Strategies To Exploit Uncertainty in Tobacco

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.
On the other hand, the anti-tobacco lobby is vociferous, and with the TPSAC being stacked in favor of individuals with anti-smoking positions, we view the status quo as a very unlikely outcome as well.
To exploit the uncertainty in the menthol category, we've outlined three investment strategies across multiple securities and risk thresholds:
Debt: Buy Lorillard bonds. The credit market appears to be pricing in a worse scenario than the equity market, even though we think a bankruptcy scenario is highly unlikely.
Equity: Wait for headline risk to provide an entry point. A negative TPSAC report could provide an attractive entry point to Lorillard's equity, which appears to be valued on a probability-weighted basis.
Paired equity trade: Buy Lorillard, sell Reynolds American (RAI
) stock. Lorillard's stock should rally harder in the absence of Draconian measures, while a short position in Reynolds should cushion the blow in the event of a ban because we think it will not be able to retain the majority of its revenue from Kool menthol cigarettes.