QUALIPORT
Tobacco: Is It Worth The Litigation Risk?

By Maynard Paton (TMFMayn)
August 20, 2001

Rochester, Kent – Tobacco shares always look cheap. While cigarette companies have a steady demand for their products, brand loyal customers and great free cash flow characteristics, you'll rarely see their shares on a price to earnings (P/E) ratio above 15.

Although the regulatory measures trying to reduce the general sale and advertising of tobacco don't help, the low ratings are mostly due to the long-standing threat of enormous litigation payouts.

So, do the enticing business characteristics of tobacco companies offset the risk of large legal bills? I think so, although you have to be selective with your tobacco pick.

Class action

When reviewing the UK tobacco sector for the Qualiport, I dismissed British American Tobacco (LSE: BATS) because of its heavy exposure to the litigious US market. It's very important to note that the other two UK players, Qualiport watch list member Imperial Tobacco (LSE: IMT) and its main domestic rival, Gallaher (LSE: GLH), have no exposure to either the US market or US courtrooms.

However, that's not to say Imperial and Gallaher don't have any legal battles. Both companies have faced, and will continue to face, numerous claims for smoking-related damages in the UK. But so far at least, neither firm has paid out a penny in compensation.

But it's a different story in the US. Perhaps the most celebrated case in the States is the Engle class action, as it's only the tobacco class action case that has ever proceeded to trial. After seven years of courtroom arguments, April 2000 finally saw a collection of US tobacco firms pay compensatory damages totalling $13m to three Florida smokers. To put that amount into perspective, US tobacco giant Philip Morris (NYSE: MO) earned post-tax profits of $8.5b last year alone.

However, what grabbed the headlines was the Engle jury's $145b worth of "punitive" damages (i.e. costs levied to simply punish the accused). But as Philip Morris explains, none of that $145b will be paid out until every claimant (that is, just about every other Florida smoker) has had an individual trial, a process that could take decades. In the meantime, with appeals and retrials in the offing, the case drags on.

Big question

The big question then is whether UK tobacco investors will see hefty damages against Imperial or Gallaher in the future? My answer would be "probably not". Some points to consider:

* Although the trend of seeking legal damages is increasing (e.g. the recent introduction of the Access to Justice Act), UK courts are far more conservative in deciding levels of compensation than their US equivalents. Furthermore, English law prohibits the awarding of the "punitive" damages that make all the headlines in the US.

* Apart from the claimant and the lawyers, it's not in anybody's interest to see the tobacco industry crippled by legal bills. Certainly the government would lose out – Imperial and Gallaher combine to generate £8b a year in duty for the Treasury. And those who enjoy smoking would find life difficult too – who would risk selling their cigarettes in the UK if Imperial or Gallaher were taken for everything they had?

* There number of potential claimants is dwindling. These days, it would be difficult to prove you didn't know about the dangers of smoking. As time goes on, so the general level of possible payouts diminishes.

Valuation

All that said, the risk of costly courtroom payouts still exists. And while I may be more doubtful of the risks than others, it will undoubtedly take a long time before any final verdict on the UK players is reached. In the meantime then, how does an investor factor in the legal risks and all the other general negativity placed upon the industry?

A somewhat simplistic way would be to review what the stock market has done in the past. Since its 1997 spin-off from Hanson (LSE: HNS), Imperial Tobacco has averaged a prospective free cash flow yield of 9.5% and a prospective dividend yield of 4.8%. Using those average valuations and current forecasts, a suitable Imperial share price for today would be in the low 700s. That feels about right, especially when considering the favour accorded to "defensive" shares at the moment (Imperial's share price is currently 834p).

And finally, while prominent in the tobacco industry, those investors who feel impending litigation could be harmful to their wealth should bear in mind recent comments from BAT: "Losing an individual case from time to time is simply a cost of doing business in the US, and a cost, moreover, that is by no means unique to tobacco companies."

A casual glance at the Financial Times over the past few days revealed three different types of companies all expecting large claims for compensation. Ford (NYSE: F) is in trouble over exploding tyres, Bayer is in the firing line concerning difficulties with an anti-cholesterol drug, while Morgan Stanley Dean Witter (NYSE: MWD) faces up to its allegedly dubious stock tips. And even selling portable escape ladders can bring multi-million dollar lawsuits too, as this morning's news from Kidde (LSE: KID) shows.

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