Two draft chapters of the upcoming report into the use of menthol by the Tobacco Products Scientific Advisory Committee (TPSAC) point to a relatively benign outcome to the Food and Drug Administration's (FDA) investigation into menthol. We continue to expect measures to be taken against the menthol category that will not have a material impact on equity valuations. Our fair value estimates for the industry remain in place. We think the industry is fairly valued at present, but Lorillard, LO which stands to be most impacted by the outcome of the FDA review, still offers around 15% upside, even if the FDA imposes some restrictions.
TPSAC's draft chapters showed that the panel will advise the FDA that "the evidence is insufficient" to conclude that smokers of menthol cigarettes face a higher risk of smoking-induced disease than smokers of nonmenthol products. However, the panel found that the addition of menthol may make smoking more addictive. This leaves the door open for the FDA to reduce the levels of menthol used in tobacco (or even the levels of nicotine, the addictive substance in cigarettes) in an attempt to make cessation easier for smokers. However, we doubt that a ban will be implemented without conclusive evidence that the addition of menthol increases the health risk of smokers, and the evidence from the published chapters appears to point to less Draconian measures. Given the size of the $25 billion menthol category, a ban would lead to a black market, in our opinion, an outcome the FDA will be willing to avoid because it would loosen the agency's grip on industry regulation.
The disclosed chapters form only part of TPSAC's investigation. The full report will reveal the panel's findings as to the role of menthol in the commencement of smoking, as well as cessation, and whether tobacco manufacturers have targeted menthol products at certain demographic groups. These factors will have an impact both on TPSAC's recommendation and the FDA's ultimate decision. However, we think that the disclosed chapters drop a strong hint that a ban will not be implemented, and we have further confidence in our thesis that the ultimate outcome will be relatively benign. With that in mind, we think the stock still offers around 15% upside, despite the modest bounce following the release of the chapters, but with a high degree of uncertainty surrounding the eventual outcome, we recommend investors look for alternative strategies to exploit the situation. For example, Lorillards's 6.875% 2020 senior notes traded up 1.5 points as the spread tightened 20-25 basis points on the news to +290. As we have highlighted in our monthly Credit Best Ideas, we expect the bonds could tighten to +200 as the credit market gains confidence that the outcome to the firm's credit risk will be relatively benign over the long term. Assuming the credit spread reaches our target, we believe the bonds continue to have another 5 points of upside appreciation potential.
