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Strategies To Exploit Uncertainty in Tobacco

Credit and equity investments to play amid scrutiny of the menthol category.

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After taking control of tobacco regulation in 2009, the U.S. Food and Drug Administration (FDA) is investigating the use of menthol in cigarettes. Its tobacco panel, the Tobacco Products Scientific Advisory Committee (TPSAC) is due to report its findings by March 23, 2011, and the FDA will issue a binding ruling after that. We envision three ultimate outcomes: menthol is banned (6% probability); no action is taken against menthol (16% probability); no ban, but tighter regulation (78% probability).

With a ban on menthol a potential outcome, investors have reason to harbor concerns about the future of  Lorillard (LO), the maker of Newport menthol cigarettes. However, based on our conversations with anti-smoking lobbyists, FDA officials, tobacco executives (including Altria (MO) CEO Mike Szymanczyk and Lorillard CFO David Taylor), and representatives of smokers' rights groups, we think a ban is unlikely for the following reasons: The scientific evidence being considered by TPSAC is ambiguous; A black market for menthol cigarettes could emerge, limiting the FDA's ability to oversee the category; Tax revenues for governments at all levels would be impacted; Eighty percent of African-American smokers consume menthol products, so this issue has a racial component.

Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.