FDA Regulation Will Broadly Affect Big Tobacco

S&P Ratings says the newly signed regulatory bill will change the tobacco industry's competitive landscape and raise future costs

By Elena Serdyuk From Standard & Poor's RatingsDirect

On June 22, President Barack Obama signed into law a tobacco regulatory bill giving the U.S. Food & Drug Administration oversight of the industry, including the tobacco companies' manufacturing and marketing practices. The changing regulatory environment has raised questions about the credit implications for the tobacco industry.

The legislation will give the FDA authority to restrict certain marketing and advertising practices, oversee the manufacturing of cigarettes, and demand detailed disclosure of tobacco products' ingredients—while requiring the tobacco companies to pay for the additional oversight through user fees. It will also mandate larger, more prominent health warnings on labels and ban all flavored cigarettes except menthol products.

All of these policies may in our view alter the competitive environment in the industry by hindering new product development, putting up barriers to entry, and raising the overall cost of doing business.

Philip Morris USA, the largest U.S. tobacco manufacturer, has stated its support for the bill, while R.J. Reynolds and Lorillard, the second- and third-largest industry players, opposed it. Competitors have criticized Philip Morris, claiming that the sales, marketing, and advertising restrictions would help the company maintain its market share.

Despite the broad potential effects of the FDA regulations, we don't expect the bill's passage to have an immediate impact on our ratings and outlook on the largest-rated tobacco manufacturers or on tobacco settlement-backed securitizations (structured transactions secured by payments from participating manufacturers under the 1998 Master Settlement Agreement [MSA]). In addition, we don't expect to make changes to our current criteria assumptions for tobacco settlement-backed securitizations as a result of the legislation. Our ratings on all such securitizations currently have negative outlooks or are on CreditWatch negative, and we believe our existing assumptions adequately address the risks inherent in these transactions.

Effects On Tobacco Industry Players

We don't expect the FDA regulations to have an immediate rating impact on the tobacco manufacturers, including the three largest companies by market share: Richmond (Va.)-based Altria Group (MO) (S&P rating, BBB), parent of Philip Morris USA; Reynolds American (RAI) (BBB-), parent of R.J. Reynolds Tobacco; and Lorillard Inc. (LO) (BBB-), parent of Lorillard Tobacco.

We believe that these manufacturers' strong cash flow generation, solid margins, and respective market positions provide support to their current ratings and partly offset the risks associated with FDA regulation, in addition to ongoing litigation risk and contraction in the domestic cigarette industry. However, our negative outlook on Lorillard reflects greater uncertainty about the impact FDA regulation may have on the menthol cigarette category, given the company's greater exposure and leading position in this category. We would consider lowering the rating on the company if we believe that future changes in policy will materially affect Lorillard's business, including further restrictions or a potential prohibition on the sale of menthol cigarettes.

We also believe the regulations may pose risks to the domestic tobacco industry as a whole over an intermediate to long-term time frame, and we will continue to monitor the situation as the new FDA tobacco-regulating entity takes shape—and as the government writes more detailed regulatory legislation.

Ad Curbs may favor MSA participants

The new legislation includes a number of marketing restrictions that would limit magazine advertising displays to black-and-white text, ban the descriptors "light," "mild," or "low tar" (which can imply that certain products are less harmful), and forbid free giveaways with the purchase of tobacco products. Some of the marketing restrictions—such as the prohibition on youth targeting, a ban on youth access to free samples, and limitations on tobacco brand name sponsorships—are part of the MSA guidelines that participating manufacturers (PMs) are already following.

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