An Ideal Time For Tobacco Spin Offs?
It was the best news the tobacco industry had received in months. On Aug. 14, a federal appeals court ruled that the Food & Drug Administration had no power to regulate cigarettes--a decision that protects the industry, for the time being, from government bureaucrats meddling in the makeup and marketing of its products.
News of this triumph, however, did little to perk up the companies' long stagnant share prices. Bellwether Philip Morris Co. rose 1 3/16, to 42 1/4, on the day of the ruling. At a closing price of 41 9/16 on Aug. 31, the company's stock trades about 10% below where it did when congressional settlement talks were launched 14 months ago. In fact, notwithstanding a recent string of courtroom victories, tobacco stocks have been in their worst rut in years. Based on 1998 estimated earnings, Philip Morris' price-earnings ratio of 13.1 is a mere 63% of the p-e for the Standard & Poor's 500-stock index. That's up from the 55% relative valuation before the market's late summer dive, but still lower than the stock has traded in five years (chart). Rival RJR Nabisco Holdings Corp. has an even lower relative p-e, 42%.
For tobacco chieftains, it's back to square one. Last year's congressionally brokered settlement of the key suits against the industry was to be the magic formula that would rescue the beleaguered stocks. But public enmity for the industry was so high that Congress kept increasing the price of peace, ultimately driving the companies to kill the measure themselves. Now that it's clear that Washington isn't giving Big Tobacco litigation protection anytime soon, industry leaders have little choice but to come up with a new grand strategy.
PREMATURE? The cigarette makers' next silver bullet is likely to be the spinning off of their tobacco units from the rest of their companies, according to sources inside and outside of the industry. Such a strategy would, first, free their nontobacco divisions from exposure to huge potential litigation losses.
Spin-offs also would likely increase the value of their tobacco businesses, currently treated as nearly worthless by the market. Because the freestanding cigarette units would have the cash flow to offer high dividends, Salomon Smith Barney analyst Martin Feldman argues investors would pay a higher premium for this income stream than they do now, "hidden" as it is among other revenues. He estimates if Philip Morris spun off its tobacco companies, the value of its pieces would increase from 41 9/16 to about 58. He thinks RJR could climb from 21 7/16 to 35.
Already, Britain's BAT Industries PLC is scheduled to split its tobacco and financial-services businesses on Sept. 8--and an announcement that spin-off plans were on track caused shares to rise 7% in London on Aug. 25. RJR Nabisco would act quickly to spin off its food business if the tobacco companies settle the Medicaid suits brought by a coalition of 37 state attorneys general, says a highly placed RJR executive. Laurence A. Tisch, chairman of Loews Corp., says he "would look at" spinning off subsidiary Lorillard Tobacco Co. from Loews' insurance and hotel units if the state AG cases settle, but he adds that it's premature to consider the issue before then. A Philip Morris spokesperson says the company is not interested in separating its tobacco unit from its Miller beer and Kraft food divisions at this time, though analysts say the company would be under pressure to do so if an RJR spin-off succeeded.
The key to executing the spin-off strategy is hammering out a deal with the states--which may be difficult. Talks began again in New York on Aug. 27, but BAT, RJR, and the state of Massachusetts have dropped out. Although the industry is facing a wide range of legal attacks, the 37 Medicaid suits, seeking hundreds of billions of dollars, are seen as those that could most likely drive the companies into bankruptcy. And as long as there's a chance of insolvency, antitobacco lawyers could try to block a spin-off by arguing that such a move could prevent clients from collecting if cigarette companies later went bankrupt. Under long-standing principles prohibiting "fraudulent conveyance," companies can't shed assets if there's a chance potential creditors might need them.
Until now, tobacco companies have resisted shareholder pressure for spin-offs by arguing that the overall legal environment was so hostile they had no chance to beat back attacks by plaintiffs' lawyers. But because of the industry's recent winning streak in court, executives now believe they could convince a court that the private lawsuits against them are unlikely to mushroom into a potentially bankrupting threat. On Aug. 13, for example, BAT's Brown & Williamson Tobacco Corp. successfully overturned a $1 million decision in favor of a Florida smoker--restoring, for now at least, the industry's perfect record against suits brought by individual smokers. Several state and federal courts throughout the country, meanwhile, have blocked class actions against the industry in recent months.
Pointing out that the industry's recent win record is sprinkled with a few key defeats, personal injury lawyers say the companies are exaggerating their success. Nonetheless, Columbia Law School professor John C. Coffee says if the companies and the states can settle, it would be hard for private lawyers to halt any spin-offs.
Still, no restructuring is possible unless Big Tobacco can make the state Medicaid cases go away first. Neither the companies nor the state attorneys general involved in the talks would discuss their negotiations. Despite the fact that some key players have walked out, Sanford C. Bernstein analyst Gary D. Black believes that both sides will eventually work out a deal and attributes the recent turbulence in the peace talks to gamesmanship. Nonetheless, there are some tough issues to resolve. For example, companies want to make sure the increased costs they will shoulder in order to pay the states won't give foreign companies and a handful of tiny domestic competitors an opportunity to grab market share (box).
Even if Big Tobacco settles the state cases, the White House has in recent days threatened to bring a suit that would aim to recoup hundreds of billions in federal funds spent on treating smokers' illnesses. Such a filing would give any judge pause before allowing tobacco companies to split.
Despite the obstacles, though, spin-offs are probably still the companies' best hope. If they aren't able to shed their tobacco units, manufacturers will be stuck right back in the same litigation nightmare that drove down their share prices in the first place.
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