The Tobacco Products Scientific Advisory Committee, an advisory panel of the Food and Drug Administration, released its findings into menthol tobacco products on Friday. The panel concluded that menthol cigarettes have a negative impact on public health, but fell short of recommending a ban on the use of menthol. Our thesis that the FDA will not ban menthol remains intact, and we continue to expect a much more benign outcome, such as marketing restrictions. We are maintaining our fair value estimates for the tobacco manufacturers present on the US market, including Lorillard (LO), which has the greatest exposure to menthol.
We think a menthol ban is unlikely because if a black market were to emerge, the FDA would lose the ability to regulate the category. In addition, with menthol accounting for almost one third of the US cigarette market, government revenue would be significantly affected. If the TPSAC report had explicitly called for a ban, we may have revised this opinion because the FDA would have come under pressure to block menthol. However, we think the absence of any policy recommendations in the report eases the political pressure on the FDA and gives the regulator the flexibility to take a more lenient approach. We still expect some measures to be implemented, which could include restrictions on direct-mail marketing or even a reduction in the content level of menthol in tobacco products, but we still believe a ban is unlikely.
The market appears to agree with our thesis. Lorillard jumped 10% on Friday and is now trading very close to our $88 fair value estimate. We think there will be more upside to the stock if the FDA takes no action at all against menthol, but that is a low-probability outcome, in our opinion, and we think the market value fairly reflects a relatively low-impact outcome.
Philip Gorham, CFA is an equity analyst with Morningstar.
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