Why Your Government Wants You to Smoke Cigarettes

The largest civil settlement in history totaled $246 billion, paid out over 25 years.

The Tobacco Master Settlement Agreement was signed in 1998 by four tobacco companies, and it details payouts to all 50 states and six U.S. territories.

In addition to the huge financial burden, the master settlement also prohibits tobacco companies from targeting young people, bans cartoons from tobacco advertising, restricts brand sponsorship of teams and events, eliminates outdoor and public-transit advertising, restricts lobbying, and requires tobacco companies to disclose internal documents to the public.

All 50 states and the District of Columbia prohibit the sale of tobacco products to minors. Idaho and Washington prohibit the distribution of samples to the general public at little or no cost. At least 10 states have imposed bans on smoking in bars (!) and restaurants. In Baltimore's Inner Harbor area, you're not allowed to smoke anywhere, inside or out.

It all sounds like more than enough reason to stay away from tobacco stocks.

On the other hand, there's an important detail that most people don't know about the 1998 agreement: The master settlement payments rise and fall with cigarette shipments.

If cigarette volumes go down, the payments go down. But if the volumes go up... payments go up even more. It's a perverse paradox: Your state government hopes you smoke like a chimney, and it – not Big Tobacco – is going to gouge you for the privilege.

Big Tobacco's payments to politicians and lawmakers don't end with the master settlement. Federal and state excise taxes kick the payoff up another notch. The federal excise tax is $19.50 per thousand cigarettes, or about $0.39 a pack. In 2007, combined state and municipal excise taxes ranged from $0.07 (South Carolina) to $3.66 (Chicago) per pack of cigarettes. Last year, 10 states increased taxes, adding another $0.20 to $1 per pack.

Between high state excise taxes and the master settlement, tobacco companies have become a bizarre sort of utility company. Let me explain...

A public utility is really just a good business into whose pockets and affairs the government has permanently intruded, but whose survival is thereby assured. State governments make more money off each pack of cigarettes than anybody. If Big Tobacco fails, municipalities all over the United States fail.

That's no phantom idea, either. There's real leverage here... Back in 2003, an Illinois judge told a Big Tobacco company it had to post a $12 billion bond before it could appeal a defeat in a class-action lawsuit. The company said the move could force it into bankruptcy court and prevent it from making a master settlement payment.

Washington state's attorney general flew to the company's side – seven years after suing it for billions – telling the court, the bond "could deal a significant, unnecessary financial blow to the states." Virginia, California, New York, and Kansas put more than $7 billion in bond issues on hold until the matter was cleared up. The company didn't go bankrupt. On the contrary. It's made more than $50 billion in net profit since then.

Over the years, I've discovered different types of competitive advantages a business can have. One type of competitive advantage stems from "rules and regulations." The SEC's rules and regulations keep Standard & Poor's and Moody's entrenched as national ratings organizations. The Food and Drug Administration and its rules for new drugs keep big pharmaceutical companies entrenched, making it difficult for smaller companies to fund new drug development. Without intellectual property law, Microsoft would be a much smaller company... if it still existed.

Big Tobacco is benefiting from the onerous taxes only it can afford, the master settlement. States demand such high payments, they've put small manufacturers of bargain-priced cigarettes out of business. That's one reason the cigarette business is so profitable. U.S. cigarette sales totaled $70 billion last year. The total profit: $8.8 billion – an impressive after-tax profit margin of about 13%.

The Cato Institute, a libertarian think tank, is less delicate even than I am about Big Tobacco's competitive position post-settlement. In a 2000 report, Cato's Thomas O'Brien wrote, "Tobacco companies have purchased, with smokers' money, permission to raise prices collusively and suppress competition."

For investors, this means simply big cigarette companies have an enduring competitive advantage.

Remember, too, cigarettes are not a cyclical business. The economy is bad right now, but smokers will continue to smoke. Cigarettes remind me of what the late, great Lee Garfield, creator of the Baltimore landmark, Lee's Ice Cream Factory, once told me about his business. He said, "I never worry about the economy. When people can't afford to go to the beach or buy a new car, they can still afford to shell out a buck or two for some ice cream."

Cigarettes are like that, too – a cheap, readily available form of daily escape. What's a smoke break but a chance to get away from it all without spending $15,000 and flying to Hawaii?

Given their government-backed advantages, unrelenting global demand, and cheap valuations, buying shares in Big Tobacco will turn out to be one of the best investment decisions you can possibly make right now.

Good investing,

Dan Ferris