HOW TOBACCO FIRMS WILL MANAGE

By Daniel Kadlec

In a memo to employees only hours after the deal was sealed, Steven Goldstone, CEO of RJR Nabisco, wrote that the historic agreement "radically changes the way we do business." No kidding. The tobacco industry in the U.S. will have to adjust from being a cash-rich, freewheeling marketer to one of the most regulated businesses in the U.S.; from an industry that can't advertise enough to one that can barely show its face. And to pay for the agreement, tobacco executives are going to install one of the biggest price increases in the history of consumer products: possibly more than $1 a pack, a 50% boost. That's enough to break a lot of habits. Consumption could fall some 15%.

Managing a company in that kind of flux could make even a nonsmoker reach for a butt. You can assume, though, that Big Tobacco thinks business will be better, or it wouldn't have come this far. Profit margins on cigarettes are now about 34%. Last year Philip Morris had an operating profit of $4.2 billion on domestic cigarette sales of $12.5 billion. Unquestionably, tobacco is a cash crop that can cover the settlement tab and still reward stockholders. And with advertising and legal outlays likely to be scaled back, the industry can recover some of its costs immediately.

At least that's what investors seem to think. Tobacco stocks fell Friday, the day of the deal. But it was mere profit taking after a two-week run-up in which shares of Philip Morris, the No. 1 tobacco company, jumped 9%, reaching a new high on Thursday, while No. 2 RJR rose 14%. Tobacco stocks have sold at a discount, compared with other packaged-goods company shares, because of the legal uncertainties. Many analysts expect the stocks to keep on chugging once Wall Street can reliably calculate the settlement costs. "As uncertainty is removed, the stocks move up," says Roy Burry, tobacco analyst at Oppenheimer & Co. Investors may be willing to pay up for the newfound safety of predictable, if lower, earnings.

The settlement promises to speed up what was happening anyway. Cigarette consumption in the U.S. has been declining for years, but on mostly unregulated foreign shores business is brisk. American cigarette sales internationally are rising 3% to 5% a year, and companies such as RJR are grabbing half their revenues there already. There's nothing to suggest that will change soon.

As the number of smokers declines in the U.S., however, look for a market-share duel to the death. When cigarette advertising on TV and radio was barred in the early 1970s, RJR's Winston was the household name in cigarettes. Philip Morris adapted better to print, though, and boosted its Marlboro brand to prominence. RJR needs to regain some ground, but it won't be easy. "We'll all be jockeying for position in Playboy and Penthouse," an RJR insider quips. Adult magazines are among the few places the tobacco companies would continue to advertise.

Because marketing will become such a challenge, it should continue to be a powerful part of management within the industry. Jeffrey Harris, economics professor at M.I.T., estimates the industry spends $5 billion a year on advertising and wide-ranging promotions. Those budgets will shrink. But some venues, like point-of-sale displays, are still viable. Tobacco companies could open cigarette-only retail outlets for adults and pretty much do anything they liked inside.

Over the past few years, tobacco companies have spent heavily to update their manufacturing facilities, resulting in several rounds of layoffs. There could be yet another wave of consolidation--or even wholesale corporate restructuring--across the industry, as cost cutting becomes paramount. Some lawyers will lose out as the industry redirects some of the $600 million it spends annually on legal expenses. Remarkably, the industry will find some savings on its tax bill: the settlement costs are deductible.

--By Daniel Kadlec. With reporting by Aixa M. Pascual and Stacy Perman/New York

With reporting by AIXA M. PASCUAL AND STACY PERMAN/NEW YORK