menthol. In our opinion, the FDA statement falls short of this burden of proof.

Another issue could be the timing of a ban. We estimate the minimum time it would take to implement a menthol ban would be two years: one year to formulate the regulation and another year to allow the marketplace to adapt to the upcoming ban, in line with previous product restrictions such as “lights” in 2010. It is highly likely that tobacco manufacturers will pursue legal challenges to any proposed legislation. There is also likely to be legal action from convenience stores, for whom tobacco represents at least one third of operating profit, and a menthol ban could reduce gross profit by $38,000-$44,000 per store per year, according to Management Science Associates. Litigation is likely to delay the implementation process.

Menthol cigarette use is highly skewed to African-American smokers, so the timeline for implementing a ban within President Trump’s first term in office is tight. The FDA commissioner is a presidential appointee, and the next president, were Trump to lose the 2020 election, is likely to be more politically sensitive to the African-American voting bloc than Trump himself.

Menthol Volume Wipeout Looks Unlikely The worst-case outcome for Big Tobacco is that the imposition of a federal menthol ban wipes out one third of the U.S. market. This scenario is highly unlikely because it implies that all menthol smokers quit immediately, or that the entire menthol category moves to an illicit market. According to Centers for Disease Control data, African-Americans attempt to quit at a higher rate than whites (72.8% of current daily smokers reported that they intended to quit in the 2015 CDC survey versus 67.5% of whites) but have lower cessation success rates, possibly due to lower utilization of cessation treatments. Indeed, in its preliminary scientific evaluation of the possible public health effects of menthol cigarettes, as part of its 2013 analysis, the FDA itself stated that its evidence "supports the conclusion that menthol in cigarettes is likely associated with increased dependence" and that "menthol in cigarettes is likely associated with reduced success in smoking cessation." It seems likely, therefore, that a menthol ban would not lead to an immediate decline in volume, although it may make cessation easier for smokers in the long term. Furthermore, it is likely that a ban would either encourage consumption of an alternative product or send the category underground.

If menthol smokers switch to nonmenthol, it is possible that the bulk of consumption would be captured by the cigarette manufacturers. Most offer a regular tobacco alternative under the same brand umbrella and would likely retain most of the volume under threat from a menthol ban. Newport (owned by British American) has a nonmenthol variety, as do Camel (also BAT) and Marlboro (Altria). Imperial Brands may face the largest volume risk, as Kool does not have a nonmenthol variant, but we believe the company is likely to be able to launch one under the substantial equivalence rule. Logically, if menthol is banned because it is a greater danger to public health, then a nonmenthol version of the product with a similar tar level and tobacco blend would most likely meet the substantial equivalence test of causing no more questions of public health.

One possibility that would support the argument that consumption would switch to nonmenthol cigarettes is that smokers could add liquid menthol to regular tobacco cigarettes. The availability of menthol nicotine vaping liquids would make this relatively easy, especially given that menthol liquids are exempt from the FDA’s current proposals to tighten regulations around liquid sales. This would probably fail the “net benefit to public health” burden of proof, however, as it may substantially increase the level of nicotine consumption per stick, which would not be a desirable outcome.

Illicit markets for cigarettes usually take two forms: smuggled and contraband. An illicit market in which the product is smuggled across borders usually occurs when smugglers arbitrage the difference in retail price between jurisdictions with large excise tax differentials or regulatory regimes, especially when those jurisdictions share a border. Canada’s own federal law prohibiting menthol cigarettes came into effect in October 2017, so the risk of smuggled product from north of the border appears to be quite limited. We believe there is a greater risk of increased contraband product making its way into the United States, potentially from Mexico. This would be a negative for tobacco companies because contraband consumption would come at the expense of the manufacturers’ volume.

Vaping Restrictions Likely to Be Net Positive for Big Tobacco We think the only surprise about the FDA's proposals to restrict the marketing of vaping flavors is that these measures weren't brought in sooner. It has long been our assertion that freely available flavored liquids, particularly in the online channel, would attract regulatory scrutiny because of the likelihood that they would be purchased and consumed by nonsmokers and young people in particular. Although the FDA was initially slow to clamp down, in our opinion, the emergence of Juul, which has grabbed more than 70% of the U.S. vaping market in just three years, has prompted the regulator to take action. In his statement, Commissioner Gottlieb referred to youth consumption of e-cigarettes as an "epidemic," citing data from the 2018 National Youth Tobacco Survey, which claimed that there was a 78% increase in current e-cigarette usage among high school students in 2018 over 2017.

The measures currently being proposed by the FDA appear likely to curtail the appeal of vaping to young nonsmokers. The tightening of the age verification process will make it harder for underage users to purchase the products. However, the exemption of mint and menthol flavors is a loophole that we expect to be closed. If menthol-flavored liquid remains easier to obtain than other flavors, surely young vapers will gravitate toward menthol, and the argument that menthol acts as a gateway to initiation--the very argument that the FDA is now advancing to support its proposal to prohibit menthol cigarettes--will apply to vaping as well.

We think the tobacco manufacturers have little to lose and possibly something to gain from the proposed tighter restrictions on vaping flavors. Vaping is currently a negligible component of the revenue of most of the large-cap cigarette makers. We estimate that vaping represented just 1% of BAT’s top line in the first half of 2018, around 3% of Imperial Brands’ revenue in the fiscal year ended Sept. 30, and negligible for Altria in the nine months to the end of September. We do not believe any of the large cigarette makers are profitable in vaping at present, although the category may be modestly accretive to Imperial’s EBIT next year.

With very small, margin-dilutive vaping businesses, and with most of the category value having so far accrued to Juul, we expect only Altria to lose from tightening regulation in the vaping category as a result of its intention to acquire a 35% stake in Juul. Although the regulation is intended to crimp the adoption of vaping by nonsmokers, particularly young consumers, it is possible that it will also slow the migration from smoking to vaping and the dual use of both products, which we believe represents a large segment of the market. A 2017 survey in the Netherlands by the European Network for Smoking and Tobacco Prevention indicated that 98% of current vapers were current or former smokers.

Ban on Cigar Flavors Will Have Little Impact on Cash Flows The third FDA proposal is to ban all flavors in cigars. Along similar lines to its arguments around cigarettes and vaping, the FDA argues that a higher proportion of youth smoke flavored cigars, and by eliminating flavors, the FDA would be discouraging initiation among youth.

We anticipate this will have very little impact on the cash flows of the tobacco companies under our coverage. Imperial has the most exposure to cigars through brands such as Montecristo and Cohiba, but we estimate flavored cigars are de minimis in terms of revenue and EBIT.

Market Is Pricing In Worst-Case Scenario As we believe the probability of a menthol ban remains less than 50%, we are maintaining our fair value estimate for the affected tobacco companies we cover. However, we have stress-tested our valuations for the large-cap tobacco manufacturers based on two downside scenarios--a worst-case scenario and a more likely scenario--and may adopt one of these scenarios if the FDA moves. The key assumptions in those scenarios follow.

In our worst-case scenario:

• All menthol volume is immediately lost to the industry as menthol smokers either quit or switch to contraband, leading to a rebasing of volume in 2021.
• For simplicity, we assume this happens on the day of the implementation of the ban on Jan. 1, 2021.
• There is no upside from vaping restrictions, as this is already accounted for in our base-case assumptions and fair value estimates.

In our higher-probability downside scenario:

• Half of the industry menthol volume is retained, as some smokers are unable to cease smoking and switch to nonmenthol cigarettes.
• Smokers switch to nonmenthol variants of their current brand, which implies stable market shares.
• For simplicity, we assume this happens on the day of the implementation of the ban on Jan. 1, 2021.
• Beyond 2021, we assume that the prohibition of menthol creates a disruption in the marketplace that encourages some smokers who switch to nonmenthol to cease smoking. This leads to an acceleration in the U.S. industry structural decline rate to 4.5% per year from around 3.5% currently.

Our analysis shows that the market is more than pricing in the worst-case scenario. In particular, the market reaction to the impact on BAT appears to be overdone. Sentiment in the tobacco space has swung from being too optimistic to being overly pessimistic following the severe slowdown in growth in heated tobacco in Japan. Even before the FDA announcement on menthol and vaping flavors, we believed the large-cap tobacco companies offered an attractive margin of safety. The reaction of the market to the announcement has created an even better opportunity for investors, however. For example, BAT's market value has declined 14% since The Wall Street Journal broke the story of the FDA's intentions. This is above the 12% value destruction we estimate would occur in our most likely downside scenario and not that far away from the downside impact of our worst-case outcome (22%). In other words, the market is pricing in a scenario very close to the worst case for BAT on top of an already attractive margin of safety.

We have also looked at the potential knock-on effect of a menthol-driven reduction in cash flows on balance sheet leverage and dividend coverage, and we expect some risk to dividends in the worst-case scenario. For all three companies, dividend coverage (measured by earnings) would barely cover the dividend we would expect to be paid in 2021 in our base case, and we would expect either a modest dividend cut or slower dividend growth between now and the implementation of a menthol ban. Under the conditions of our higher-probability scenario, however, Altria and BAT have greater flexibility to meet their 2021 dividend. Even in these conditions, it appears that Imperial would find it difficult to continue to raise its dividend at 10% for the next three years. In our base case, we assume that Imperial will begin to slow the pace of its dividend growth to the midsingle digits in fiscal 2020, but if the probability of a menthol ban increases over the next 12 months, we now believe this slowdown could be pulled forward.

We think the disproportionate pullback in market valuations has increased the margin of safety in Big Tobacco. We think BAT looks particularly attractive, and we believe Imperial Brands is also materially undervalued. However, this development shows that despite a relatively uneventful decade, black swan events still occur in this industry, and investors must have the appetite for fat-tail risk when investing in tobacco stocks. This is reflected in our recent decision to downgrade our moat trend ratings across the industry to negative from stable. Menthol risk is likely to be a new overhang over the group for at least another year or two, but with dividend yields now back up to the mid-single-digit range, investors will be paid to wait for sentiment to improve in tobacco.