Upstart brands hurt Big Tobacco

Jan. 4, 2004
The News & Observer
By Pat Stith, staff writer
Copyright 2004 The News & Observer Publishing Company.

KEYSVILLE, VA.--Mac L. Bailey's cigarette manufacturing plant, a one-story building longer than two football fields laid end to end, looks out of place next to a country road in the middle of nowhere. But for two 10-hour shifts a day, four days a week, this plant hums, making up to 20,000 cigarettes a minute.

Compared with Philip Morris USA and R.J. Reynolds Tobacco Co., the giants of the cigarette industry, S&M Brands is tiny, selling in only eight states. But there are dozens of companies like S&M, and they're growing, taking customers away from the cigarette goliaths and their world-famous brands. As sales of those brands go down, so do the annual payments Big Tobacco agreed to make to the states as part of a settlement five years ago.

Bailey, a fifth-generation tobacco farmer, started his cigarette business 10 years ago. In the first week, the company sold 27 cartons. Now he employs 215 people -- and he's selling a million cartons a month.

There are 30 other little companies like S&M selling cigarettes in North Carolina, some carrying edgy brand names such as "Grim Reaper" and "Bull Snit." Some, such as Alternative Brands in Mocksville, manufacture cigarettes. Others, such as Birdtown Enterprises in Cherokee, import them. Birdtown buys cigarettes made in Brazil so cheaply that they retail here for as little as $1 a pack, about $2 less than the big companies' premium brands.

Across the United States, there are hundreds of other little cigarette companies like these. In four years, their market share has multiplied more than tenfold, from 0.5 percent of cigarettes sold in the United States in 1998 to 6.5 percent in 2002, according to the National Association of Attorneys General, which says the numbers for 2003 will be more startling.

Their growth, driven primarily by low prices, is causing consternation not only in Big Tobacco boardrooms but also in state capitals, because it is eroding multibillion-dollar payments the states won as part of a historic settlement with the industry in late 1998.

Two factors growing out of that settlement threaten to reshape the cigarette industry:

* The big companies more than doubled the wholesale price of cigarettes, generating far more income than they needed to pay for the settlement. Those price increases, combined with massive increases in state and federal cigarette excise taxes, created sticker shock -- and an opening for small cigarette manufacturers and importers. Imports have increased 700 percent since prices started going up in 1997.

* Lawyers representing the tobacco companies and the states left a loophole in the agreement that allows companies that didn't join the settlement to get back most of the money they pay into escrow funds. Those funds were required to allow the states to collect if they ever sued and won -- and to force the little companies to charge more for their cigarettes. The big tobacco companies and attorneys general across the country are now working feverishly to close the loophole with new legislation.

A. Blake Brown, a professor of agricultural economics at N.C. State University, said as the barriers to competition fall and state attorneys are unable to stop the growth of the importers and startup companies, the Big Four may be unable to pass along the cost of the settlement to consumers.

"In my view, it could change the entire industry," he said.

States want to help

The reason for the push for legislation: money.

Gov. Mike Easley says the states and Big Tobacco need each other. Billions of dollars are on the line for both.

Philip Morris, RJR, Brown & Williamson Tobacco Corp., and Lorillard Tobacco Co., the four biggest cigarette manufacturers in the United States, agreed in 1998 to a record-busting settlement of all current and future state claims against them. Numerous states had sued the cigarette giants to recover money the states spent caring for Medicaid patients with smoking-related illnesses.

In a deal negotiated by the states' attorneys general, the Big Four agreed to pay North Carolina and 45 other states an estimated $195.9 billion by 2025, and billions more after that in perpetuity.

Those settlement payments, however, are not guaranteed. They are tied to cigarette consumption and to the Big Four's market share. If those go down, the payments go down.

The deal was crafted to help suppress the big companies' competition. In effect, the agreement made the states partners with the Big Four in protecting their market share, which at the time was 96.4 percent, according to the attorneys general.

The settlement agreement required the states to enact legislation that "effectively and fully neutralizes the cost disadvantages" facing the Big Four and other cigarette manufacturers who joined the agreement.

A state that failed to pass the legislation -- or failed to enforce it -- would be penalized, as North Carolina soon learned. North Carolina lost $1,388,336 for being 19 days late getting the "model" legislation ratified and signed into law in July 1999, according to the N.C. Attorney General's Office.

State attorneys general have filed several hundred lawsuits against cigarette companies that did not comply with the "model" legislation. The settlement also created a $50 million war chest for the attorneys general, paid for by the major tobacco companies.

All cigarette companies were invited to join the agreement. About 40 have joined; hundreds of others have not. Those that joined right away didn't have to pay anything unless they substantially increased their market share. They would also be immune from future lawsuits by the states. Those companies had 3 percent of the market in 1998.

Mac Bailey's S&M fell into a third category of companies -- they had 0.5 percent of the market in 1998 -- that chose not to join the settlement. These companies can be sued by the states, and they are also required to put a set amount per carton -- about $3.06 in 2002 -- into an escrow fund to pay future judgments. After 25 years, if the money hasn't been lost in court fights, they will get it back.

Companies that made this choice could grow without penalty.

But a piece of the settlement is causing problems for the major tobacco companies and the states. Companies that didn't join the agreement can legally get back most of the money they place in escrow right away, sometimes within a week, as long as they are only doing business in a few states.

That provision was a mistake, according to Mark E. Greenwold, chief counsel for tobacco for the attorneys general.

"The desire was to create a situation where it would not be punitive to companies that stayed out of the agreement but at the same time would not give them an advantage over companies that came into the agreement," he said.

The intent was to require companies that stayed out -- and thus were free to increase their market share -- to make essentially the same payment per cigarette into escrow accounts as the Big Four made to the states. But the way the law works, the fewer states in which a nonparticipating company markets cigarettes, the less it is required to leave in escrow.

If a company sold cigarettes only in North Carolina and Virginia, for example, it would get back almost all of the money it placed in escrow. Of the settlement money paid by the Big Four, North Carolina only gets about 2.33 percent, and Virginia about 2.04 percent. So a company that did not join the agreement and sold only in those two states would have to leave 4.37 percent of its scheduled escrow payment in the account.

Greenwold said he didn't know who made the mistake. In any agreement as complicated as the tobacco settlement, he said, there are unintended consequences.

"It's so easy to go in now and take this 150-page agreement and say, 'Boy, what a bunch of dummies. They got something wrong.' "

But Everett W. Gee III, Bailey's stepson and S&M's general counsel, says there was no mistake.

"They had hired the smartest lawyers on Earth to represent them, particularly the major tobacco companies," he said. "They didn't miss this. They don't miss anything. They were scared to death that this escrow statute would be held unconstitutional."

Easley agrees with Gee. But the governor, who helped negotiate the settlement when he was attorney general, says now that the agreement has survived several constitutional challenges, the states have "nothing to lose" by trying to force companies that didn't join the agreement to leave every dollar in escrow.

If a company challenged the new law and won, things would just go back to the way they are now, he said.

New legislation?

Settlement money is not the only thing at stake for North Carolina; the state leads in production of flue-cured tobacco and cigarette manufacturing.

But money is the reason there is a concerted effort, orchestrated by the attorneys general, to pass laws in the states to force the upstarts to charge more for their cigarettes, and make them less of a threat to the Big Four.

Many of the states are addicted to the tobacco payments, relying on that money to balance budgets. More than a fourth of the settlement money paid to North Carolina -- $193.8 million of $678.8 million -- has been diverted from its original purposes and used to shore up the budget.

Nineteen states have already passed laws requiring companies such as S&M to leave all the money in escrow. In North Carolina, the Senate voted 46-0 for the legislation last year, but it was blocked in the House.

Last September, the attorneys general association sent a memo marked "PRIVILEGED AND CONFIDENTIAL" to all attorneys general, their chief deputies and state tobacco contacts, blaming companies such as S&M for the drop in payments to the states. The memo said falling payments "underscore the urgency" of taking steps to deal with the rapid growth of companies that had not joined the agreement.

"Attorneys General should consider how to share this information with other interested agencies of state government," the memo said. "The [National Association of Attorneys General's] Tobacco Project will be pleased to work with you to facilitate such communication."

The attorneys general say the Big Four market share fell from 96.4 percent in 1998 to 86.2 percent in 2002. And it continued to fall in the first half of 2003.

But the memo downplayed data showing that about 75 percent of the drop in payments to the states stems from Americans' smoking fewer cigarettes. Consumption is down, which was one of the objectives of the settlement.

Effect of new laws

The legislation proposed in North Carolina and elsewhere would achieve two goals. First, by requiring the companies to place more money in escrow, the states would increase their opportunity to recover part of their Medicaid expenditures if they sue. Second, forcing the smaller companies to leave more money in escrow would force them to raise their prices, and reduce their threat to the Big Four.

Easley favors the legislation and said he would push for its passage when the General Assembly returns to Raleigh in May. "I believe it's something we have to do," he said. "I think public health groups will push for it as well."

But the N.C. Justice Center's Health Access Coalition, a nonprofit consumer health advocacy group, won't be one of them. Project Director Adam Searing said he has no interest in working for legislation that helps the major tobacco companies.

"I could care less about it, frankly," Searing said. The economic-interest link between the state and Big Tobacco is just another downside to the tobacco settlement, he said: "And I don't think that's a very good position for the state to be in."

Price matters

The big tobacco companies may or may not have left the escrow loophole in the law intentionally. They did raise prices on purpose.

They started in 1997 when a settlement appeared imminent. And they raised the wholesale price of cigarettes 14 times in five years, from $1 a pack to $2.37, according to the U.S. Department of Agriculture. That included a hike of 45 cents a pack in November 1998, when the settlement was signed.

Easley and Brown, the NCSU professor, said the price hikes far exceeded the amount needed to pay for the settlement.

"The cost of the [agreement] arguably was 40 to 60 cents a pack, on the outside," Brown said. A study he co-wrote pegged the cost of the agreement at 38 cents a pack.

Easley, one of the key negotiators, said: "We were talking about 25, no more than 30 cents a pack."

The price hikes were initially good for business.

In its annual report to the Securities and Exchange Commission, R.J. Reynolds Tobacco Holdings Inc. reported that profit from continuing operations increased from $195 million in 1999, to $352 million in 2000, and to $444 million in 2001 before dipping to $418 million in 2002.

Tommy J. Payne, RJR's executive vice president of external relations, says the company did not raise prices beyond what was needed to pay the settlement costs.

"The range that both the governor and Blake [Brown] gave you is just too low," he said.

RJR says it has cost the company 49 cents a pack to cover payments it has made to the states plus its share of a $5.15 billion payment to tobacco farmers and tobacco quota holders.

Price is clearly an issue for the major companies. Last week, Philip Morris said it would offer discounts of 80 cents a pack to retailers, some of which would be passed to consumers. The discounts would cut the price difference between the big company's premium brands and the cheaper brands.

Ironically, one of the cigarette industry's early price hikes saved Mac Bailey's company.

In the early days, S&M lost up to $100,000 a month, according to S&M President Steven Bailey, Mac Bailey's son, who concocted the blends that became Bailey's cigarettes. By 1997, when the Big Four began hiking prices, Mac Bailey said he had spent all the money he had and all the money he could borrow.

Gee, the company's general counsel, said the big companies were greedy.

"They created this vacuum and, boy, capitalism has come in and filled it," he said.

Staff writer Pat Stith can be reached at 829-4537.
News researcher Brooke Cain and database manager David Raynor contributed to this report.