SCHIP and Tobacco: Nails in the Coffin?

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SCHIP and Tobacco: Nails in the Coffin?

For the first part of the series, click here.

By Mehgan Belanger

NEW YORK -- While the regulations surrounding the April 1 increase of the federal excise tax (FET) on tobacco are unknown as of press time, the impact it will have on the tobacco industry is clear to many convenience store retailers and advocates, who indicated this law -- on top of the crumbling economy and slumped consumer spending -- could spell the end for those retailers already struggling due to the recession or those dependent on tobacco as traffic and profit drivers.

"This is certainly going to affect tobacco sales volume. April and May will really tell the story, and it will be tough going into the summer months when tobacco consumption [historically] increases," said Mary Szarmach, vice president of trade marketing for Smoker Friendly, who anticipated an 8 to 10 percent decline in consumption as a result of the new FET rates.

The consumption decline estimated by the Congressional Budget Office and the U.S. Treasury is similar, with at least a 10 percent decline in sales of cigarettes and tobacco products, according to Thomas Briant, executive director of the National Association of Tobacco Outlets (NATO). He added: "Convenience stores should prepare for this significant sales decline."

In addition, many existing problems in the convenience channel will be exacerbated when the new FET rates go into effect, according to an editorial letter written by Tony Miller, senior vice president of sales and marketing for Thorntons Inc., and obtained by CSNews Online earlier this month. Given that cigarettes represent 30 to 45 percent of convenience store inside sales, he wrote, the deterioration of the category will have devastating consequences.

These include increasing the cost of doing business, with inventory cost rising by an average $6,000 per store and $1 million for a chain of 166 stores. Credit card transaction fees will also increase due to rising cigarette retails, while internal shrink dollars will rise as well, Miller wrote.

Other fallouts include potential sales loss. Miller said it was difficult to calculate losses with any certainty, but cited tobacco industry experts who predicted additional declines of 6 to 10 percent, on top of the current trends of 3 to 4 percent.

"If the convenience store industry experiences double-digit sales declines in its largest inside-sales category, it will have an epic impact on the way we do business -- an impact that influences our total retail strategy," he said in the letter. "With unit sales predicted to decline by more than 10 percent, retailers will need double-digit percentage increases in average retails to make up the loss in revenue dollars." He added consumers will most likely absorb additional price increases above and beyond the excise taxes.

Fortunately, the changing nature of the convenience industry develops flexible business owners. "C-stores are very good at adapting to change. They'll find ways to work with the issues," said Chris Tampio, senior director of government relations for NACS.

But c-stores will not be alone in being impacted by the consequences of higher taxes.

"Small independent retailers will have a tough time, no question, weathering the storm. [As will] small independent wholesalers that rely on tobacco and small manufacturers," Smoker Friendly's Szarmach said, noting the FET hike's impact on tobacco will cause a ripple effect in c-stores, spreading to other in-store categories, and affecting ancillary sales and impulse purchases. "The question is, will this change the number of times [tobacco customers] stop at c-stores? They have always been good foot traffic generators."

Throughout the tobacco industry, as many as 117,000 American jobs will be lost after the tax increases tax effect, out of the 1.2 million American jobs in the tobacco manufacturing, wholesaling and retailing segments, NATO estimates.

In addition, the FET increases may significantly put the future of certain tobacco segments at risk, according to tobacco experts. While most of the new FET rates equaled hikes of 156 percent, the little cigar and roll-your-own (RYO) areas -- often considered a bright spot in c-stores' tobacco sections thanks to impressive growth rates in recent years -- did not get off so light.

Little cigars' FET rate increased from 4 cents per pack to $1.01 per pack, equaling a 2,635 percent increase, and the tax rate on RYO increased from $1.09 per pound to $24.78 per pound, a 2,145 percent increase, according to NATO's Briant. Members of Congress believed the more than $24-per-pound tax rate on RYO would be approximately equivalent to the tax rate for the number of manufactured cigarettes that could be made with a bulk pound of cigarette tobacco, he explained

"This astronomical increase in the RYO tax will severely harm manufacturers, wholesalers and retailers that sell RYO tobacco," he added.

The RYO FET increase is so massive that the small percentage of smokers using it will do a "double take," and ask whether the potential savings of making their own cigarettes is worth doing so, said Szarmach. For example, one pound of Smoker Friendly's private-label RYO tobacco, which makes roughly 2.5 cartons of cigarettes, is currently priced at $24. With the new tax rate, that same amount of tobacco will be approximately $50.

"On a tight budget, can customers afford that purchase?" she asked. "It will be interesting to watch where that segment falls ... I hope the RYO and MYO manufacturers can weather this one."

Moreover, to prevent consumers from using the considerably lower-taxed pipe tobacco in the place of RYO tobacco, the TTB will alter its definition of the two segments of OTP to clarify the differences, according to Cigar Association of America (CAA) President Norm Sharp. "They are taxed differently, and because the rate increase on RYO was so huge, the TTB is worried it will see an increase in pipe tobacco sales as a result." In addition, cigar wraps will be placed in the RYO segment, he said.

Overall, the new FET rates may change the dynamics of the entire tobacco category. Since consumers are very value-conscious during the current recession, the tax hike may create an environment where lower tiers of tobacco products may become more attractive to customers. "Third tier and private label fourth tier will be more palatable to customers," Szarmach said, adding she doesn’t disagree that lower tiers will grow, though she has seen the premium brands, such as Marlboro, Camel and Newport, retain their market share throughout price increases in the past.

"[Customers think], 'I'll smoke less but it'll be what I want,'" said Szarmach. "Our Marlboro business has been really good, and continued to grow. But obviously we're in wait-and-see mode."

But what may be the most dismal element for tobacco retailers concerning the SCHIP law and the resulting FET increase is the potential rise in crime due to more expensive products.

"This is going to push people to the black and grey markets, and to the Internet to purchase illegal cigarettes," said NACS' Tampio. "We see this as brewing crime ... the government has created a commodity in cigarettes, and a very valuable one. When people rob a c-store they ignore the cash. There's more money in cigarettes than anything else in the store."

He added c-stores are not the only ones at risk for crime, but also wholesalers' and suppliers' truck drivers and delivery employees.

Taking this into account, c-stores should review security procedures regarding robberies and thefts with employees, and upgrade security and surveillance systems both inside and outside stores, recommended NATO's Briant.

While the tobacco industry suffers, the sole party that may stand to benefit from the FET increase is U.S. states, which in many cases tax tobacco on a percentage of the selling price, explained Sharp.

"The FET is a big hit that is magnified by the fact that state excise taxes are imposed as well. The states will be getting more excise tax revenue and it means they'll get more sales tax revenue. But the products are becoming more expensive and its occurring at a time of severe economic downturn." And all of these factors "do not appear to be deterring states from enacting their own tobacco tax increases," he concluded.