Between Patents And The FDA, Big Tobacco Smokes (MO)(RIA)(STSI)

Big tobacco got over yet another big news hurdle yesterday after a U.S. District Court sided with Reynolds American (RAI) in its long-running patent tussle with Star Scientific (STSI), this on the heels of new FDA regulations passed by Congress last week.

Tobacco stocks such as Reynolds and Altria (MO) that have been hammered in recent days by the threat of new FDA regulations may begin to be viewed this morning as relative value plays by some investors. The threat of Reynolds — and potentially others — having to pay hundreds of millions of dollars in patent infringement damages to Star seems much more unlikely than was  the case just days ago.

Small tobacco player Star Scientific has cast a long shadow over big tobacco – and especially RAI – for the better part of the past 8 years. Its patent claims against the world’s No. 2 tobacco player were  initially filed back in May 2001. Star argued that it had a unique system of curing tobacco that removed cancer-causing agents that was being copied.

Even though the case was dismissed in U.S. District Court in 2007 and questions have been raised about whether a patent ever should have been issued, Star continued the legal battle. Many traders in Star appeared to be in the stock because of the perceived value of its patents.

That value has eroded overnight with the ruling, with Star’s stock down more than 70%.

The threat posed to big tobacco by Star is not completely gone. The company may very well fight on to the Federal Circuit Court of Appeals.

But yesterday’s ruling does appear to significantly diminish the legal threat. As a result, a sentiment shift may be in store for RAI and other big tobacco names. In the wake of the Star ruling and  last weeks’ FDA news, there are suddenly more knowns than unknowns for big tobacco names – many of which have been trading at high dividends and low P/E multiples relative to the S&P 500.

The tobacco stock of the day may indeed be Reynolds. With overhangs removed, traders may take  not of its 8 times forward earnings multiple and its 9.3% dividend yield.

The tobacco stock to watch for the longer haul may be Altria. More regulation is on its way, and the company in the best position to absorb the additional costs and potentially pick up market share in the process may be Big Mo.

Mike Tarsala