The Future Of Cigarettes

Social pressures, anti-smoking laws, FDA enforcement put pressure on industry's top-selling product

Convenience store operators whose cigarette sales are simply holding steady may consider themselves big winners as the industry comes to terms with shrinking demand for its No. 1 seller, higher retails, more anti-smoking bans and stepped-up regulatory compliance.

C-store cigarette volume declined 8 percent in 2009 according to Altria Group figures, and, according to the Convenience Store News Industry Forecast, is expected to fall 0.2 percent in 2010 and nearly half a percent in 2011.

While increases in excise taxes have pushed average cigarette dollar sales to $412,104 per store, up from $365,436 in 2006, many retailers have repositioned — or are attempting to reposition — their stores with other profit centers whose margins and cash flow can replace the cigarette category's declining — or potentially declining — contribution.

Smoking bans, excise tax increases and manufacturer price increases have put pressure on cigarette unit sales at the 10 Bonkers stores operated by Richmond-Master Distributors Inc., the South Bend, Ind.-based supplier that owns the Bonkers chain and 37 Low Bob's Discount Tobacco outlets. Richmond-Master Distributors also licenses another 85-plus Low Bob's sites.

“Cigarette sales are steady to down in our c-stores,” said Frank Davoli, the company's director of sales and marketing. “In the tobacco stores, cigarette sales and sales of other tobacco products and accessories are up slightly this year.”

The executive points to the tobacco stores' product variety and smoker-friendly environment for Low Bob's sales bump. “Those stores are a haven for smokers, who are in the minority,” he said. “The moral majority frowns upon smokers, but has no problem with the tax revenue the sales of cigarettes and other tobacco products generate for cash-strapped city, county and state budgets. Their motto should be ‘We don't like tobacco, but we will take the money!’”

Indeed, while four states — New Hampshire, Rhode Island, Oregon and New Jersey — are considering legislation to lower excise taxes — most have raised or are considering raising them. “For those who think states will roll back excise taxes on cigarettes — well, where will they make up that money? All of the states' budgets are in trouble,” said Mike Zielinksi, president and CEO of Royal Buying Group Inc., which has some 300 retailer members enrolled in its tobacco merchandising program. “Smokers, who are in the minority, will find it very hard to fight future tax increases. Some grassroots campaigns have been successful, and we should keep fighting, but unless states find another vice to tax, it will be hard to roll back tobacco taxes.”

However, despite such pressures on cigarette sales, the c-store industry may see a steadier category in the future, Davoli said, as retails stabilize and the relative price gap between discount and premium brands continues to shrink. “This trend bodes well for the major manufacturers, and I can see them trading share among themselves and gathering some share from fourth-tier manufacturers that close up shop, as we saw in 2010,” he said.

As the FDA works to ensure retailer and manufacturer compliance to the Family Smoking Prevention and Tobacco Control Act, there will be little incentive for new companies or brands to enter the market, Davoli said. “This will offer much-needed stability to the major manufacturers' cost structure and promotional investment,” he predicted.

Indeed, the c-store operator foresees cigarettes and other tobacco products (OTP) continuing to be a major contributor to the industry's profits and inventory investment. But the cost of selling cigarettes will increase as the cost of regulatory compliance rises, he predicted. “Due diligence is needed when assessing retails and gross profit.”

At Miller Oil Co.'s 33 Miller Marts and Miller's Neighborhood Markets, director of marketing and category management, Jack Trebilcock, has seen tobacco sales grow slightly. “Anyone who is seeing flat sales or a bit of an increase should be happy, since the number of smokers keeps falling,” he said. “But five years from now, I think sales will be down significantly.

“Like many retailers, we have been looking for something to replace the category's sales and margins, and we're promoting our one-stop convenience. We're working on foodservice, but we are a few years away from making that a solid profit center that can take over the No. 1 spot.”

The retailer credits the tobacco category's relative buoyancy to an increase in other tobacco product sales and the chain's cigarette pricing strategy following the big bump in federal excise taxes two years ago. When others increased cigarette prices, Miller Marts and Miller's Neighborhood Markets held retails steady.

“I thought that would be a great opportunity to steal some customers, which we did,” Trebilcock said. “We took a little bit of a margin hit, but slowly over the next couple of years we raised the prices. We're at the point now where the margin on cigarettes is up almost 2 percent over last year.”

Still, Trebilcock is seeing many of the chain's cigarette customers switching to other tobacco products, especially single and multipacks of cigars. “People are buying cigars in onesies and twosies for 99 cents to $1.29 each because though there will always be diehard cigarette smokers, some just need that little fix and grab a couple cigars instead of buying a whole pack of cigarettes,” he said, adding he believes the sales shift to OTP will continue.

Nielsen figures reveal unit sales of other tobacco products were up 8.8 percent in the 52 weeks ending Jan. 22, 2011, with the smokeless segment up more than 10 percent and cigar unit sales up more than 8 percent.

For now, the marketing executive is most concerned with competition from other c-store operators, especially large chains like 7-Eleven and Wawa. “They both have [high-margin,] established foodservice brands, and if they decide to really go after the cigarette business by selling at or below 10-percent margin, that would be devastating for us,” he said.

MAXIMIZING MERCHANDISING PROGRAMS

To compete, Miller Marts participates in the tobacco companies' highest-level merchandising programs and works to keep inventories low and turns high. All of the stores offer a two-pack special and some, especially in the northern part of the state, aggressively price cartons. “But carton sales are shrinking as the price and regulations increase,” Trebilcock said.

The retailer believes cigarette manufacturers are pushing smokers into specific purchases — and exerting control over the category — through their merchandising programs and promotions. “In our area, there is a great emphasis on Camel and Pall Mall, Marlboro, L&M and Newport,” he noted. “RJ Reynolds chose not to put Winston, Kool and Salem on the back bar so that people could see them. Virginia Slims and Parliament are no longer on the back bar.”

With little room under the counter to store other brands, Miller Marts is finding its ability to offer a wide variety challenged. “Our stores do automatic replenishment and know exactly what is selling, but the cigarette companies are reducing SKUs and it's chasing some customers away,” Trebilcock said.

The tobacco companies' promotions on Pall Mall and L&M are meant to trade smokers down from premium brands, he explained. “At a 30- or 40-cent difference in the per-pack cost between those brands and premium brands, I'm not sure it is enough to make a Camel smoker a Pall Mall smoker,” he said. “Deep discounts of $2 off a pack will push people to come down and buy a pack and try it, but then we've seen smokers go back to the premium brands after they come off deal.”

“Due diligence is needed when assessing retails and gross profit.” Frank Davoli Bonkers and Low Bob's stores

Indeed, tobacco manufacturers aren't necessarily concerned with the best merchandise mix for a particular location, agrees Royal Buying Group's Zielinski.

“Tobacco companies have been much more accurate in projections for new product launches and maximizing product assortment,” he said. “They use data so much and have been doing it so long — and yet, for c-store operators, local demographics play a huge role in how the category performs. But often the tobacco company isn't looking to address consumers' wants and needs, but the tobacco company's wants and needs.”

Still, Zielinski encourages every retailer to give their tobacco representatives feedback on products, promotions and sets. “It does influence the companies, but retailers won't see immediate change. For instance, a company may decide to send out five, rather than 50, boxes of a brand new item to a store. Changes to tobacco companies' programs and promotions do happen, but they aren't as immediate as most retailers would prefer.”

As a group, Royal Buying retailers are seeing flat or slight decreases in tobacco unit sales. But those who have most recently signed on to the tobacco program are seeing unit sales suffering smaller losses or even slight gains as RBG takes over managing the manufacturer programs and promotions. They are also ensuring the right amount of product is delivered, price promotions are being reconciled and display payments are being made.

“Sometimes when they join our program, retailers will have contracts with just one or two of the cigarette majors, whereas our program has contracts with all of them as well as the OTP manufacturers. We are maximizing the category. That sales-bump will plateau though as the industry as a whole sees lower unit sales.”

Andrea Myers, executive vice president of Kocolene Marketing, agreed with Trebilcock and Zielinski, saying the large tobacco companies' merchandising programs are pushing brands that may not necessarily be the customers' first choice. “They aren't going to support the display of fourth-tier brands, which are very price driven,” she said. “But our customers will come in and ask for ‘the cheapest pack of cigarettes you have.’ They don't care if it's not merchandised [on the back bar.] Our emphasis on the fourth tier is why our company has not seen the big decline in cigarettes sales as some others have.”

To attract the dwindling number of smokers, the Seymour, Ind.-based operator of 12 c-stores and 19 Smokers Host tobacco stores has clearly established its stores as destinations for low-priced cigarettes. For five years, stores advertised, “Cartons for as low as $20.99,” without naming a specific brand. “That banner may have represented five different brands over five different years,” Myers noted. “The cartons on promotion would be in a box, under a tarp or under the counter.”

“Five years from now, I think sales will be down significantly.” Jack Trebilcock, Miller Oil Co.

As Kocolene's c-stores are remodeled, more room is being devoted to cigarettes that are not merchandised on the wall behind the counter. “What used to be space for a filing cabinet or employees' purses now holds product,” Myers noted.

A new Smokers Host store, set to open later this year, will have a sliding cigarette rack hidden behind a wall behind the counter. “Those SKUs won't be visible, but it will provide our employees easier access to more cigarettes,” the retailer said.

Despite her focus on cigarettes, Myers, like other retailers, has seen customers buy fewer cigarettes, moving to other tobacco products as opportunities to smoke dry up and price sensitivity increases.

“I don't see the tobacco category going anywhere — but where someone may have purchased two packs of cigarettes in the past, now they are buying one pack of cigarettes and one pack of snus,” she said. “Or they are smoking filtered cigars, based purely on the cheaper price, since they look and smoke similar to cigarettes.”

Royal Buying Group's Zielinski believes the filtered cigar market is already going south in some areas, however, as local excise taxes are increased on those products. “The bump in those sales was all related to the 2009 increase in excise tax. I pity some of the little cigar manufacturers. The market went up fast, the business model changed very quickly and now it seems it is going bad in some states.”

As for other products taking the place of cigarettes, the retail veteran said tobacco companies are “trying to create a category” out of sticks, snus, lozenges and other cigarette alternatives. “They are hoping one of them takes off,” Zielinski said. “It's frustrating for retailers who are contractually obligated to put in, for example, a snus product, even if it doesn't sell.”

The moist segment is turbulent too, as moist customers want the freshest possible product and c-stores may not be the best source. “There are some new packages coming out to keep it fresher. But the whole tobacco category is becoming much more complicated with all of these alternative products. At some point, some product will be the preferred product for nicotine [when a smoker can't smoke].”

Despite the many pressures on cigarette sales, Kocolene's Myers doesn't foresee cigarettes moving from the chain's number-one sales spot. “We are well equipped to tackle whatever comes our way,” she said. “You have to do your homework and get to know your state representatives and be prepared. If we go out of the cigarette business, we will go out kicking — but I don't think we will go out. But you do need to be all in or all out of this category.”

Those efforts have positioned the stores to attract customers who once bought their tobacco products from mom-and-pops who have chosen to get out of the cigarette business or from grocery stores that have decreased their tobacco set. “You need someone pretty dedicated to the tobacco category to stay on top of the regulations, but others leaving has helped filter customers our way,” Myers said.

Her primary competitive concern now is drug stores, CVS and Walgreens in particular. “A year or so ago, we didn't really see them competing hard in the tobacco world,” Myers said. “Yes, we saw them go after the gallon milk and candy business, but we've been able to compete with them in those categories. Now, I see CVS offering a bigger variety of cigarettes and competitive pricing. We've added pharmacies to our manager's pricing survey and have told them to walk into CVS or Walgreens and look around.”

Davoli is most concerned about Native American sales, Internet sales and sales of contraband and untaxed product. “I see black market sales of cigarettes growing, as excessive taxation and regulation always lead to a rise in criminal activity.”

Even with such competition, c-stores, with more than 75 percent of all cigarette sales, will continue to dominate the category, Zielinski predicted — unless the government interferes. “That's the scary part. We don't know what the government will do. If it stays out of the way, tobacco will remain the number one selling product.8221;

FDA STORE CHECKS

Trebilock and Davoli, like most other operators, also are concerned about FDA regulatory compliance, as the agency has contracted with states for store checks.

Indeed, NACS Senior Vice President, Government Relations Lyle Beckwith said FDA regulatory compliance is the number-one issue facing cigarette retailers today. The law prohibits the sale of cigarettes or smokeless tobacco to people younger than 18, prohibits the sale of cigarette packages with fewer than 20 cigarettes, prohibits distribution of free samples of cigarettes, restricts distribution of free samples of smokeless tobacco and prohibits tobacco brand name sponsorship of any athletic, musical or other social or cultural events. What is less clear is how the FDA will approach interaction with the industry regarding compliance checks.

“The FDA clearly gives states the ability to apply more rigorous criteria to any of the FDA regulations,” Davoli said. “This could lead to an unlevel playing field from state to state, especially along the borders. We need to push for fair and equitable federal regulations and keep the playing field level.”

In early 2011, Beckwith and other NACS representatives met with Dr. Lawrence Deyton of the FDA Center for Tobacco Products. “FDA has a difficult mandate from Congress, given the deadlines they've been given,” Beckwith told Convenience Store News. It's hard to know based on what they've done thus far in terms of tobacco regulation and guess what they will do in the future.”

Among Beckwith's concerns: the way retailers are informed of possible violations. “The FDA is accustomed to dealing with large drug manufacturers and food companies,” the NACS executive said. “But 90,000 retailers in this country are one- or two- store operators. There is a much better way to connect with one of these retailers than sending a two-page letter that lists five or six violations they say may have occurred and giving a retailer 15 days to respond with a plan to rectify the situation. A one- or two-store operator will not know how to respond to this.”

That letter could be reduced to half a page, name the violation and ask for evidence that the retailer has enrolled his employees in a responsible tobacco retailing program, Beckwith said. “We want an effective regulatory and communications scheme that works without putting burdensome regulations on small businesses,” he said.

Although retailers' fines can be reduced if they prove they have participated in a certified training program, and the FDA has released a list of components such a program should include, the agency hasn't yet certified any specific program. “The We Card program is ubiquitous and should be approved,” Beckwith said. “Based on everything the FDA has said so far, we believe using the We Card program would be an effective defense.”

At Kocolene, Myers said the company has not had to make any adjustments to its tobacco policies related to preventing underage sales. “Everything the FDA wants to see, we were already doing,” she said. “The government just wants to see you are on top of the regulations and are a responsible retailer. It's not affecting our cost of selling cigarettes. There are representatives meeting with the FDA soon and if anything is changed or further clarified in that meeting we will react if we need to. ”

At Miller Mart, employees ask every cigarette purchaser for ID, regardless of age. “If that doesn't happen, we take disciplinary action, because we are that serious about avoiding underage sales,” Trebilcock said.

On another regulatory front, NACS is fighting the possible ban of menthol cigarettes the FDA is considering. “In a vacuum, we wouldn't care if menthol cigarettes are legal or illegal; we want to sell legal products on a level playing field,” Beckwith said. “But given that menthol cigarettes are 30 percent of the market, if they were banned, the FDA would be creating a black market for contraband product that won't be going away. The black market doesn't check ID or collect taxes, but takes legitimate business from our members. Just as FDA gets control of tobacco, how absurd is it they will put one third of it into an unregulated black market?”

The Tobacco Products Scientific Advisory Committee recently issued a report saying “the removal of menthol cigarettes from the marketplace would benefit public health in the United States.” However, FDA is not bound to follow any recommendations in the report. “Hopefully they will see it is no one's best interest to create a black market that would spread way beyond menthol cigarettes,” Beckwith said.

One other regulatory issue on the horizon, which is being challenged in court, is the threat of the category “going dark,” as it is in Canada and other countries. In that case, cigarettes would have to be kept out of sight and promoted only with black and white advertising. “I don't think that will be considered in the immediate future, but we could look at it in a year or two,” Beckwith said.

“Now, I see CVS offering a bigger variety of cigarettes and competitive pricing.” Andrea Myers, Kocolene Marketing

Such drastic steps would be devastating to the category, Trebilcock said.

But Myers isn't letting “what ifs” affect her cigarette strategy now. “I like to be conscious of what is coming down the pike in the immediate future and be ready for it,” she said. “Someone in my position shouldn't be caught off guard, but I hate to dwell on things so far into the future that it changes what I do in the market we are operating in today.”