Will FDA Regulation Redeem Philip Morris?

The landmark ruling Friday by a federal court in North Carolina that nicotine is a drug and that the Food and Drug Administration can regulate tobacco could, in an unintended and strange way, ultimately benefit Philip Morris Cos.--along with long-suffering, addicted smokers.

To be sure, the stock of the world’s leading tobacco company, a favorite holding of pension and mutual funds, took the news hard on Friday. It closed down 5%, or $2.125 a share, at $39.50. But those investors who held on or bought Philip Morris may better understand the long-term picture.

There are two reasons for saying that. The first and more cynical is that regulation benefits the market leader in any industry because it stifles competition. Flexible big companies often use regulation to further their own interests.

No coincidence that Geoffrey Bible, the company’s chairman, told shareholders Thursday that Philip Morris is adaptable now. The company, he said, is “prepared to work with government representatives and others to develop a regulatory system that would be balanced, reasonable and effective.”

More important for Bible’s company and its 154,000 employees, regulation will lead to work that can lessen the moral stain that blights Philip Morris and other tobacco firms.

That stain is really not for producing cigarettes. They are legal products, and state and national governments here and around the world eagerly collect taxes on cigarettes.

Rather, it’s that Philip Morris and other tobacco companies have never turned their best efforts to producing a less hazardous cigarette.

Unwilling to admit publicly that smoking was dangerous to begin with, Philip Morris and others made only half-hearted efforts to reduce the danger.

The result has been decades of argument, subterfuge and unnecessary illness. Now regulation could turn this skilled company and industry to developing a less deadly relaxant. Cigarettes won’t be banned, but regulators may hope to eliminate them over a period of years by reducing nicotine levels.

Whether that will happen--and what people will be smoking or ingesting 20 years from now--is unknowable. But the prospect of FDA regulation, with real consequences for public health, ironically could be an encouragement to talks going on now over settlement of smoking-related health claims.

The bill that tobacco firms will have to pay for state Medicaid expenses on smoker illnesses could be steep, but Philip Morris has money--$69 billion in annual sales and $7.6 billion in cash flow from income and depreciation. It can raise cigarette prices in any case. To be sure, a trial soon to begin in Florida to determine liability for lung cancer “is potentially a bankrupting event,” says analyst Gary Black of the Sanford C. Bernstein research firm. Still, it would take years for such a lawsuit to reach a verdict--if it’s not headed off by a settlement.

Meanwhile, whatever modified cigarette is sold to an addicted public of 40 million Americans and hundreds of millions of people around the world, Philip Morris will do most of the marketing. It now sells 48% of the cigarettes in the U.S. market and has big market shares in 40 other countries--41% in Germany, 54% in Italy, 57% in Hong Kong--although not yet officially in China because the Beijing government controls distribution.

There’s a lesson for all business in the story of how this come-from-behind company attained that position. Thirty years ago, Philip Morris, with Marlboro, was an also-ran among companies that had built the tobacco business--American Tobacco with Lucky Strike (now American Brands, without cigarettes) and R.J. Reynolds, with Camel and Winston (now RJR Nabisco).

But New York-based Philip Morris, a combination of urban sophistication and rural, Southern cunning, understood before other companies that business had become global. It went global itself, hiring talented people overseas and giving them authority. One, a Briton named Hamish Maxwell, led the company from 1983 to 1991. Bible, the 59-year-old current chairman, is an Australian accountant who worked for the United Nations and joined Philip Morris in Switzerland.

Moving easily in international circles, Philip Morris made licensing deals with government tobacco monopolies in Europe and elsewhere, getting Marlboros sold alongside national brands.

Philip Morris applied the added income gained from overseas sales to becoming more competitive at home. In 1974, it spent $200 million to build a manufacturing complex in Richmond, Va., that turned out 25 million packs a day, almost three times what rivals could produce. In 1975, Philip Morris’ Marlboro passed Reynolds’ Winston to become the top U.S. brand.

The pattern continues. Today the company is investing $300 million in a manufacturing complex in Russia and has completed a plant in Malaysia to supply Asian markets.

In the 1980s, Philip Morris acquired General Foods (Oscar Mayer meats, Jell-O desserts) and Kraft Foods (Kraft cheeses). Food is not as profitable as cigarettes, but Philip Morris’ array of branded products, with $28 billion in annual sales, gives it a continuing global business no matter what happens to tobacco.

Philip Morris may be a pariah to many people, but many others find it an attractive investment. No fewer than 900 institutional investors--pension funds, mutual funds--hold 62% of Philip Morris’ outstanding shares.

They have reaped returns of 30% a year from appreciation and dividends the last two years--although Philip Morris stock languished in the early ‘90s and now may do so again.

But the stock’s main drawbacks have always been the threats of tobacco lawsuits and the moral question of cigarettes’ danger.

One doesn’t often hear the word “moral” in connection with investments, but it applies. The state of Pennsylvania last week announced that its pension funds would no longer hold tobacco shares. It’s not the first state to do so.

“A business must have a moral purpose,” says Warren Bennis, USC professor and authority on leadership in business.

Yet that is precisely why Friday’s court ruling could be a blessing in disguise for this industry. A money settlement, however expensive, that removed the threat of years of lawsuits would be cheap at almost any price.

And FDA regulation that forces Philip Morris and other companies to make more socially acceptable products could ironically be just what the business needs--not to mention poor addicted smokers.