The Evolution Of Tobacco

4/1/2013

The future is now as electronic cigarettes lead a significant takeover of the back bar

Change is inevitable. It happens every day, in every category, in every industry.

Take the auto industry, for example. Cars with stick shifts gave way in popularity to automatic transmissions. Leaded gasoline was surpassed by unleaded. And now, some are betting electric vehicles are the future of America's automotive fleet.

Tobacco — and tobacco retailing — is no different. Once upon a time, cigarettes came without filters. Then, "light" cigarettes gave way to "gold" and less than 100 years ago, menthol cigarettes were unpopular (try telling that to Lorillard Inc. today). Just as with the auto industry, some are betting on electric as the future of tobacco — in this case, electronic cigarettes.

The difference is, in the tobacco category, the future is now. Once considered a mere curiosity, the e-cigarette has refused to be taken lightly and has gained the respect and approval of retailers and, more importantly, consumers.

"It is very early, but I expect consumption of electronic cigarettes to surpass traditional cigarettes in 10 years," said Bonnie Herzog, managing director of tobacco, beverage and consumer research at Wells Fargo Securities LLC. "E-cigarettes are to tobacco what energy drinks are to the beverage category — profitable, quickly growing in volume and shelf space, and increasingly gaining consumer acceptance."

R-E-S-P-E-C-T

For several years, convenience store retailers had eyed e-cigarettes with some hesitancy, but then Lorillard acquired blu eCigs for $135 million in April 2012 and the move gave credibility to the entire segment. Currently, about 70 percent of all e-cigarettes are sold online, but c-stores reign supreme in e-cigarette distribution when it comes to brick-and-mortar retailers.

C-store operators are drawn to e-cigarettes' healthy margins and "low maintenance" selling (Read: No controlling contracts, yet), according to Herzog. Some retailers have been entering the electronic cigarette arena slowly, while others have dived right in and found success.

The Pantry Inc., parent of Kangaroo Express, is one c-store company that embraced the products early on and found it had a winner in the tobacco category. "I think electronic cigarettes can now be considered a prominent part of the category," said Jen Eaton, category manager for other tobacco products (OTP) at the North Carolina-based convenience store chain.

Anne Flint, senior category manager of tobacco at New England-based Cumberland Farms Inc., echoed that sentiment and called e-cigarettes "a silver lining" in the tobacco category.

In general, convenience retailers are carrying between three and five brands, with disposables moving better than starter kits and rechargeables, according to industry insiders.

Disposables are the No. 1, 2 and 3 e-cigarette sellers at QuickChek Corp., noted Tim Holiday, category manager for the New Jersey-based c-store chain. The operator of stores in New Jersey and New York is also seeing a rise in starter kits, said Holiday, who participated in Convenience Store News' annual Tobacco Summit, held this year at Tobacco Plus Expo International in Las Vegas.

The popularity of disposables over kits might depend on where a store is located. The price of kits may be a barrier to entry for some consumers, but in states with higher cigarette taxes, paying $60 for a rechargeable kit is cheaper than paying $80 for a carton of cigarettes, explained Dave Williamson, general manager of retail at Hill City Oil Co./Jubilee Food Stores in Louisiana.

So, now that electronic cigarettes have gotten their foot in the door, what comes next?

According to retailers, the rising OTP segment will grow to resemble traditional cigarettes. "If the [OTP segment] stays around, it will be a lot like cigarettes — with premium and discount brands," said James Conrad, tobacco category manager at Royal Buying Group Inc.

Question marks, though, remain around flavors. In 2009, the Food and Drug Administration (FDA) banned flavored cigarettes, and many wonder if the agency will do the same when it finally hands down e-cigarette regulations (see Play by the Rules on page 44).

At least one electronic cigarette maker isn't taking chances that flavors will be here today, gone tomorrow. "We think flavored e-cigarettes will be banned so we are not even going there," said Pete Danielson of CIGR8 Electronic Cigarettes, a sponsor of the CSNews 2013 Tobacco Summit.

If they are here to stay, retailers will have a real dilemma on their hands — space. Many merchandise e-cigarettes on the counter, but as every c-store operator knows, counter space is valuable real estate. The problem becomes bigger as more products and SKUs enter the marketplace, explained Rich Mione, senior director of merchandising at VPS Convenience Store Group.

"Counter space is very valuable space. In order for e-cigarettes to have a permanent home, retailers will need to make a commitment to the category and have the ability to be flexible with product mix," Mione said.

E-cigarettes need to be able to hold their own in the overall tobacco category as well, QuickChek's Holiday added. "For us, e-cigarettes start out on the counter in lockable display cases as an introduction, and then the product has to be able to sustain itself behind the back bar," he said.

FLAMING OUT?

Electronic cigarettes could not have come along at a better time for c-stores, which have been battling declining cigarette sales and compressed margins for some time. Total cigarette volume accounts for $85 million in retail sales. However, volume has been declining for the past four decades — and the decline has been accelerating. In fact, cigarette volume has been decreasing 3 percent to 4 percent per year, Herzog told retailers at the CSNews Tobacco Summit.

Premium brands have taken the biggest hit, she said. They represent about 70 percent of total industry cigarette volume. While impressive, that figure is down from 91 percent in 1984.

Jeff Arnold, procurement manager at Maverik Inc., noted that lower-priced brands are lifting the cigarette category for the North Salt Lake City-based chain. "We are growing volume, and our same-store sales dollars are up," said Arnold, noting that the retailer sells both the Pyramid brand and Maverik's own brand of cigarettes.

The rising costs of cigarettes due to manufacturer price increases and increased taxation at both the federal and local levels has caused inventory problems for retailers. Many, especially smaller retailers, are having difficulties with the increased value of the inventory they are forced to carry in order to maintain in-stock conditions. More money invested in inventory means less for investing in other areas of the business, according to the retailers at the Tobacco Summit.

One solution, according to Holiday of QuickChek, is to use technology to better manage inventory. He estimated that the 130-store chain reduced its cigarette inventory by roughly $750,000 with no increase in out-of-stocks through computer-assisted ordering.

Convenience stores are also facing increased competition for the almighty cigarette dollar. When it comes to distribution, the convenience channel is still winning, but that doesn't mean it shouldn't be looking over its collective shoulder. Dollar stores and drugstores are on the to-be-watched list.

"Dollar stores are a big concern," said Williamson of Jubilee Food Stores. "The CEO of Dollar General uses words like convenience when he speaks about the business."

Retailers at the CSNews Tobacco Summit also said they are worried that anti-smoking groups will step up their campaigns to "demonize retailers" who sell tobacco.

In Canada, drugstores are not allowed to sell cigarettes, and it will be interesting to see if a similar ban moves to the United States, said Peter Chappell, senior category manager for Mac's Convenience Stores, a division of Alimentation Couche-Tard Inc. For now, though, drugstores such as Walgreens and CVS continue to sell cigarettes in the U.S.

Other regulatory issues of concern to retailers at the Tobacco Summit include upcoming FDA proposals to regulate e-cigarettes and OTP (expected this month) and an FDA review of modified risk products (later this year). "Bottom line, increased regulation could hurt growth in some areas, but creates opportunities for growth in new categories," Herzog commented.

SIGNIFICANT OTHERS

While the tale of two cigarettes is getting a lot of attention from convenience store retailers, there is more to the tobacco story than just these two segments. For instance, the other products in the other tobacco products category offer real growth opportunities.

"No doubt this is an exciting category for us and for convenience stores," said Mione of VPS Convenience Store Group, which operates 420 stores under several banners, including Village Pantry, Scotchman and Li'l Cricket. C-stores dominate share in OTP, which acts as a destination category for the channel. He also advised that to be successful with OTP, retailers need to be aware that space allocation is very important, variety is key and flexibility is a must.

As Mione pointed out, the days of a one-size-fits-all OTP category are long gone.

Holiday reported that QuikChek "is planning for five years from now" by expanding the OTP departments in its stores today.

OTP dollar sales in convenience stores increased from 4.1 percent of total tobacco sales in 2000 to 10.8 percent in 2012, according to David Bishop, managing partner at sales and marketing firm Balvor LLC. Though it has been "a gradual evolution," OTP and its effect on the total tobacco category has been consistent, noted Bishop.

Delving deeper into other tobacco products, Joe Teller, director of category management at OTP manufacturer Swedish Match, another Tobacco Summit sponsor, explained that moist snuff tobacco (MST) is driving the majority of the growth. Meanwhile, cigars are holding their own, with multipack foil pouches and single sticks taking the lead over traditional cardboard packs.

Snus remains in a period of transition. When VPS Convenience Store Group first started digging into snus, Mione said the retailer noticed that the segment was not doing well in every store, but those stores with strong snus sales were doing very well. "It has legs," he stated.

Teller agrees. "It may be slow, but every trend line we are seeing is going up over time," he said.

The cigars segment, while still posting strong sales for convenience stores, is seeing its own evolution of sorts. "There has been a real migration from the five-pack down to the two-pack or single," noted Arnold of Maverik. Royal Buying Group's Conrad said the independent retailers it serves are also reporting that singles and two-packs are selling best.

The proper cigar assortment remains a question mark. Chappell of Mac's explained that finding the right assortment can be particularly challenging due to the space limitations behind the back bar. Cigar users also tend to switch up their purchases depending on flavors and availability, posing another obstacle to pinpointing the proper mix, Mione added.

One tip Teller offered is to go big in both single packs and foils. "You have to be in both businesses," he said. "If you have a product in a single pack, you better have it in foil, too."

At least one c-store operator is giving cigars more space. QuickChek is letting the segment occupy more real estate and coming out with promotions that feature new styles and flavors. "I still think we are in the year of the flavor — and not just with cigars," Holiday said.

How much longer this flavor run lasts, though, is up in the air. The cigar industry is playing a wait-and-see game with the FDA and possible regulation. Many agree that flavors will be the first to go, so manufacturers are expected to begin moving away from flavors.

Flavored or not, single and multipack cigars can be good for business in the convenience channel. The cigar shopper is inside a c-store more frequently than any other tobacco consumer. Plus, their basket size is not as high, which means there's room for growth for c-stores who go after it.

Play by the Rules

After losing its bid to regulate electronic cigarettes as drug delivery devices, the Food and Drug Administration (FDA) said it was going to regulate the products like tobacco. That was in April 2011. Two years later, the industry is still waiting.

Some believe regulations could finally be introduced this month, but what form they will take remains to be seen. There is heavy speculation that e-cigarette rules will closely mirror those of traditional cigarettes — particularly in regards to a ban on flavors.

Still, others debate the FDA's authority to regulate e-cigarettes. Even if regulations are handed down, there's the question of when — and if — the rules will be enforced.

"It is very likely that the agency will issue deeming authority to regulate e-cigs as tobacco products as early as April 2013," said Bonnie Herzog, managing director of tobacco, beverage and consumer research at Wells Fargo Securities LLC. "However, we also think it's likely there will be legal challenges to this decision, which could take months, if not years, to be resolved."

If e-cigarettes are deemed to be regulated by the FDA, Herzog expects several things to occur: barriers to entry would increase; existing electronic cigarette companies would be entrenched; the industry would likely consolidate; and Altria Group Inc. would likely enter the arena in some fashion.

Despite the uncertainty, Herzog added that "we continue to expect that the e-cig category could have a meaningful positive impact on the tobacco industry's profitability long-term."

— Melissa Kress

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