C-stores & Core Tobacco Consumers Face Tempered Recovery

RESTON, Va. — While there has been a lot of talk about the improving economy, the recovery for the core tobacco consumer may have peaked, according to one tobacco analyst.

"There is a lot of talk about the market improving but I am not getting the sense that things are really improving that much," said Nik Modi, managing director and analyst at RBC Capital Markets LLC, during Convenience Distribution Association's latest webinar, "Tobacco Industry: State of the Union" on Aug. 29,

Modi pointed to two household goods companies to illustrate the state of the core tobacco consumer: Colgate-Palmolive Co., which saw net sales growth in the past few months and Kimberly-Clark Corp., which saw negative sales growth.

One makes toothpaste, other toilet paper, he noted.

In addition, the convenience channel has been seeing its share of struggles, as traffic weakened in the past few months. According to Modi, several factors are driving that weakness:

• Gas prices: Prices at the pump have been trending above the three-year average, and that was before Hurricane Harvey — which could drive gas prices up 10 percent going into Labor Day. 
• Weather: It has been "incredibly precipitous" in the east and west coast this year. 
• Geopolitical: Uncertainty has weighed on the consumer psyche.
• McDonald's: A summer promotion on soft drinks likely reduced convenience store traffic, but it is a temporary initiative.
• Immigration: Rhetoric and reform have been putting pressure on Hispanic consumers, especially unacculturated Hispanics who have been going out less — though there has been some recovery.

That being said, the strength of the core tobacco consumer has tempered but is still strong, he explained. "We are finding a clear disconnect between economic data and what we are seeing in the public marketplace," Modi noted.

Overall, 57 percent of retailers believe the U.S. consumer is still improving — which is not much of a change from the March quarter. 

Cigarette trends are down about 4.5 percent, primarily driven by the increase in California's state excise tax and "for the first time we are hearing about consumers trading down in the category," Modi explained, adding there has been "a very distinct commentary coming from the industry" as some premium brands struggle.

"We expect cigarette volumes will return to the traditional negative 3 percent to 4 percent," he added.

As a result of Prop 56, which led to the $2 increase in California's state excise tax in April, Modi noted that Altria Group Inc. and Reynolds American Inc. took list price increases earlier than expected.

However, despite some speculation that another increase is around the corner, "I don't share that belief," he said, adding the tobacco companies may return to their normal timetable by taking a list price hike in November. 

Looking to the future, the impact of the Food and Drug Administration's (FDA) change in tobacco policy to shift the focus to nicotine remains to be seen. However, the change could trigger a "compensation effect," the tobacco analyst said.

According to Modi, any change in policy could take years — as evidenced as the agency's menthol report, which has been pending for seven years.

As part of its process, the FDA will conduct an unintended consequences study, he noted, adding, "Unintended consequences are a really powerful thing to think about."

One possible outcome in the shift to lower nicotine levels in cigarettes would be adult smokers smoking more — known as the compensation effect, Modi explained. "You need to take a step back and think about the unintended consequences," he added.

He did note, however, that he was impressed that the FDA's announcement included an open commentary on reduced-risk products. "It was the first time there was a clear statement from the government on reduced risk," Modi said.

Playing a role in the reduced-risk arena are heat-not-burn products. International players like Philip Morris International (PMI) and British American Tobacco plc are moving to heat-not-burn products as they innovate.

Notably, PMI is testing its iQOS heat-not-burn product in 20 countries, with two lead markets: Tokyo and Milan. However, Modi is not convinced the product will be as successful here as it is in other markets.

"The consumer base is very different and I am not sure the U.S. consumer will adopt these products as quickly," Modi said. "You are not talking apples to apples in terms of countries."

The analyst pointed out that many consumers "were burned by electronic cigarettes" and heat-not-burn could face an uphill battle in the United States.

Another area to keep an eye on, according to Modi, is legalized marijuana — which is on the rise at the state level. "The reality is, when we get closer to 15 to 20 states we will start seeing a dialogue at the federal level," he said, adding 60 percent of Americans think marijuana should be legal.

In terms of economic impact, legalized marijuana generated $6.7 billion in sales in 2016, he added.