“The court (at long last) returns to this long-running dispute over the U.S. Food and Drug Administration's (“FDA”) decision to regulate, or “deem,” premium cigars under the Family Smoking Prevention and Tobacco Control Act of 2009 (“TCA”). In July of 2022, the court held that the FDA's decision to deem premium cigars was arbitrary and capricious insofar as the agency failed to consider data before it concerning the use of premium cigars and the health effects of such use.” - CIGAR ASSOCIATION OF AMERICA, et al., Plaintiffs, v. U.S. FOOD AND DRUG ADMINISTRATION, et al., Defendants, 8/9/2023

One of the last things a government agency wants to see is for a court to call one of its decisions arbitrary and capricious. An agency especially wants to avoid having a final Memorandum Opinion reaffirm such a thing, which is exactly what happened to the FDA last month:

"This final opinion is a momentous victory for the cigar industry, liberating it—including STG—from the grip of the FDA, which gained authority over the product class in 2016. Granted, the ruling can be appealed by the FDA until October 9th, but if the FDA does not pursue that route, or if that route concludes with the final opinion upheld, the long-term effects will be pronounced."

Sure enough, on September 29, 2023, The United States Department of Justice filed, on behalf of the FDA, a notice of appeal.

The move is somewhat of a headscratcher. Surely, the FDA’s case remains exceedingly weak, and one must ask why the FDA wishes to spend valuable resources in this pursuit when cigars make up a small fraction of total tobacco products in the United States, and premium cigars only comprise a small subsegment. Further, most recent government data highlights low underage usage of cigars. Intuitively, the underage usage of premium varieties, which are more expensive and less attainable, would be even smaller. Are there not bigger fish to fry?

No matter. While the FDA losing its appeal would undoubtedly be a benefit to Scandinavian Tobacco Group, I don’t believe the FDA (somehow) clutching a win would defacto be a loss for the company. Rather, the enviable position the company finds itself in appears more akin to heads-I-win, tails-I-win-more.

If the FDA’s appeal—a costly process, both in time and money—succeeds, the status quo persists. Premium cigars will remain under the FDA’s deeming rule, maintaining the requirement of Substantial Equivalence and other various legal hurdles that will continue to stifle new competition, helping insulate STG’s exceptional portfolio of products.

The threat of flavor bans still remains. But that would be the case regardless of whether the FDA won its appeal or not due to what is currently defined as a premium cigar (emphasis added):

"a cigar that: (1) is wrapped in whole tobacco leaf; (2) contains a 100 percent leaf tobacco binder; (3) contains at least 50 percent (of the filler by weight) long filler tobacco (i.e., whole tobacco leaves that run the length of the cigar); (4) is handmade or hand rolled (i.e., no machinery was used apart from simple tools, such as scissors to cut the tobacco prior to rolling); (5) has no filter, nontobacco tip, or nontobacco mouthpiece; (6) does not have a characterizing flavor other than tobacco; (7) contains only tobacco, water, and vegetable gum with no other ingredients or additives; and (8) weighs more than 6 pounds per 1,000 units.""

The FDA’s rule proposal to prohibit flavored cigars still lingers. If this rule were to ever go into effect, it would undoubtedly affect STG product lines such as CAO CAO Flavours, which are infused with a variety of notes such as cherry and vanilla. However, in total, non-tobacco flavored cigars make up a low single-digit part of STG’s total U.S. volumes. Such a ruling would be much more averse to, say, Swisher, the private company that owns Drew Estate, which produces the ACID line—one of the most popular offerings of flavor-infused cigars. While a banning of flavored cigars would decrease market demand to a degree, the total void left would be one for STG to opportunistically fill.

If a successful FDA appeal perpetuates the stifling of competition, a failed appeal would, intuitively, have the opposite effect. Yet, following last month’s final Memorandum Opinion on Cigar Association of America et al. v. United States Food and Drug Administration et al, I wrote:

"New premium handmade cigar products will no longer be bound by requirements such as the Substantial Equivalent pathway, promoting faster and greater breadth of variety. While S.E., PMTA, and other pathways have acted as additional barriers against new competition, scaled vertically-integrated infrastructure, including superior distribution, alongside significant brand recognition still remains a considerable advantage. More importantly, being freed from the FDA will spare the industry from what could have been future potential arbitrary and capricious actions, greatly reducing regulatory tail risks."

This is worthy of elaboration.

Producing premium cigars is arduous. There are hundreds of steps, mostly done by the hands of skilled laborers, over the course of years. There are natural risks, geopolitical risks, and risks regarding how products are treated across countries. It ties up large amounts of capital, and if you were to be a new entrant without strong relationships to source materials, distribute, and sell product, and with zero brand recognition, all you might be left with is a mountain of product you are unable to prosper from.

Conversely, Scandinavian Tobacco Group, in addition to its exceptional and long-standing relationships with growers, handles everything from fermentation onward. To further protect against risks such as natural disasters or major supply chain shocks, the company also, at any given time, stores over two years’ worth of tobacco leaf. All of this provides it with an extreme level of control over product quality and consistency (it is becoming more accepted that many New World cigars, i.e., cigars from countries such as Nicaragua, Honduras, and The Dominican Republic, are above Cuban varieties in quality and consistency, although the Cuban Habanos’ legacy still makes them widely-saught globally—not that that matters in the U.S. due to the existing embargo).

With the level of complexity in mind, it is critical to understand the typical consumer journey and consumption trends within the United States. The initial purchasing patterns of premium cigar smokers generally start in person. They experience the walk-in humidor, smell the aromas, and are assisted by experts to walk them through the nuances of the product. Experience and exploration lead to the understanding of one’s own palate, and over time, purchasing patterns shift online. STG’s retail, including retail superstores and a number of leading e-commerce platforms for cigars, is tailored to facilitate the consumer, no matter how far along in their journey they find themselves. While consumers regularly build preferences towards specific brands, including the exceptional portfolio held by STG, there is considerable and growing experimentation and exploration that occurs, even amongst aficionados. This is where STG’s expertise in production quality and consistency, as well as existing infrastructure throughout New World countries, would further extend its competitive position should the FDA fail its appeal. With regulatory hurdles lessened, STG may be able to more nimbly experiment and introduce creative New World varieties and collaborations to the market, leveraging the equity built in brands such as CAO, Macanudo, Cohiba, and now Alec Bradley. New offerings, spanning from light Connecticut Shade wrappers to dark Maduros, can include innovative blends, shifting balances of fillers from different origins. The company simply has unique resources to cater to the market in ways that no one else can. Value creation is not strictly about creating the most sought or most expensive, but rather, includes creating the most expansive offerings to cater to the widest number of palates, foster experimentation, and support the social culture built around the product.

At the same time, in this scenario, a degree of new competition arising would be inevitable. However, that competition will likely be semi-reliant on STG’s platforms to sell its products. Additionally, history has shown us that the complexities of the industry often result in sub-scale producers, even those with quality products, struggling to thrive throughout full cycles. For this reason, especially when considering its ability to leverage insights through its large sales channels, STG may be able to not only better anticipate and adapt to changes in consumption patterns but can gather precisely informed data on future acquisition targets.

Ultimately, Scandinavian Tobacco Group's production of maximum long-term value will rest on its ability to remain focused on the desires of the consumer, and the environment it can do that best is one that the FDA has no part in.