The FDA made big news last week (July 28, 2017) when it announced a “comprehensive nicotine strategy” last week that could include reducing the nicotine delivery from combusted cigarettes to below addictive levels. If FDA actually implements such a policy in an effective way, that would be a big step forward. (Whether or not such a policy would actually work in the real world was not clear until, over the last few years, the FDA has supported some very well-done research showing that this is possible and could be implemented quickly.) Doing so, however, will take time to develop and then survive the inevitable industry lawsuits so it is, at best, years away.



The other big thing that the FDA did was to extent the already generous amount of time that it had given e-cigarette companies to comply with the law, pushing the compliance date out 4 years, to 2022. This means that e-cigarettes will remain the Wild West, at least from a federal perspective.



They also said that they were encouraging e-cigarette companies to apply to make cessation claims and exploring ways to make getting such claims approved with the ultimate goal of shifting people from combusted cigarettes to e-cigarettes. While this could theoretically be a good thing, the fact is that the overall evidence still shows that e-cigarette use is associated with less not more quitting cigarettes and the evidence that e-cigarettes are more dangerous than originally thought keeps piling up.



So, the FDA is giving the industry a big immediate gift in exchange for the possibility of inflicting some pain later.



On July 31, Wells Fargo tobacco analyst Bonnie Herzog saw the new FDA position as a good thing for tobacco:



FDA & Tobacco Industry Are Aligned on "Continuum of Risk" Approach - What should have been a quiet Friday morning in July turned into an incredibly busy day given the FDA's unexpected announcement of a new and comprehensive approach towards nicotine with the goal of "rendering cigarettes minimally or non-addictive" while taking a "continuum of risk" approach that should encourage innovation in reduced-risk products (RRPs). We spent the day fielding numerous calls from investors trying to make sense of the potential implications of the new regulatory framework on the industry and tobacco stocks. After digesting the turn of events, it seems clear that uncertainty is back and, with that, some level of overhang on valuations in the n.t. However, we ultimately believe this could prove to be a positive for big tobacco, especially MO since we think: (1) its terminal value is now higher as it benefits from consumption shifting to RRPs/iQOS; and (2) the probability that PM acquires MO remains high and timing could be soon given the multiple spread between the two is the widest it's been in over 6 years. Therefore, we reiterate our Outperform rating on PM & MO and encourage l.t. investors to buy the dip in MO since we think the sell-off in the stock is overdone. Additional Thoughts and Observations - (1) We continue to believe PM will acquire MO as reported by Reuters without mgmt comment since we believe MO will ultimately be a big beneficiary of these regulatory changes as conversion increases to RRPs/iQOS and MO takes incremental share at a faster rate. Based on our scenario analysis, we think MO could be worth closer to $90/shr (vs $80/shr prior) as conversion to iQOS increases to 50% of industry vol. by 2025 (vs 34% prior). (2) Proposed changes by the FDA must be science based and consider unintended consequences - i.e. nicotine levels in cigs can't be eliminated or reduced dramatically since a black-market would result. Further, the FDA needs to consider that by reducing the levels of nicotine in cigarettes, it may actually cause smokers to smoke more. As such, we realistically don't see major changes to nicotine levels with any change likely to be very moderate over an extended period of time. Importantly, we expect the FDA will encourage continued RRP innovation with the goal of increasing adoption of these products - a huge positive for MO/PM given iQOS. (3) We believe the FDA's decision to embrace "continuum of risk" (as opposed to abstinence) as the cornerstone of its approach is a l.t. positive for the tobacco industry as it should increase conversion towards RRPs, which gives MO/PM a competitive advantage given their first mover advantage & superior technology with iQOS. (4) The level of uncertainty has most decidedly increased and while we see limited downside risk in MO's stock, there is some risk the stock trades sideways n.t. (5) Any proposal by the FDA will likely take many months, if not years, so there will be no impact on the industry for quite some time but it could mean the uncertainty and lack of visibility will persist. (6) We believe the industry in some respects has been ahead of the FDA with its efforts to reduce risk especially given PM's publicly stated goal to "design a smoke-free future" with iQOS. (7) We believe it's more likely that the FDA approves PM's application to commercialize iQOS in the U.S. as well as its modified risk application.



While I generally think Bonnie is over-enthusiastic about the tobacco industry, including e-cigarettes, I think she is right that overall the new FDA position is good for the tobacco industry.



The one thing that she says that I do not agree with is the statement that "nicotine levels in cigs can't be eliminated or reduced dramatically since a black-market would result." While FDA cannot reduce nicotine to zero, they have the legal authority to set the nicotine at levels that would not support addiction. Herzog also repeats that standard industry argument that a black market would result if FDA sets a very low nicotine level. The industry uses this argument against almost every policy that affects the tobacco supply and, as far as a know, it has never marterialized. Moreove, it is often the major multinational cigarette companies that promote the illegal trade as part of their marketing efforts. FDA could prevent this by implementing rigorous product tracking as defined in the FCTC Protocol to Eliminate Illicit Trade in Tobacco Products that would block product diversion.



The FDA did say that it was going to make another attempt to regulate flavors, something they tried to do in the 2016 deeming rule that the Obama White House blocked. Hopefully, the FDA will move quickly on this matter based on the language that it had tried to include in the deeming rule.



Another thing that the FDA could do now is to expand its excellent public education efforts (the Real Cost and its other media campaigns) to educate people, especially kids, that e-cigarettes are not “harmless water vapor,” are a gateway to smoking cigarettes, and a dangerous even if people don’t progress to cigarettes. The California campaign is a good model.



Most important, all of this reinforces the importance of local action to prohibit the sales of flavored tobacco products, including menthol, that have been led by the African American Tobacco Control Leadership Council and that are taking off all over the country with active support from the broader public health community. The most visible evidence that this is important is the fact that the tobacco companies, led by RJ Reynolds, have already invested nearly a million dollars to overturn the San Francisco flavor ordinance. This will be a seminal fight and it is gratifying that the health community has come together to defend the ordinance against the industry’s repeal referendum.



The FDA’s action also highlights the importance of other local and state action to control ecigarettes, particularly including them in smokefree laws and tobacco taxes. These are important public health policies that lie beyond FDA jurisdiction.