The US Surgeon General released a report last Thursday warning that cigarette smoke causes immediate damage to smokers' lungs and DNA, even in small amounts and from secondhand smoke. However, we do not think the report's findings will have a material impact on consumption patterns in the United States, and we are maintaining our fair value estimates for the tobacco manufacturers.
The report also accused manufacturers such as US-based Altria (MO), Reynolds American (RAI), Lorillard (LO) and UK-based British American Tobacco (BATS) and Imperial Tobacco (IMT) of deliberately making cigarettes more addictive through the use of nicotine in their products. While this report goes slightly further than previous surgeon general reports in pointing the finger at the motives of manufacturers, and it is explicit about the impact on human DNA, the negative effect of smoking on public health has been widely known for decades. A predecessor of the current surgeon general acknowledged the link between smoking and cancer in 1964, an announcement that triggered a long-term decline in demand. Almost half a century later, we think the impact of further reminders about the dangers of smoking has diminished significantly. While Thursday's report is likely to persuade small numbers of smokers to quit, we do not expect a material impact on volume.
We have analysed the effect of numerous variables on cigarette demand, and we think the most effective tool for reducing consumption is pricing. We would be more concerned about large excise tax increases than we are about this announcement. Nevertheless, the announcement is a reminder that regulators and public health officials are likely to clamp down further on the tobacco industry in the medium term, and with most tobacco firms currently trading slightly above our fair value estimates, we think the market may be underestimating the industry's risks.
