Why Tobacco Won't Quit

By Daren Fonda

They are pathetic, aren't they? Even on the harshest days, you can find them huddled in the doorways of every office building in America, sucking in those sweet and deadly toxins. What do you say to people who engage in this relentless act of self-destruction?

Thank you--that is, if you're a tobacco company or an investor in one. Two years after absorbing what was supposed to be a death blow, the industry seems once again as healthy as a vegan marathoner. And last week it got an unexpected pick-me-up from the Bush Justice Department. The DOJ said it may be willing to settle a Clinton-era suit seeking to recoup more than $20 billion in health-care costs. The feds essentially admitted that their case is weak, a view not shared by outraged antismoking advocates, who see the shift as a gift to the industry, which contributed $7 million to the Republican Party.

Not that Big Tobacco needed the generosity. Consider the fortunes of global leader Philip Morris. The firm was the Dow's best performer last year, rising 91% in a turgid market. Tobacco profits, buoyed by strong domestic growth, reached a record $10.6 billion. No. 2 R.J. Reynolds Tobacco and No. 3 British American Tobacco also saw their sales and profits reach new heights.

To appreciate the industry's alluring economics, consider that 90 small, privately held companies have started up to exploit the low-price market; a few years ago, only 10 such firms existed. "The stars are aligned for tobacco stocks," says Bonnie Herzog, a tobacco analyst with Credit Suisse First Boston. "Everything is working in their favor."

It wasn't supposed to be this way. Starting in the mid-'90s, tobacco makers suffered a string of setbacks, culminating in 1998 when the four largest firms settled with 46 states for $206 billion (over 25 years) to help pay for smoking-related illnesses. Big Tobacco agreed to curb advertising, stop marketing to minors (no more Joe Camel) and fund a national antismoking group to police their practices. In 1999 the Clinton Administration filed its suit. More recently, Philip Morris was assessed $3 billion in damages to a single smoker in California. Throw in price increases of more than 60% that had begun to cut demand, and domestic tobacco seemed doomed.

Today it is clear that none of these threats are terminal. "We put out well-crafted p.r.," says Edward Sweda, a senior attorney with the Tobacco Control Resource Center at Northeastern University. "But the companies are engaged in business as usual."

For starters, Washington is a friendlier town. Attorney General John Ashcroft opposed the Clinton suit when he was a Senator and shows little zeal for prosecuting the industry further. Another round of federal excise taxes, championed by Clinton, is not in the offing. To pre-empt harsher regulations and win protection against future lawsuits, Philip Morris is even asking Congress to grant the FDA limited oversight. Such longtime foes as Illinois Senator Dick Durbin are nonplussed. "It's laughable," he says, referring to the DOJ's settlement talks. "In a real negotiation, they could have included [FDA] regulation with teeth. Now they'll be lucky to get anything."

As for the states that led the fight against tobacco, they have become addicted to money tied to future profits from the 1998 settlement, giving them a paradoxical incentive to keep the industry healthy. "States don't have an interest in criticizing [tobacco companies]," says Morgan Stanley Dean Witter analyst David Adelman. Tobacco-loving Virginia is subsidizing research into less-cancerous smokes. The state gave $2 million to tobacco maker Star Scientific to develop a cleaner cigarette.

While the states are mainly done litigating, about 1,500 lawsuits are still pending against the industry. Philip Morris is appealing the verdict in California, where the industry seems most vulnerable. Plaintiffs have won three other suits there, although they have yet to see a dime. Tobacco's record in such cases is near perfect: it wasn't until last March, after 40 years of trying, that a plaintiff collected money, and that case is being appealed to the U.S. Supreme Court.

The bigger threat, from class actions, may also be lifting. A Miami-Dade judge recently dismissed a suit brought by Ecuador; a federal appellate court in Washington ruled against Guatemala, Nicaragua and Ukraine. In April, a Miami jury rejected a former flight attendant's bid to recoup damages for illness from secondhand smoke; that does not bode well for the 3,200 other flight attendants, each of whom must go to trial to win such damages under a $349 million settlement.

And remember that $145 billion award of punitive damages against the industry last July in Florida? Investors don't. Analysts predict that the case won't withstand appeals, which could span decades if every smoker has to prove his claim individually. Even the state of Florida, which will collect at least $11 billion from its settlement, now thinks tobacco stocks are a sound investment again; after a four-year ban, it plans to start buying shares for its $99 billion pension fund.

As a profit machine, cigarettes are proving as resilient as ever. While the average price per pack has rocketed to $2.95 from $1.74 in 1997, consumption declined just 2% last year. That is no more than the average falloff of much of the past two decades. Addicted smokers simply paid up. R.J. Reynolds reported a 27% rise in net income, to $100 million, in this year's first quarter; Philip Morris logged a 7.7% increase in income, to $1.2 billion, from tobacco sales. Throughout Eastern Europe and Asia, revenues are also rising. And China's 350 million smokers remain the ultimate replacement market.

Profitability is so great that the industry is luring new players. Such upstarts as Alliance Tobacco and CigTec have a competitive advantage: with the big companies saddling consumers with settlement costs of as much as 58[cents] a pack, the independents have been able to price their smokes, like GT One and CT Light, more aggressively. They have focused on the so-called discount segment, and boosted their share of the $12.6 billion retail market for cheap butts from 4% in 1997 to 14%, says analyst Rob Campagnino of Prudential Securities. Sales of Commonwealth Brands, the top private discounter, rose 66%, to $800 million, last year. The company, based in Bowling Green, Ky., barely registered a presence a few years ago.

Tobacco's critics argue that the industry's surge is illusory. Teen smoking is declining as much as 15% a year in states with comprehensive prevention campaigns, says Matthew Myers, president of the Campaign for Tobacco-Free Kids. Rising state taxes will reduce some demand. And while it could be years before any class action survives appeal, it may take only one to crush the industry.

Richard Daynard, head of Northeastern's Tobacco Control Resource Center, agrees that the antismoking campaigns have not made a big difference. "But they make a modest difference," he says. "If you have a 10% drop in people dying from smoking, that's 45,000 fewer deaths per year; that still leaves 90% of deaths on schedule." And paying the tobacco industry handsomely before they go.