Opportunities & Uncertainty Swirl Around the Backbar

The category faces challenges like FDA bans and price hikes, while reduced risk product innovation presents opportunities.

Danielle Romano

10/19/2023

NATIONAL REPORT — There's no question that nicotine is a critical driver of convenience store traffic. In terms of profitability, however, not as much, reported Bonnie Herzog, senior financial analyst at Goldman Sachs, during last month's "Current Trends in Tobacco and Nicotine," sponsored by the National Association of Tobacco Outlets as part of a Fall Webinar Series.

Cigarettes are the No. 1 contributor for sales, but is only about the third contributor in terms of total gross margins partly due to the lower margin profile of cigarettes vs. the rest of the products sold inside the store — with premium cigarettes the largest segment at almost 77 percent of the total category, according to Herzog.

During the webinar, Herzog explored multiple factors impacting the nicotine and tobacco category, such as market trends, the impact of downtrading pressure, the future for pricing and what's ahead for reduced risk products.

The Adult Nicotine Consumer

As Herzog noted, the adult tobacco consumer is pretty resilient but under pressure. When examining Goldman Sachs' latest "Nicotine Nuggets" survey conducted in July, the analyst is optimistic that discretionary spending will broadly increase next year.

"What's interesting to us is that it's going to be pretty balanced across many of the different income cohorts. We certainly saw a lot more pressure on the low-income consumer, historically or the more recent history, but I think that's going to moderate a bit as personal income growth does remain robust," she said. "We've got inflation rates continuing to subside. Household debt to income ratios remain at relatively healthy levels. So, we're a little bit more optimistic on the consumer to put that in perspective."

Cigarette Volume

According to Herzog, multiple facts are responsible for the decline in cigarette volume, which is down high single-digits. She pointed to:

Fuel Demand

As fuel demand moderates and gas prices begin to peak back up, consumers are driving less and many are gravitating toward more fuel efficient vehicles as well as electric vehicles. Why is that important? Herzog points out that less driving correlates to less store traffic, potentially impacting the purchase of tobacco and nicotine products.

"We have found that there's an inverse correlation between gas prices and cigarette volumes, so it does suggest there could be continued pressure on cigarette volumes moving forward," she said.

Price Elasticity

Elasticities are strengthening and that will cause downward pressure. "As you think about the manufacturers and the pricing that they've been taking, that's having an impact on cigarette volumes. And consumers are dual users or they're switching to more affordable alternatives," she said.

Retailer respondents in the "Nicotine Nuggets" survey confirmed there has been pressure on customer traffic during the second quarter of 2023. Trips have been depressed, but basket size has increased.

"About 53 percent of the retailers that we surveyed indicated that they saw lower trips in the second quarter vs. Q1, so there's a deceleration, but 65 percent of the survey respondents said that they're seeing stable to maybe higher spending per trip, which is playing a role in terms of driving a little bit better sales inside the store," Herzog shared. "Also, there's a view that consumers may be consolidating their purchases or trips to conserve on overall purchases."

Cigarette manufacturers' price hikes also play a factor in the acceleration of downtrading from premium cigarettes. Most recently, British American Tobacco (BAT) increased the list price of Newport (menthol and nonmenthol) by 15 cents to 25 cents per pack, Camel (menthol and nonmenthol) by 15 cents to 40 cents per pack and Pall Mall Box by 15 cents per pack.

"The industry has a little less or significantly less pricing power today, but I do think ultimately the flexible pricing strategies has allowed these big tobacco manufacturers to really address the volume declines more effectively," Herzog noted. "They're also using brand extensions and, ultimately, sophisticated promotional strategies to ultimately keep the consumer in their brand families."

Reduced Risk Product Consumption

Goldman Sachs forecasts cigarette volumes to remain pressured, but as consumers continue to gravitate away from cigarettes and move toward reduced risk products, that will play a role on cigarette volume consumption moving forward. Herzog pointed to increased innovation in the reduced risk product space hitting the U.S. market as a factor.

Herzog called the oral nicotine category "promising," even though the modern oral tobacco category is under 30 percent of the total oral tobacco category.

"It's growing very rapidly, but it's still quite small," she said. "The category is attractive, it appeals to a younger, more affluent and more educated consumer, and the margin profile is much more attractive. So, this is where I’m hearing more retailers are allocating space to this category because, simply, it's driving volume, sales, and, certainly profitability."

Update on the FDA's Rulings

In terms of the total e-cigarette category, retailers and wholesalers are pretty cautious and it has a lot to do with U.S. Food and Drug Administration's (FDA) pending premarket tobacco product application (PMTA) decisions. The agency expected to complete 55 percent of its PMTA reviews by the end of September and 100 percent by the end of the year.

When it comes to the FDA's rulings, Herzog provided her perspective on its menthol cigarette ban, in which a final ruling was supposed to be delivered in August and still has not come. The FDA also said it will give an update on its proposal to set a maximum nicotine level for tobacco products in December, "but I am assuming that’s going to be kicked as well," Herzog said.

"In my view, nothing's going to change in the market for many years because it won't be implemented for a couple of years, if not longer, and there's likely to be litigation from the industry," she reported. "So, I don't foresee anything changing in the market for four, five-plus years, maybe if ever, quite frankly."

If there is a ban, the manufacturers who will be impacted the most include, according to Herzog:

BAT — 55 percent of the company's cigarette volumes are menthol
Imperial — 50 percent of the company's cigarette volumes are menthol
Altria — 20 percent of the company's cigarette volumes are menthol

"As a reminder, IQOS does have a PMTA and [Modified Risk Tobacco Product application], but it's not yet clear how that's going to be addressed in this potential final ruling," Herzog commented.

Marketplace Opportunities

As Altria focuses on "Moving Beyond Smoking" toward a smoke-free future, the manufacturer has multiple products in the innovation pipeline:

The company will leverage its joint venture with Japan Tobacco for Ploom X and it expects to file a PMTA in the first half of 2025 and an MRTP later that year.
The manufacturer introduced SWIC, a heat-not-burn tobacco product, at its investor day earlier this year; however, it has yet to file a PMTA. "I'm optimistic it should appeal to vapor users who have historically tried or rejected some of the current e-cigarette products that are in the market," Herzog offered.
After closing on its acquisition of NJOY earlier this year, Altria will be rolling out NJOY ACE into more U.S. stores.

"But I should mention, as Altria is moving beyond smoking or into a smoke-free future, keep in mind, it's critical that their cigarette business with Marlboro stays relatively strong or stable because that's going to fuel or finance some of the growth into these other areas as they push aggressively or as aggressively as they can given the [FDA’s regulations]," Herzog said.

Moving onto Philip Morris International (PMI), Herzog said the company is a big competitor in the U.S. market given its acquisition of Swedish Match and its product ZYN. The acquisition gives PMI a distribution platform sales team to essentially reintroduce IQOS in the U.S. market next year.

"From Philip Morris' perspective, they have zero position in cigarettes, so their goal is going to essentially be to convert as many smokers in the U.S. market to IQOS," the financial analyst said.