Big Tobacco and Government Collude

As a menthol smoker, nothing got me more upset than that infuriating passage in the recent tobacco bill that explicitly gives the FDA authority to ban menthol. It’s so clear what’s going on, I can’t stand it.

I think Linda got most of it right the other day. This bill is definitely a test of strength for the government. And I even think the term “Nicotine Nazis” perfectly describes the group doing this. But, I think she missed one point…

It’s not all about governments suppressing its citizens… at least not in this case. The reasons behind this bill are twofold:

First, smoking bans and taxes have actually helped incumbents remain seated — no matter what the level of government. Therefore, a huge federal bill restricting it – “to save the children from those damn luring flavors” – is the obvious step for liberals looking to stay in power.

Second, and here’s where true greed takes over, it’s the tobacco industry itself. Why do you think the largest U.S. cigarette manufacturer supported this legislation? It helped write it!

I’ve been following the tobacco industry pretty close as of late… not just because I’m a 2-pack-a-day smoker, but because as the resident income guy, I know how these companies can be cash cows. Many kick off huge dividends. It’s bills like this that brought me to a tobacco play outside the U.S.

In that research, one thing became painfully obvious: the U.S. market is drying up. Apparently, and quite to my surprise, those ads are actually working. Just in the first quarter of this year, Philip Morris USA sold nearly 6 billion less cancer sticks than Q1’08. It even saw its enormous market share slip a few basis points.

You can say the same about its largest competitor RJ Reynolds. These two giants are in a lose-lose situation. They have to deal with a shrinking customer base and still battle with smaller competitors like Newport – my brand.

Newport, owned by Lorillard, is the country’s best selling menthol. The two big players were starting to lose to this small-time operation and they didn’t like it. This bill will give the FDA the power to both ban menthols AND stop new competition.

The FDA will have the authority to deny any new tobacco product that doesn’t “demonstrate health benefits to society as a whole.” What kind of tobacco product would “benefit society as a whole” according to the FDA. This is the same federal agency that picks and chooses which drugs should be sold in this country depending on which pharmaceutical company put the largest bribe in its pocket.

Even if you do get approval for a new product, you sure as hell can’t market it. The marketing restrictions in this bill are just as astounding.

Regardless of Linda and my rants, the bill did pass. Obama is signing it. It is law. Now what?

Well, I may be an income guy that’s long international tobacco, but I’m also a penny stock guy too. I like to gamble from time to time. Here’s an easy way to take advantage of the probable ban on menthol:

98% of Lorillard’s sales come from Newports [49.5% of all Newport sales were to blacks according to the 2005 National Survey on Drug Use and Health —ed]. That means, 98% of the company’s revenue will disappear overnight – the minute FDA Commissioner Margaret Hamburg decides to ban menthol cigarettes. Lorillard, which otherwise would be a great long opportunity, is now a perfect short play.

You can either do that, or pick up some put option contracts. It’s hard to say when the ban will come, but as a gambler, I’d say by the end of this year. The Lorillard January 2010 $60 puts (LTOML.X) look like one way to play it. Depending on where you stand, you can check out various contracts with different strike prices and expiration dates here

Most of these have very little volume. So, be careful. And if you are a smoker, my best advice is “smoke ‘em if you got ‘em!”

Jim Nelson

June 22, 2009

The Daily Reckoning