Down, But Not Out

Increasing taxes plus increasing regulation equals increasing challenges for cigarette retailers. Despite all the gloom surrounding this segment of the tobacco category, though, retailers agree cigarettes are still a bread-and-butter offering for the convenience channel.

Nielsen data shows cigarette sales stumbled a bit in the beginning of this year. For the four-week period ended Feb. 15, total c-store cigarette dollar sales fell 3.2 percent, compared to a 1.5-percent decrease the period before and a 0.2-percent increase during the same period last year.

The steeper decline, according to Bonnie Herzog, managing director of beverage, tobacco and convenience store research for Wells Fargo Securities LLC, could reflect accelerated volume displacement from traditional cigarettes to the e-vapor category. Herzog has repeatedly stated that she believes electronic cigarette consumption could surpass traditional cigarette consumption in the next decade ? barring regulation that hampers e-cigarette innovation.

Still, cigarettes should not be counted out just yet. Some c-store retailers Convenience Store News spoke with estimate cigarettes account for between 27 percent and 40 percent of their in-store sales. The reason? C-stores? core customer continues to be male.

?Women buy their cartons at a grocery store [and] put them up in a cupboard. Men buy them when they are on their last stick. They throw their pack away and realize they need to stop and buy more,? said John Call, a convenience industry veteran and managing partner at Mentor, Ohio-based CF Capital Assets LLC. ?We have chased the female customer forever. We have tried to figure out a way to not make cigarettes the most important thing in the store. We have tried and we have tried, and we have failed.?

While prices and profits have changed, cigarettes? strong foothold in the convenience channel has not, echoed Ray Johnson, operations manager at Speedee Mart Inc. in Las Vegas.

?When I started in 1979, tobacco was 40 percent of our sales. This was in Houston and I was selling a pack of Marlboro for 69 cents, no sales tax. Almost 40 years later, a pack of Marlboro is $5.69 plus sales tax, and it?s still 40 percent of our business,? he said.

Total sales may have remained constant, but that is not to say cigarette margins are still strong.

?Packs of cigarettes and cigarettes in total continue to at least be a dollar leader. [But] cigarettes are no longer the margin leader they once were,? Call explained. ?We used to make 30 percent on cigarettes. Now, we are making 8, 10 or 12 percent, if we are lucky.?

According to Johnson, he cannot go much lower with his cigarette margins. With 20 stores in the Las Vegas market, the Speedee Mart chain faces unique competition: casinos.

?Competition is so fierce because the casinos have decided to sell carton cigarettes at cost and they just about killed me,? he reported. ?Gaming is so important and we have gambling in c-stores. Cigarettes have always been a draw. You have a lower carton price to get gamblers to come in. Right now, casinos? retail [price] is less than my cost on a carton.?

Some Vegas-area c-stores are playing around margin to meet the threat, he noted.

?Everyone else in town has adjusted by lowering their cigarette margins. Generally, what I try to do is maintain the pack at more traditional levels and a little less margin on a two-pack, and between 1 [percent] and 5 percent on a carton, which is unbelievable,? Johnson said. ?I can?t go any lower on margins with the exception of singles, but I don?t think it does me any good.?

STANDING THEIR GROUND

Cigarettes are not just a store-level leader, but a category dominator as well.

David Bishop, managing partner at Barrington, Ill.-based sales and marketing firm Balvor LLC, said cigarettes accounted for nearly 90 percent of tobacco category dollar sales in the convenience channel as of December 2013, a slight drop of 0.9 percent year over year.

At Circle K Stores Inc., a division of Laval, Quebec-based Alimentation Couche-Tard Inc., tobacco remains the chain?s No. 1 in-store category and cigarettes make up about 35 percent of the tobacco sales pie, said Lee Maxwell, field marketing manager.

Cigarettes also comprise the lion?s share of tobacco sales at Nice N Easy Grocery Shoppes. However, according to Matt Paduano, vice president of category management, that share is ?declining rapidly? in upstate New York because of competition from Native American reservations, border states with lower cigarette excise taxes and ?bootlegging? of untaxed cigarettes.

Throughout the nation, the cigarette segment has continued to face challenges in the form of price increases and taxation. As Bishop noted, the Family Smoking Prevention and Tobacco Control Act of 2009 added a Food and Drug Administration (FDA) user fee to the price of cigarettes. The Master Settlement Agreement in 1998 and an increase in the federal excise tax in 2009 also had significant impacts on the price of a pack of smokes.

?With all that being said, if you look at the past 10 years, it has been a slow landing for deceleration. I think retailers get that,? Bishop said. ?Cigarettes are declining at a rate that?s probably manageable from a retail business perspective because they need to come up with new growth platforms to offset the declines in profit. That being said, OTP (other tobacco products) has some of the growth, but it doesn?t have enough growth to offset the profits.?

IN-CATEGORY COMPETITION

OTP, which includes smokeless, cigars, electronic cigarettes and more, is gaining ground where cigarettes are ceding it, but its momentum is not as great as it once was, retailers agree.

For example, Circle K?s Maxwell said multiple-stick packs of cigars boost stick movement, but dilute retail. The 5-for-3 and 3-for-2 deals are slowing growth in retail and margin dollars, he said. However, smokeless is still growing units and dollars at Circle K locations.

For the most part, the same holds true across the c-store industry. According to Bishop?s research at Balvor, smokeless accounts for the majority of OTP dollar sales, followed by cigars, electronic nicotine devices, papers and pipe/cigarette tobacco.

For many in the business, OTP growth ? especially smokeless ? is a direct result of smoking restrictions and bans. Speedee Mart?s Johnson experienced this firsthand when Las Vegas enacted smoking bans in 2007. ?From that point on, OTP has been increasing,? he said.

Product innovation, too, has helped OTP pick up speed, but comes with drawbacks.

?You get to the point where you constantly need new innovation in the pipeline to sustain the kind of growth rate we?ve enjoyed,? Bishop said. ?That gets harder and harder as the base business in terms of dollars or volume gets bigger.?

He also cited that OTP is just starting to feel the headwinds faced by cigarettes for years.

?We?ve seen efforts to increase the cost of consuming those products, primarily through taxation. That has happened to different degrees throughout OTP causing some fairly dramatic shifts when they occurred, like through pipe and roll-your-own tobacco in 2009,? said Bishop. ?But those components are plaguing it to a lesser extent than cigarettes.?

ELECTRONIC WAVERS

Electronic cigarettes ? and possibly other electronic devices like e-hookahs ? could soon be facing their own challenges. As Bishop has noted, the headwinds for cigarettes have been the tailwinds for e-cigarettes. But as the industry waits for the FDA to issue regulations on the segment, more states and municipalities are taking matters into their own hands by adding e-cigarettes to existing smoking restrictions and banning the sale of products to minors.

Some states ? most recently Washington State and New Jersey ? are taking a look at taxing electronic cigarettes as well. All of these developments are the same obstacles industry insiders point to when explaining the slump of traditional cigarettes.

Additionally, Bishop raises the concern of litigation in the electronic cigarette industry.

?We have the litigation risk that is separate from the regulatory risk that is separate from the taxation risk,? he explained. ?That?s a little different than [what] we are seeing in other places, given how hotly contested the technology element of this segment is.?

Imperial Tobacco plc?s subsidiary, Fontem Ventures B.V., filed nine U.S. patent lawsuits in federal court in Los Angeles on March 5. The company is taking aim at Lorillard Inc., NJOY Inc., Vapor Corp. and eight other makers of electronic cigarettes. It asked the court to rule that its patents were valid and for the defendants to pay as-yet unspecified damages.

E-cigarettes do face their own unique set of headwinds and those headwinds are probably more trade-related than consumer-related, according to Bishop.

?The headwinds cigarettes have ? taxation and smoking restrictions ? [are felt by] consumers,? he said. ?But in the case of litigation risk, consumers aren?t really familiar with, exposed to or aware of that. However, retailers and wholesalers are. That?s important because wholesalers and retailers like to mitigate their own risk. If there?s a chance that something could change that exposes them negatively, they will likely not react in a certain way.?

For now, at least, c-store retailers are enjoying a booming electronic cigarette business.

Speedee Mart started carrying e-cigarettes when Las Vegas smoking laws changed in 2007. In the beginning, the stores sold one disposable brand from England for $24.99, but it was free if the customer was gambling in the store. Fast forward seven years and Speedee Mart now carries 10 e-cigarette brands.

?The technology changes so fast and what people are buying changes so fast. [For] anything new, I get a little bit of [it] and see what happens,? Johnson noted, adding that the chain?s No. 1 SKU in the electronic cigarette segment is an e-hookah.

E-cigarettes are making a strong showing across the Circle K chain as well, according to Maxwell, yet the segment is still only a small part of OTP compared to smokeless and cigars. He does acknowledge that the momentum around e-cigarettes has tamed a bit and therefore, he is devoting more space to the segment than it currently merits based solely on sales.

?With the huge initial growth, it had to slow some,? Maxwell reasoned.

In upstate New York, Nice N Easy is seeing its electronic cigarette sales grow by double digits, even though, like Circle K, it is still a small slice of overall OTP sales, Paduano said. That could change as the chain undertakes an initiative to increase the segment?s presence through fixtures, new products and marketing efforts to boost customer awareness.

OUTSIDE FORCES

As the various segments of the tobacco category fight for space on the back bar ? and for customer dollars ? the competitive landscape outside the c-store is seeing its own evolution.

On Feb. 5, CVS Caremark made headlines with its announcement that it was exiting the tobacco retailing business effective Oct. 1. Convenience industry insiders hailed the decision because, after all, less competition can?t hurt. However, it may not actually be a boon for c-stores.

?I don?t think them getting out of tobacco is going to help convenience stores,? said Call of CF Capital Assets. ?It will help if the convenience store is next to a CVS, but by and large, the typical CVS shopper is female and females typically don?t come by our stores to buy cigarettes.?

Johnson echoed those thoughts. ?It was exciting news when CVS said it would stop selling cigarettes. Everyone said how wonderful it is going to be, but the majority of the people buying cigarettes at CVS are female or seniors and they are more likely to go to the grocery store to buy cigarettes than they are to go to a convenience store,? he said.

Nevertheless, Johnson does intend to go after those customers. ?Our goal is to capture half of that business,? he said. ?And I hope other drugstores, like Walgreens, follow suit.?

Circle K is also looking to attract the CVS tobacco customer. ?We are counting on being able to capture some of those customers,? said Maxwell. ?Some, and who knows how many, will migrate to other channels of trade such as grocery and maybe even the Internet.?

Even more important than drugstores, c-store operators must keep an eye on dollar stores.

?Dollar stores selling cigarettes may be more of a threat, primarily because c-stores and dollar stores appeal to a similar demographic in terms of income,? Bishop noted.

There is also the sheer fact of the proliferation of dollar stores across the country. Both Dollar General and Family Dollar have collectively between 16,000 and 17,000 stores in the United States, and they are both now selling tobacco and beer.

?In markets where those dollar stores are more prevalent, like the Southeast for instance, those retailers will say they didn?t realize until they started looking more closely that the dollar stores are very much a competitor to their tobacco business,? Bishop said.

Price also plays a part. ?Dollar stores tend to be more price competitive than drug and they are opening more locations. I think they definitely present much more of a threat to the tobacco retail business than the drugstores have, at least from a CVS perspective,? he said, adding that Walgreens is a formidable tobacco retailer with a lot of locations, but it is also going to be faced with its own pressures since the CVS announcement.

THE FLAME STILL BURNS

Any business is cyclical, and outside forces and in-category competition are sure to continue for traditional cigarettes ? plus new, unforeseen headwinds ? but the consensus is convenience stores won?t be extinguishing that flame anytime soon.

The way Call sees it, cigarettes will carry on at around 30 percent of sales.

?I don?t know what may come around to change that, but I know we as an industry have tried to supplement with food, fresh foods, you name it. We have tried our best to change that matrix and have been unable to do so to any large degree,? he said.

?[Cigarettes] still remains a very strong category. I think until they make it an illegal product, it will remain a very strong category.?