Unforeseen Consequences

In 1997 36.4% of American Youth smoked. In 2017 this figure fell to a mere 8.8%.

So what happened? What broke the tobacco industry’s stranglehold grip on the national narrative surrounding tobacco? What allowed restrictive regulation to enter the tobacco industry?

The catalyst for all these changes wasn’t a groundbreaking study, political speech, or social event.

The major reason for the change in regulatory treatment of tobacco was something so impossible to predict, even if I told you the reason outright you would struggle to connect the dots.

Tobacco was regulated because KKR, a leveraged buyout firm, purchased RJR Nabisco, the largest smoking/snacking company in the world in 1989.

Before its sale to KKR, RJR Nabisco was an amalgamation of the largest tobacco company in the world, RJR, and the dominant snacking company of the day, Nabisco.

The two companies merged in what they hoped to be a mutually beneficial marriage. While RJR was throwing off cash by the ton, the market valued it at a depressed multiple due to investor skepticism around the longevity of tobacco. By combining the two businesses, RJR and Nabisco management hoped that their aggregate profits would be valued based on more favorable multiples associated with the snacking industry.

The leader of RJR Nabisco was a Canadian with an accounting background named Ross Johnson. Johnson was known for his jovial disposition and love of corporate privileges that came with being an executive in the late 20th century. He befriended celebrities of the day like Jack Nicklaus and Don Meredith, spirited around the country on his jet, and regularly organized massive golf tournaments on the shareholders’ dime.

Johnson spent freely on business expenses, though his definition of a “business expense” was very liberal and self-serving. In his mind, excessive levels of spending were necessary to stay at the forefront of the consumer’s mind and remain atop the competition. Johnson’s cavalier attitude toward spending company dollars was perfectly captured when he said “A few million dollars are lost in the sands of time.”

But even greater than his love of executive perks and corporate spending was his desire for action. In prior executive roles, Johnson was known to pull all-nighters drinking and talking with his lieutenants about plans for the company’s future. The products of these late-night drinking sessions were complete reorganizations of his business divisions, some of which employees and shareholders deemed unnecessary and many deemed detrimental to the operations of the business.

Unlike traditional managers who relied on market analysis and carefully crafted plans, Johnson believed that “ultimate success comes from opportunistic, bold moves which by definition, cannot be planned.” This motto excused his erratic behavior.

After the RJR Nabisco merger, the multiples that management hoped to achieve never came to be. The company’s stock price remained depressed. And though he was financially secured to live the rest of his life in luxury (he was promised an annual salary of $700k at retirement) Johnson, as described in Barbarians At The Gate, “could never leave well enough alone. There was shit to be stirred.”

So in an attempt to free his company of the public markets that, in his view, so unfairly valued his business Johnson put together a syndicate of buyers including RJR Nabisco Management and the investment banking firm Shearson Lehman to bid $75 a share for the company and take it private.

Not to be outdone by the Management and Shearson Lehman group, almost every major Wall Street firm jumped in on the action - moving with much speed and little information to form bids that would ensure they were involved in the biggest LBO of the day. 

As Michael Lewis wrote in 1988, “The first man to do a giant deal becomes the world’s expert in giant deals. The winner of the Nabisco auction will stand first in line for the others. The current market value of General Motors, for example, is a mere $24 billion. Sears, Mobil, Eastman Kodak also become fair game once Nabisco has been bought.” Every firm wanted to participate in the largest deal of the time because then they would be crowned the foremost authority in large deals. And with the largest deals came the largest fees. 

In a betrayal of Shakespearean magnitude, one of Johnson’s lieutenants, John Greeniaus colluded with KKR, back channeling information about bloat spending that could be cut which allowed KKR to underwrite a higher and winning bid. Greeniaus was then installed as CEO of RJR Nabisco.

His reign as CEO was cut short as his plan for raising revenues and cutting costs to improve the margins of the business was unsuccessful. While Greeniaus insisted on raising prices, consumers became fed up, switching to alternative products. 

A deafening blow was delivered to RJR Nabisco on what is now called “Marlboro Friday” when chief competitor Phillip Morris slashed the prices of their premium Marlboro cigarette brand by 20%. This reduction in prices allowed them to cut into RJR Nabisco's market share, and further weaken the remaining loyalty RJR held among customers with their Camel Brand. A price war was the last thing RJR Nabisco needed when it was saddled with $20 billion in debt that required annual interest payments in the billions.

Following his inability to capitalize on his grand plans for the company post-LBO, Greeniaus was removed as chief executive and replaced by a Davis Polk attorney with no management experience, Steve Goldstone. Goldstone was concerned with the huge debt levels of the business, imminent threats from Phillip Morris, and mounting litigation toward the tobacco industry as a whole.

While in the past, RJR Nabisco was able to fend off litigation with its ace team of internal lawyers and hefty political sway in Washington, the massive interest payments and competitive onslaught from Marlboro Friday impeded their ability to wage war in the courtroom as they once did.

Legislators and attorneys general smelled weakness on the carcass of the once-great company and the vultures began to circle.

With few options, Goldstone took an “if you can’t beat ‘em join ‘em” approach, deciding to invite regulators into the manufacturing plants. The former Davis Polk lawyer believed that “the industry has been so brilliantly successful in keeping out regulation that it’s lost all credibility. It has lobbied itself into a position where it is an outlier.” 

Goldstone hoped that this gesture of good faith would allow the tobacco industry to settle the multitude of lawsuits against them in a manner that saved them money and allowed the industry to survive. 

So in a last-ditch effort to survive the legal onslaught, the tobacco industry settled with 46 states, largely as a result of RJR Nabisco taking the lead in opening the door for possible settlement and regulation only because it was financially necessary for them to do so. The agreement between the major tobacco players and the states’ attorneys general included restrictions on outdoor advertising, using cartoon characters in ads, and sponsoring sporting/cultural events. It was a watershed moment for big tobacco and public health.

In a fit of ego and determination not to be left out of the biggest LBO of the time, Henry Kravis and George Roberts bought RJR Nabisco. And because they financed the purchase of RJR Nabisco with huge amounts of debt, the company’s free cash flow fell dramatically. And because their free cash flow fell dramatically they couldn’t pay for the extensive legal defense and lobbyists in Washington necessary to promote tobacco. And because they couldn’t pay for legal defense and lobbyists they were forced to settle with the state attorneys general. Because of this settlement, the tobacco industry had to change its marketing tactics and acknowledge its harm to society resulting in the stigma the industry receives today. And because the industry came clean about its harmful effects, smoking levels fell and millions of American lives were saved and extended.

Who could have predicted that? Because Wall Streeters wanted to maintain their status and high fees, the tobacco industry was regulated and stigmatized, and America got healthier. 

As Bryan Burrough so eloquently wrote “It’s impossible to overstate the irony of this. The impetus for the eventual historic, huge ($206 billion) tobacco litigation settlement was the failure, in effect, of a $25 billion LBO. The weakened RJR couldn’t afford to keep fighting every last lawsuit like it always had. There were just too many of them - nearly two-hundred-and-fifty suits, or three times the total of a decade earlier.”

Events unfold in unpredictable ways that you can only make sense of in retrospect.