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Over the past several months, the Food and Drug Administration (FDA) has been reviewing data as it considers banning, or at least limiting, menthol, or mint-flavored, cigarettes. Many scientists have argued that adding menthol to cigarettes exposes smokers to more toxins and increases their cancer risk. Ban advocates believe that adding menthol flavoring masks the harshness of tobacco, thus making it easier for smokers to tolerate smoking. Tobacco companies, on the other hand, say that adding menthol does not make a cigarette more harmful or addictive.

The Tobacco Products Scientific Advisory Committee (TPSAC), which advises the FDA regarding the regulation of tobacco products, announced on March 18th that “the removal of menthol cigarettes would benefit the public health in the U.S.” In other words, it effectively recommended a ban on these products. We should note that this is a non-binding recommendation to the FDA, and the FDA ultimately has the final decision. The good news for the tobacco industry is that not only is the assessment very general in nature, but that it also removes, for the time being, the headline risk that has long been an overhang for domestic cigarette makers. However, we must now wait for the final decision from the FDA, which could take several months and have a long-lasting impact on the industry.

There are three companies in our Tobacco Industry coverage that have menthol products in their portfolios: Lorillard (LO), British American Tobacco (BTI), and Reynolds American (RAI). Lorillard has the greatest exposure to the menthol regulation issues. It is the third largest manufacturer of cigarettes in the United States. Its flagship product, Newport, is the top selling menthol and second largest selling cigarette brand in the country.  This product accounted for roughly 90% of the company’s sales in 2010, so clearly any ban on this ingredient would hurt results significantly. However, investors in Lorillard seem to have viewed the TPSAC announcement favorably. Its shares jumped roughly 10% the day after the announcement, and were up some 25% as of April 13th, as the recommendation was seen as more of a general statement rather than an effective ban.

British American Tobacco was less affected by the news, with its stock price up only marginally since the announcement. Menthol products make up less than 10% of total volume. Reynolds American’s primary menthol product, CAMEL Crush, features a menthol capsule that allows smokers the choice between regular and menthol, but this product is not a significant revenue contributor. However, its stock price is up about 10% since the TPSAC announcement.

Ultimately, we think the FDA is unlikely to recommend a ban on menthol cigarettes. There is no absolute proof that these products are any worse than regular cigarettes. We think the FDA will need more compelling evidence if it wants to forbid the sale of these goods. In addition, illegal sales in the black market could occur if menthols are banned, and we think the FDA needs to address this concern. There is no timetable for the FDA’s final decision, although it is expected to give its first progress report within three months. We anticipate additional updates thereafter.

Rather than an all-out ban on menthols, the FDA will likely focus its efforts on policies that will help users make well-informed decisions in regard to these products. Marketing restrictions, packaging notifications, and regulation of pricing and promotion are all on the table. We still envision some overhang for the stocks in the industry. Lorillard, in particular, remains a risky venture, thanks to its significant menthol sales, but as of now, we don’t anticipate any negative news that would drag the stock down significantly. Despite the regulatory risk, the company continues to have strong brand strength, solid growth prospects, and a high dividend yield.
 
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.