Several analysts believe that the tobacco industry will grow as new, more acceptable ‘nicotine delivery systems’ replace cigarettes. But tobacco stocks are priced as though the industry will disappear in a few years. The future is unknowable, but some historical perspective is in order.
MASTER SETTLEMENT AGREEMENT
For almost 500 years, governments have paid lip service to destroying the “evil product” but have always opted to tax it instead. The degree of condemnation has varied over time, but even today lots of ‘stakeholders” besides tobacco company shareholders receive billions of dollars from tobacco.
The customary payment of excise and income taxes was expanded in 1998 when the four major cigarette makers signed a Master Settlement Agreement (MSA) with the 50 states attorneys general that provided billions of dollars to the states, based on the number of cigarettes sold each year.[i]
The MSA committed these tobacco companies to pay state governments forever. In theory, this money went to each state to cover the costs of smoking-related illnesses and educate children about the dangers of tobacco. As often happens when money and politics mix, the reality did not measure up to the theory. Beginning in 1998, the cigarette manufacturers became a tax and fee collector with a growing list of “stakeholders.” Taxes and fees were 52-55% of the revenue received from cigarette sales. (This did not include income tax paid by the tobacco industry suppliers and employees.) The Tobacco Road website gave a description of the MSA. [LINK]
WHERE DID THE MONEY GO?
The Government Accountability Office reported that, for the 16 years 2000-15, the MSA paid the states $145 billion. The states spent less than half on the promised health and tobacco control. The tobacco control portion, the MSA cornerstone to prevent children from smoking, got a paltry 5.7% of the money.
Politicians spent over half the money on vaguely defined categories like Shortfall, Unallocated, and Infrastructure. This spending gives every appearance of a giant piggy bank for dispensing pork. [LINK].
The misdirected spending appears to have gotten worse in the last 6 years. A couple examples:
The former Mississippi Attorney General believes that if his state’s political leaders had stuck to their plan, the state would now have a trust fund of more than $4 billion earning about $320 million annually to spend on health care. He is disappointed that the trust fund was fleeting.
In a typical pattern, slowly at first state leaders began removing funds from the trust to fill budget holes. They agreed to the raid as long as there was a commitment to replenish the trust fund. Each year legislators and the governor balked at making the repayments, while at the same time removing more money to fill other holes. [LINK] Many states strip funds from their MSA account to cover budget imbalances for unrelated purposes, depending on the goals of the state legislature and governor.
Only 3 percent of all MSA dollars and other funds from tobacco taxes went toward the funding of state and local tobacco control programs. You can see a detailed history of the MSA payments by state [LINK]. The payments have been almost $8 billion per year for 24 years. The money spent on preventing tobacco use has been less than ½ of 1% of the total. [LINK]
INDUSTRY SHIFT
As cigarette sales decline, the tobacco industry has created alternatives to ‘deliver nicotine.’ The e-cigarettes have raised high school students’ use of tobacco to its highest level in 19 years. 31% of high school students and 13% of middle school students – 6+ million kids – use some type of tobacco product.[LINK] These ‘oral’ products have excise taxes, though not at the same level as cigarettes.
This chart shows the history of the many ‘stakeholders’ who received $755 billion dollars from tobacco sales during the 19 years 1998-2016. [LINK] During the last 5 of those years, payments remained in the $47 billion a year range, even as cigarettes sales declined. [LINK] And for the most recent 5 years payments were about the same annual level. The 20% decline in cigarette unit sales was offset by taxes on other tobacco products and much higher state excise taxes. [LINK] Even given a projection of continued reduction in cigarette sales, the next 25 years will probably bring the “stakeholders’ another $300 billion.
These numbers do not include profits for tobacco shareholders. The profits amount to only about 20% of the total cash generated by tobacco company sales. They also do not include the markup by retailers who buy the cigarettes from the tobacco manufacturers for resale to consumers, and the income tax generated by that profit.
The steady flow of money from tobacco is not lost on those who have benefited from it. Several state attorneys general are moving toward using the MSA as a model to tax vaping products. The health impacts of vaping are still being debated, along with the impact of smokers switching from traditional cigarettes to products with fewer health risks. But no matter the outcome from a health (or moral) viewpoint, these products are likely to experience much higher excise taxes. There is little reason to believe states will be any more responsible with money from a vaping settlement than they have been with their MSA funds.
Even after the tax burdens, tobacco companies are still profitable enough to spend more than $12 to market tobacco products for every $1 the states spend to reduce tobacco use. According to data from the Federal Trade Commission (2017), the major tobacco companies spend $9.4 billion a year – over $1 million each hour – on marketing.
FOLLOW THE MONEY
“The only thing more addictive than nicotine … is money to the legislatures of this nation” Christine Gregoire, the Washington State Attorney General, 2002
In any analysis, ‘Follow the Money’ is a good rule. What people say is not nearly so important as what they do. And it is clear that many, especially politicians, are addicted to the cash they get from tobacco. And tobacco products remain among the most profitable in the world. With this long history, and given that human nature changes little, the tobacco industry will not likely disappear in the foreseeable future. Users will want ‘nicotine delivery’ systems. The options will be a legal market that fills the coffers of government or a black market that will have few controls and many negative consequences.
Steve Goldstone, the attorney turned CEO for RJR, led the big four cigarette companies into the ‘peace talks” that resulted in the MSA. His question in 1998, while controversial, is still valid – How should smoking be controlled? “I finally saw that there wasn’t a chance in hell of any resolution to this problem in the near future… I know these guys love to put this in moral terms, but if they can’t convince Congress to ban this product, we (society) don’t have any choice but to sell it. There’s an interesting question you should ask the public health people. ‘What do you think smokers would do if they didn’t smoke?’ They get some pleasure from it, and they also get some other beneficial things, such as stress relief. Nobody knows what they’d turn to if they didn’t smoke. Who knows what the hell they’d do.” [See Goldstone at NY Security Analysts]
In a future post, we will explore what tobacco analysts believe the outcome will be, and what it means for tobacco stocks.
[i] The MSA covered 46 states. Florida, Minnesota, Mississippi, and Texas settled separately.
E cigarettes deliver much more nicotene than ordinary cigarettes!