New Smoke Signals

C-stores must tap into emerging trends to evolve with the tobacco category

Convenience Store News Staff Report

Managing the ever-changing tobacco category may seem daunting to convenience store retailers dealing with limited space, but the best ones are analyzing the category on a daily basis, ready to slice and dice it as necessary.

The tobacco segment is not dying, according to experts. It is merely evolving, and as the tobacco industry becomes more innovative, c-store operators must open their eyes to the new smoke signals, which in many cases, produce no smoke.

For instance, Deutsche Bank analysts reported in September that smokeless tobacco had the best monthly volume so far this year with a 4.1-percent increase. At the same time, electronic cigarettes' dollar sales rose 123 percent. Backing up the smokeless trend, a new Smoke-Free Alternatives Trade Association (SFATA) was formed in March and debuted at the 2012 NACS Show last month.

Here's a look at more of the latest tobacco category indicators.

1. Cigarette Price Increases Will Be Offset by Promotions

In late September, UBS analysts said in a research note that U.S. cigarette pricing is expected to remain under pressure for 2012's second half, and that while the outlook for 2013 is still unclear, "it seems [Reynolds American and Lorillard] are looking to manage their businesses as though the pricing environment will not improve."

Bonnie Herzog, managing director of tobacco and consumer research at Wells Fargo Securities, agrees with the pricing pressure assessment. "I expect another modest price increase by the end of the year, consistent with what we've seen historically," she said.

She noted, though, that this price increase will be offset by promotions on both existing brands and new products, citing new menthol items in particular.

2. Menthol Competition Has Fired Up

Herzog referred to the menthol subcategory as "a more attractive segment of the overall tobacco industry" right now and said competition has "absolutely heated up." While Lorillard's Newport brand remains the menthol leader, category innovation and promotion are coming from both Philip Morris and RJ Reynolds (RJR).

The latter gradually introduced new Pall Mall Black and Pall Mall White menthol cigarettes, which complement its standard menthol version Pall Mall Green. National distribution begins this month. According to Richard Smith, RJR spokesperson, the launches reflect category growth nationally and a shift in smoker preferences.

3. A Ban on Menthol Is Not Expected

Despite some investor concerns regarding a ban on menthol, UBS analysts went on record to say they do not expect the U.S. Food and Drug Administration (FDA) to ultimately ban the flavoring. Herzog agrees and said she never believed there would be a ban on menthol and that the chances for an outright ban "are close to zero."

"I would never say 'never,' but because of the unintended consequences, it would not make sense — too many issues would result," she explained, adding there is still a probable chance there will be some modifications made by the FDA to the segment.

4. Graphic Warnings Case Is Up for More Appeal

In early October, the U.S. Justice Department filed a petition asking for the full court of the U.S. Court of Appeals in Washington, D.C., to rehear the challenge to the FDA's requirement that they place graphic health warnings on cigarette makers' packaging. This came after a three-judge appellate panel for the same court in August affirmed a lower court ruling blocking the mandate due to First Amendment violations.

The appeals court rarely grants appeals for a full court hearing. Professor Michael Siegel of Boston University's School of Public Health said in his blog (tobaccoanalysis.blogspot.com) that while granting en banc review is uncommon, it is possible that this case could get the full court hearing for having "extraordinary" significance or because it involves disagreements between appeals courts on similar issues.

Siegel said if the full appellate court does not overturn its panel's decision, the U.S. Department of Justice is likely to appeal to the U.S. Supreme Court, and he believes the Supreme Court will "most certainly take the case," with the ultimate disposition of the case then occurring at that level.

5. Dollar Store Competition Is Fresh and Feisty

Industry experts advise c-stores to aggressively respond to recent dollar store competition in the tobacco arena by pursuing promotion and marketing opportunities to keep customers coming to their stores for smokes. Earlier this year, Family Dollar added tobacco to its mix, with premium and value-brand cigarettes, as well as cigars.

Family Dollar has gone on record noting that tobacco is a category that drives very frequent trips to its stores and that its down-market customers over-index in cigarettes.

Despite protests from anti-tobacco groups and others, the dollar store chain is seemingly in tobacco to stay, with others in the dollar store channel expected to follow.

6. Republican Win Considered Favorable for Tobacco

In Wells Fargo Securities' recent report, "Election 2012 — A Race to the Finish," Herzog speculated that an Obama win may be "slightly negative overall" for the tobacco sector due to the likelihood of increased regulation and taxation.

A Democratic win would create a greater likelihood of tobacco taxes increasing, she said, making cigarettes more expensive and affecting consumption near-term. The federal cigarette tax rose from 39 cents to $1.0066 per pack in 2009 under the Obama Administration.

A Republican win may be a slight positive for the sector, she stated, noting that the dividend tax rate remaining at its current 15 percent — which was enacted during the George W. Bush Administration — would bode well for the attractiveness of tobacco stocks.

Looking at the top U.S. cigarette brands, Herzog relayed that Altria (Philip Morris) is expected to outperform Lorillard and RJ Reynolds due to innovation behind the Marlboro brand and "superior marketing resources."

7. E-Cigarettes Expected to be the Wave of the Future

According to Wells Fargo equity research, the electronic cigarette industry's size is thought to be about $300 million in revenue currently at retail, and it's estimated it could grow to $1 billion over the next few years with gross margins likely comparable to cigarettes. The c-store channel was labeled the most popular for e-cigarettes by survey respondents.

In the report, Herzog suggests that electronic cigarette consumption could surpass traditional cigarette consumption in the next decade.

Mark Wunder, CEO of CigReviews.com, said e-cigarette reviews on his site have "skyrocketed" over the past two years, reflecting the growing interest in the product, which he also believes has the potential to change the tobacco industry.

8. NGP Moving Beyond E-Cigarettes

Next Generation Products, or NGP for short, are definitely in the works beyond e-cigarettes.

For instance, Sentiens LLC, a North Carolina research and development company, recently launched Novus Twigs, a "botanically-based cigarette alternative." The company said the product looks exactly like a cigarette and offers "a lifestyle solution for smokers and non-smokers."

The alternative, which lasts for about three hours, is neither an e-cigarette nor a smoking cessation product. According to Sentiens, Novus Twigs "delivers a smoking sensation through a combination of sensory stimuli associated with cigarette smoking — from the outer white wrap to the inner paper to the all-natural botanic formula itself — without the socially unacceptable side effects of second-hand smoke, odor and ashes."

Also in the arena of NGP, Philip Morris in 2011 purchased the rights to a technology that lets users inhale nicotine without smoking. It is also developing other NGP, including an aerosol nicotine delivery system and a mechanism to heat tobacco in a cigarette, which it has said it expects to launch in 2016 or 2017, according to media reports.

Philip Morris is reportedly not considering e-cigarettes as an interim step for its NGP because its strategy is to commercialize NGP with regulatory approval that allows the company to specifically say how the product benefits a smoking consumer. It won't launch a product without being able to make a claim, reports stated.