Menthol Ban Would Hasten Volume Decline

Photo: Валерий Моисеев

The U.S. Food and Drug Administration’s plan to ban menthol cigarettes and flavored cigars is credit negative for the tobacco industry and settlement asset-backed securities because, if enacted, the initiatives would accelerate cigarette volume declines and hurt profitability, according to Moody’s Investor Service.

Tobacco companies that sell menthol cigarettes in the U.S. market would be negatively affected, although some existing smokers will likely migrate to nonmenthol cigarettes, thus limiting the negative impact of such measures on consumption.

Given their strong financial metrics, tobacco companies would likely be able to absorb any decline in performance without a major deterioration in their credit metrics. Approximately 29 percent of cigarette sales in the U.S. are menthol flavored per Euromonitor.

On April 29, the FDA said that it would work toward developing a regulation banning menthol cigarettes and flavored cigars within the next year. Moody’s expects tobacco companies would seek to strike down such a ban through the courts, so implementation could be years away. Any ban would need to be science-based or it would not withstand judicial review.

The investor service estimates that U.S. cigarette volumes will decline between 3 percent and 5 percent over the next three years to five years excluding a menthol ban. However, it believes a menthol ban would likely accelerate that rate of decline to the low double-digit level. “We expect tobacco companies would be able to take pricing actions to initially offset this decline, but their ability to do so would diminish over time as cigarettes become less affordable,” Moody’s wrote in a note to investors.

“We believe that banning menthol cigarettes, which represent around 29 percent of U.S. cigarette sales by volume, would also likely increase illicit trade, resulting in a loss of revenue for legal manufacturers as well as a loss of tax revenue for federal, state and local governments.”

Among the companies with the most exposure are British American Tobacco (BAT) and Altria Group, according to Moody’s. Through its subsidiary, Reynolds American Inc., BAT generates approximately 20 percent to 25 percent of its operating profits from menthol cigarettes. Altria Group Inc. generates approximately 20 percent of its sales from menthol cigarettes.

Given their strong financial metrics, tobacco companies would likely be able to absorb any decline in performance without a major deterioration in their credit metrics.

Moody's Investor Service

BAT relies on the U.S. for about 45 percent of its operating profits, of which underlying menthol cigarette volumes account for around 50 percent. Moody’s estimates that Imperial Brands generates around 10 percent of its operating profits from sales of menthol cigarettes, based on a U.S. contribution to total profit of around 25 percent, of which underlying menthol cigarette volume accounts for 45 percent. Like Altria, BAT has alternative products, too, in the U.S. market, such as oral tobacco and vaping products, which could at least partly offer alternatives to menthol smokers.

Altria would be impacted by a menthol ban given its large market share; however, several factors would mitigate this impact. Altria offers a suite of noncombustible alternative products, such as e-cigarettes (through its 35 percent investment in Juul) and oral tobacco, that smokers could potentially convert to should a menthol ban be implemented. Altria also sells the IQOS heat-not-burn device in the U.S. under a licensing agreement with Philip Morris International (PMI). The FDA has authorized IQOS as a modified-risk tobacco product, and IQOS could gain new users if menthol products are banned.

Finally, Altria has strong financial metrics and could potentially shift its financial policy to offset a decline in operating performance, including decreasing its dividend payout or share repurchase activity.

PMI has no direct exposure to the U.S. cigarette market and would not be negatively impacted by this ban, according to Moody’s.

The FDA stated that it intends to start the process for advancing two tobacco product standards for menthol in cigarettes and all flavors in cigars with the aim to ban these products. The agency specifically seeks to reduce the number of new smokers, increase the likelihood that existing menthol smokers quit smoking and address health disparities among minority communities, where the FDA says usage of flavored cigarettes is high.

We believe that banning menthol cigarettes, which represent around 29 percent of U.S. cigarette sales by volume, would also likely increase illicit trade, resulting in a loss of revenue for legal manufacturers as well as a loss of tax revenue for federal, state and local governments.

Moody's Investor Service

Tobacco companies believe that the published science so far has not supported regulating menthol cigarettes differently from nonmenthol and that scientific evidence does not show a difference in health risks between menthol and nonmenthol cigarettes. The companies say that scientific evidence does not support that menthol cigarettes adversely affect initiation, dependence or cessation.

Other markets have imposed similar bans, including Canada in 2017 and the European Union in 2020. Although the impact of such bans on overall cigarette consumption is still being evaluated, the rate of decline in the overall cigarette volumes sold by tobacco companies has not significantly changed so far.

A ban on menthol cigarettes in the U.S. would also be credit negative for long-dated tobacco settlement bonds backed by the 1998 Master Settlement Agreement (MSA) payments. The performance of those ABS directly depends on annual U.S. cigarette volumes, and an accelerated volume decline will materially lower revenue to the bonds. Certain alternative tobacco products, such as the heated-tobacco units used with IQOS2, are included under the MSA as part of revenue to the ABS. But these alternative products are currently in their infancy in the U.S., and their sales will not offset the material decline in revenue should the FDA implement its menthol cigarette ban, according to Moody’s.