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Will New Packaging Stop Big Tobacco?

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Graphic anti-smoking labels are coming to a tobacco retailer near you. But will it matter to tobacco companies’ profits?

The FDA is requiring that cigarettes sold in the U.S. feature pictorial warning labels on the top 50% of the front and back of the package. Similar warning labels must comprise at least 20% of advertisements. Domestic tobacco players such as Altria (NYSE: MO ) , Reynolds American (NYSE: RAI ) , Lorillard (NYSE: LO ) , and Vector Group (NYSE: VGR ) have until the autumn of 2012 to comply.

The new regulations are being implemented as part of the landmark 2009 Family Smoking Prevention and Tobacco Control Act. The labeling requirements are based on the best practices from other countries. Large labels are more effective than smaller ones, and explicit pictures are more effective than text-only cautions. Already 35 countries require health messages to cover at least 50% of the package. So if you thought abroad-only rival Philip Morris International (NYSE: PM ) might be an alternative, well, it’s already been dealing with similar issues.

Several studies show that graphic labels do promote awareness about the dangers of smoking. And research from the International Tobacco Control Policy Control Project shows that “comprehensive warning labels reduce smoking consumption, increase motivation to quit, and increase the likelihood that they will remain abstinent following a quit attempt,” explains the Campaign for Tobacco-Free Kids.

But often awareness does not translate into effectiveness, as anyone who’s tried and failed at dieting and exercising knows. Still, there seem to be indications that the packaging tactics will be at least somewhat effective.

While that provides a headwind to Big Tobacco’s profits, it doesn’t mean these companies can’t still extract more revenue from existing smokers while continuing to closely monitor their costs, as they’ve done for quite a while now. The decline in smoking rates bottomed around 2004 and has remained at about 20% of Americans. This industry still has tremendous pricing power, and market share is very important.

Moreover, because the new labels obscure a significant portion of the packaging, the new guidelines could reinforce the importance of the brands themselves. In other words, the players with strong share are likely to retain their relative positions. And that would be a relative win for Altria, the U.S. market-share leader.

Reynolds, Lorillard, and others are challenging the legality of the labels. Given its stronger position, Altria is probably the best play in this challenging environment, but don’t confuse that with excitement to run out and buy shares at this point.

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