Banking & Capital Markets

Lawyers’ Poker

The fight over tobacco leaves CFOs on the sidelines.
Russ BanhamJuly 1, 1998

Avid skier Luc Jobin knows what it’s like to hurtle down slopes not knowing what lies ahead. The recently appointed CFO of Imperial Tobacco Ltd. certainly can use this experience in his new job–managing the finances of a company whose terrain is fraught with hidden dangers.

Jobin actually is better off than most other tobacco CFOs. He works for a company that manufactures and sells cigarettes in Canada, where at least the legal climate is more temperate than in the United States. “My concerns, while large, are extremely benign compared to the CFOs of RJR Nabisco or Philip Morris,” says Jobin from the Montreal headquarters of $3 billion (Canadian) Imperial, the 85-year-old manufacturer of Player’s and du Maurier cigarettes.

“The level of litigation here is nowhere near what it is in the United States,” he continues. “Canadians are typically a lot less litigious, and our punitive damages are very different in magnitude. We’re also not facing the U.S. Congress.” Jobin is referring to the now-defunct Senate bill sponsored by Sen. John McCain (R­Ariz.) that would have increased the price of cigarettes by $1.10 a pack, required the industry to pay $516 billion over 25 years, and increased the authority of the Food and Drug Administration to regulate nicotine products. (At press time, the Senate sent the bill back to its Commerce Committee– effectively killing it–in the wake of a $40 million advertising blitz by the tobacco industry. Meanwhile, the House of Representatives was preparing its own, narrower version of tobacco legislation.) “These are unbelievable numbers,” Jobin says.

He’s right. Between the tax hikes and the lawsuits–cigarette manufacturers are currently the target of numerous class-action suits as well as an array of suits brought by 36 state attorneys general–the U.S. tobacco industry is facing some very negative numbers. Last year, for example, Philip Morris Co. took charges of almost $1.5 billion for tobacco settlements in Mississippi, Florida, and Texas. In June, Brown & Williamson Tobacco was hit with a $1 million settlement in a Florida case that included $450,000 in punitive damages–the first time a jury in a tobacco case has awarded such a penalty. And if the McCain bill had passed intact, according to some analysts, industry earnings would have declined 20 percent one year after the legislation took effect and 35 percent by the fifth year.

The CFOs, however, have been relatively silent. The finance chiefs at each of the five major tobacco companies–Philip Morris, RJR Nabisco Holdings, Brown & Williamson, Lorillard Tobacco, and Liggett Group–refused to be interviewed on the matter. “My management does not want any reference to our company in the press at this time,” says Jeff Kushner, who was CFO at Lorillard Tobacco Co. until last month. “I wish you got me in my last job as the CFO of a hardware company. I’m in an industry now that has more lawyers than I’m used to.”

Steven F. Marascia, a tobacco analyst at Richmond, Virginia-based Branch Cabell & Co., is not surprised at the finance executives’ reticence. “It’s like asking Eisenhower how he’s going to fight World War II and the war has only just begun,” he says. “CFOs can’t spell out a contingency plan when there are so many battles to be fought. We’re talking unprecedented uncertainty at a sustained high level. This is not your average CFO dilemma.”

Burning Up

In fact, there is nothing average about the current situation. “Maybe if you go back to what the liquor and beer companies experienced prior to Prohibition, you might find some similarities,” suggests Marascia. But, he adds, “In recent history, we haven’t seen anything of this nature.”

For finance chiefs, this environment is distinguished by two major characteristics: the uncertainty of future costs and the legal handcuffs on any financial engineering. “Part of the problem facing these CFOs is that the lawyers won’t let them extract any value,” says analyst Gary Black of Sanford C. Bernstein & Co. In addition, the level of uncertainty regarding the final tally for legal damages makes effective strategic planning almost impossible. “There’s no telling what that amount will be,” says Marascia.

Tobacco finance chiefs did have a brief flirtation with certainty in June 1997. At that time, a landmark $368.5 billion deal was struck with several states that gave manufacturers sweeping legal protections in exchange for marketing and regulatory concessions. Economists concluded that cigarette makers would need to raise the price of a pack by only 62 cents on average to cover the settlement’s costs. Moreover, no one could file a class action against the industry or seek punitive damages. And the firms would never be required to pay more than $5 billion in damages in a given year. Public outrage, however, squelched that agreement and led to the more restrictive McCain bill with its much higher $6.5 billion liability cap and absence of protection against class-action suits.

Without a Federal law, however, tobacco companies find themselves without a settlement and with renewed uncertainty. States and individuals are expected to press ahead with their lawsuits buttressed by the numerous damaging documents that companies previously disclosed as part of the settlement process. And President Clinton has promised to make the failed tobacco legislation a campaign issue this fall–a move that could eliminate some of the legislative allies the industry still has.

At Their Disposal

Overall, however, the tobacco industry isn’t quite in ashes yet. Although it “pretty much missed the bull market of the ’90s,” as Brian Harker, CFO of Dimon Inc., a Danville, Virginia-based tobacco processor, puts it, the current level of income at the companies remains very attractive. Philip Morris’s first- quarter operating income for its domestic tobacco business (excluding settlement costs), for example, increased 4.7 percent, to $1.1 billion, and its international tobacco operating income rose 11.3 percent in the same period, to $1.4 billion. And even smokeless tobacco manufacturer UST Inc. registered first- quarter net earnings up 11 percent, to $112 million.

Tobacco companies also have an enviable weapon at their disposal if future legislation or negative public sentiment decreases consumption. As one of the few price- insensitive industries, they can always generate cash quickly by raising prices–an action taken twice this year already. “With 24 billion packs sold annually, a 5 cent increase is a tidy $1.2 billion,” notes Jay Nelson, a tobacco analyst at Brown Brothers Harriman & Co. Such action only makes sense, says Imperial’s Jobin. “You really can’t reserve for the enormous potential costs the U.S. industry faces,” he says. “Were we facing the same issues to the same degree in Canada, our position would be to build the cost into the price of the product.”

Still, as far as any aggressive action is concerned, finance can do little. “It doesn’t take a brain surgeon to figure out what CFOs must do: encourage price increases and run a tight ship,” says Nelson. “You don’t buy back the stock, you don’t raise the dividend, and you restrict costs wherever possible.” Adds Marascia: “CFOs can’t do anything like spin off parts of the business. They just don’t have that luxury.” And they can’t do anything that will call attention to how well they are doing, says Black, such as producing earnings surprises that help drive up stock price. “They definitely don’t want to let on that things are going well,” he says. “If they do, most likely they’ll be slapped with a tougher settlement.”

Old Standbys

Tobacco CFOs have already taken many of the steps available to them. One, of course, is to take out the hatchets. RJR Nabisco’s ongoing restructuring, for example, which included nearly 3,000 layoffs last year, is expected to yield approximately $155 million in annual savings beginning in the year 2000. Philip Morris closed several facilities for an estimated annual pre-tax savings of $630 million by the same year. And the company recently extended early-retirement incentive packages to some of its older employees for a pretax savings of $290 million.

Tobacco companies have also been actively selling off low-margin subsidiaries and brands. In recent years, Philip Morris sold its Brazilian ice cream business, along with its flagship Kibon brand, its Lender’s line of bagels, Kraft’s Entenmann’s cakes, and some real estate. The company reported $877 million in gains just from the sale of its ice cream and real estate businesses last year. In addition, companies have been shifting their marketing focus to foreign sales. Last year, more than half of Philip Morris’s total tobacco sales came from overseas. “Companies have been successful opening new markets in the Far East, Eastern Europe, India, and Africa,” says Jack Kasprzak, an analyst with Richmond, Virginia-based brokerage Scott & Stringfellow.

Of course, it’s possible that the most effective CFO contributions to the tobacco industry happened several years ago. Former Philip Morris CFO Hans G. Storr, for example, was the force behind the financing of its $25 billion acquisition of Kraft Foods and other food companies at rates of less than 10 percent in the late 1980s and early 1990s. These profitable nontobacco assets could prove helpful in absorbing any future settlement costs. Both RJR Nabisco’s and Philip Morris’s food brands constitute a veritable supermarket of products, including Kraft foods, Miller beer, Jell-O gelatin, Oscar Mayer hot dogs, Oreo cookies, and Ritz crackers. Lorillard’s parent, Loews Corp., owns a profitable chain of theaters, and Brown & Williamson’s parent, BAT Industries, owns insurance companies.

The current crop of tobacco CFOs, however, must simply remain conservative and flexible. Says Marc Cohen, a tobacco analyst with Goldman, Sachs & Co., “They should not overextend the company in terms of buying shares or doing things from an acquisition standpoint,” he says. “Philip Morris’s Hans Storr always recognized that it was critical for the company to guard its credit rating.” In addition, says Imperial Tobacco CFO Jobin, a tobacco company’s investments must be positioned so they can be drawn on quickly in the event of need. “That’s what we’ve done here, so if conditions shift, we have flexibility,” says Jobin.

Fight to the Death

Even though the tobacco industry won the battle by killing the McCain bill (Democrats vowed to attach it to other legislation in hopes of resurrecting it), tobacco CFOs might eventually regret that victory. That’s because having the certainty of a settlement would have allowed them to be much more aggressive in creating shareholder value, say industry observers. Kasprzak, for example, says that in a post-settlement environment, tobacco chiefs could have thought about spinning off their tobacco enterprises altogether–as long as regulators didn’t view such action as a so- called fraudulent conveyance. “Separating would enhance the value of the food companies,” he says. “If they’re [ever] allowed to do it, I think it will happen.” And Black says that many of the companies would finally have been comfortable taking on the debt they should have taken on years ago. “It’s a crime,” he says, “that the UST balance sheet carries no debt.”

A post-settlement environment might have led to some turnover in the chief financial officer posts, says Black, since it would have required a different skill set to lead the companies into the future. But it would have also given relatively new CFOs, such as Louis C. Camilleri at Philip Morris and David B. Rickard at RJR Nabisco, an opportunity to become better business partners, adds Black. Already at RJR, the finance department has laid the foundation for such a future with a strategic plan called Finance 2000, which contains some 70 initiatives and outlines how finance can contribute value to the overall company.

Could CFOs have done anything to steer the tobacco industry away from the quicksand in which it now finds itself? Given the companies’ alleged intent to subvert the truth about nicotine, CFOs “would have needed an awfully strong backbone to stand up to the weight [of internal policy],” says Peter Crist, president of Crist Partners, a Chicago- based, senior-level executive search firm. “No magical tinkering with the balance sheet could have corrected this.” But Black says CFOs could have been more persuasive about their companies’ need to “empty the drawers” before going into settlement negotiations with the government. “You don’t want to negotiate with Congress when you have $2 billion in cash like Philip Morris, $90 billion in equity, and $11 billion in debt,” he says.

For Luc Jobin, who has been a tobacco finance chief only since mid-March, the perils faced by his counterparts in the United States offer valuable lessons. “Trying to maintain the profitability of the organization while dealing with the uncertainty of revenues and costs certainly makes it more challenging,” he says. “I don’t want to put down anyone who was a CFO in the past, but what’s going on in the U.S. tests the very fabric of this profession.”

———————————————– ——————————— Supply-Side Strangulation
It’s tough enough to be the cfo of a tobacco company in the current environment. It’s worse to handle the finances of a supply company that depends entirely on the tobacco industry. “We’re captive to whatever happens to our major customer, and our major customer is the cigarette industry,” says Paul Roberts, CFO and treasurer of Schweitzer-Mauduit International Inc., a $460 million producer of cigarette paper. Since the announcement of the now-defunct McCain bill, Schweitzer-Mauduit’s stock price has plunged from $44 per share last summer to $33 in May.

Dimon Inc., a Danville, Virginia-based tobacco processor, also has inherited its customers’ financial woes. “Our stock price has fallen from $24 in January to about $14 today,” says Brian Harker, the company’s CFO and executive vice president. “We have cautioned the markets that there is so much uncertainty right now we cannot possibly have an outlook of growth. And the reality is that there is very little we can do.”

John Kasprzak, an analyst with Richmond, Virginia-based brokerage Scott & Stringfellow, says suppliers are doing their best to weather the storm. “They’re trying not to extend themselves, and are looking for growth opportunities overseas that don’t take up a lot of cash and where the earnings value can be realized in the fairly near term,” he says. Schweitzer-Mauduit, for example, made two acquisitions this year. In February it bought Ingefico SA, a small French tobacco paper manufacturer with $35 million in annual sales. The same month, it acquired Campanhia Industrial de Papel Pirahy, a Brazilian paper supplier with $75 million in annual sales.

Dimon has been less active on the acquisition front, but it is looking to sell its small cut- flower business. “We’re looking at what makes the most sense in terms of maximizing shareholder value,” Harker says. “Fortunately, flowers are not under intense government and judicial scrutiny.”