Tobacco faces many challenges but continues to evolve

Key Takeaways

• Pressures on other channels to stop selling cigarettes may drive even more sales to c-stores.
• Premium brands are showing growth and have not been fully developed yet.
• Other tobacco products hold promise for new areas of growth, whether it’s snus, sticks, tablets or strips.
  

By Cecelia Blalock

Distributor Stephen Altman has a one-word description of the tobacco category these days--“scary”.  As president of family-owned Mountain-Service Distributors of S. Fallsburg, NY, Altman finds a host of problems threatening the tobacco sales that account for some 85 percent of his business.  They include the highest state excise taxes in the nation, competition from nearby states with lower taxes on OTP (other tobacco products), cigarette sales lost to tax-free Indian reservation stores, and increased bootlegging of cigarettes.  While these problems may be more severe in New York, they are growing increasingly common in other parts of the nation.

And that doesn’t count the looming serious threat of higher federal and state taxes, greater regulation and Internet sales. 

“We’ve been in business since 1927 and my son works in the business, but I tell him there won’t be a tobacco business for his son,” says Altman, predicting cigarettes may wind up as part of an underground economy much like marijuana is today. 

Meanwhile, Altman is fighting to grab a bigger slice of a smaller pie by offering things that differentiate Mountain-Service from other distributors, such as programs and product lines that competitors don’t have.  At the same time, the company has had to tighten its credit policies for retailers.

“As sales decrease, retailers have a harder time paying their bills if they have not reduced their costs,” Altman says.

Despite the challenges, the tobacco industry is moving ahead, confident it can survive by adapting to changing habits of tobacco users and finding ways to work more efficiently with supply chain partners.

Increased pressure
Taxes, local regulation and the economy are the major category drivers in tobacco today, says John Geoghegan, director of brand development for Kretek International of Moorpark, CA.  He attributes the steady decline in cigarette smoking to higher prices from increases in state excise taxes, restrictions on where smokers can light up, and a plethora of cessation programs and products that prompt smokers to quit.  Geoghegan predicts carton sales will continue to decline until the country reaches a critical mass of smokers, which he estimates as about 16 percent of the population, unless significant federal legislation has a further negative impact on smoking. 

It’s not all bad news for distributors who sell to convenience stores.  According to the National Association of Convenience Stores (NACS) 2007 State of the Industry report, the percentage of cigarettes sold in c-stores increased nearly 10 percent between 1999 and 2006 when c-stores sold 64.3 percent of cigarettes.  The average gross margin per store that year was $70,799.  Pressure on other channels, such as drug stores, to stop selling cigarettes may drive even more sales to c-stores. 

A taxing state of affairs
President Barak Obama’s signing of the reauthorization and expansion of the State Children’s Health Insurance Program (SCHIP) legislation in February was a major hit on tobacco because SCHIP will be funded primarily by significant increases in tobacco taxes.  In addition to hiking the federal cigarette tax from 39 cents to $1.01 per pack and $10 per carton, other tobacco products such as roll your own tobacco (RYO), big cigars, little cigars, chewing tobacco and snuff face huge tax increases.  President George Bush twice vetoed SCHIP legislation, but President Barack Obama has indicated his support for the measure.

For some distributors the situation is dire. 

“We’re under tremendous, ridiculous pressure,” declares Wisam Paulus, vice president of Trepco Sales Company of Oak Park, IL.  With tobacco accounting for approximately 85 percent of sales, if SCHIP becomes law, Paulus says he could be out of business in a few months. 

Paulus reports “incredible growth” of little cigars and roll-your-own (RYO) in the past few years.  But that growth is likely to be squashed by the proposed federal and state taxes, he says.  SCHIP would raise the federal excise tax on RYO by 2,000 percent and, when combined with higher Illinois state tax, the taxes on one pound of RYO tobacco would jump from $1.30 to $33.00. 

“The power to tax is the power to destroy,” says Mike Gold, president of Arango Cigar Company, Northbrook, IL.  Makers of hand-rolled premium cigars usually found in specialty tobacco shops, Gold is banding with other manufacturers and distributors in all channels to fight new laws they feel will drive down sales.  Gold predicts the SCHIP tax will drive RYO into the black market and has the potential to increase crime because tobacco products will become so valuable. 

More regulation possible
In addition to taxes, tobacco faces the prospect of additional regulation if legislation passed by the House that gives FDA the authority to regulate tobacco becomes law.  While the agency cannot ban all tobacco products, the agency could order significant changes in advertising or the public sale of tobacco for the protection of the public health.  States also continue to pass new anti-smoking ordinances that limit smoking opportunities. 

The beat goes on
Despite the gloomy prospects for higher taxes and more regulation, no one believes that tobacco in its many forms is likely to disappear any time soon. 

“Higher taxes have a waterfall effect,” says Altman.  “Premium smokers go to second-tier cigarettes, second-tier to third-tier and on down.  At the bottom it goes to roll-your-own.  Smokers fall to cheaper brands, they smoke less or they switch to other tobacco products.”

“Value is critical,” says Steve Shipe, vice president, sales and marketing services for Liggett Vector Brands Inc. of Morrisville, NC. “Cigarettes are expensive and the adult smoker needs to feel like he/she is getting a value for their money spent.”

Liggett Vector has seen significant growth in its Grand Prix cigarette brand, a lower priced cigarette that comes in 14 styles.  The company also has begun testing Grand Prix snus, a form of smokeless tobacco. 

While some smokers opt for less expensive brands, premium cigarettes are showing growth.  “We say smoke less, smoke better,” says Larry Sherman, executive vice president of sales and marketing for Nat Sherman, makers of premium cigarettes.  “Consumers are looking for better quality and more artisan products.  We see it in c-stores with gourmet mints and upscale drinks.  Consumers like to treat themselves and they can do that in the tobacco category. There is still opportunity.  The high end is not fully developed.” 

Also on the high end, Commonwealth Brands, Inc. of Bowling Green, KY, introduced two Davidoff Slim cigarette styles following on the heels of its spring 2008 launch of the Davidoff Premium line to the U.S. market. Davidoff Slims account for an increasing share of the company’s sales worldwide. 

On the other end of the price scale, “make-your-own (MYO) seems to be getting most of the chatter these days, not only because it’s been a steadily growing category, but also because so many retailers still haven’t discovered the sub-category,” says Steve Sandman, vice president sales & marketing for Republic Tobacco LP of Glenview, IL.  Republic is excited about its new Drum World Blends, which feature different tobaccos from around the world.  Each blend has a unique taste that Sandman compares to someone enjoying different fine wines.

Republic also is a leader in the cigarette filter tube segment and recently introduced King Size Menthol Cigarette Filter Tubes. 

In recent years, cigars have become associated with a more upscale lifestyle and in the process have quietly grown in popularity and sales.  According to The Nielsen Company, cigar sales in c-stores rose nearly nine percent in the 52 weeks ending December 27, 2008. 

Philip Morris USA is the nation’s largest tobacco company and accounts for half the nation’s retail cigarette sales, including the popular Marlboro brand.  Its parent company Altria also owns companies that market Black and Mild cigars and smokeless tobacco products including Skoal and Copenhagen.  It is rolling out Marlboro snus at retail to capture a bigger slice of the smokeless market.

Holy smokeless
While cigarettes still account for some 90 percent of tobacco sales, significantly higher taxes, changing consumer tastes, and societal pressure are prompting adult tobacco users to try alternatives.

Greg Mathe, spokesperson for Altria, predicts continued growth in OTP products, particularly snus, as consumers learn more and more about it.

“Certainly all of the alternative tobacco products are emerging and we would expect to see a flood ensue in the market over the next year or two, whether it’s tobacco sticks, strips, tablets, or things we haven’t imagined yet,” opines Sandman.  “The most emerging trend has been snus as all the major cigarette companies are now competing in this area.”

Reynolds American is developing what it calls its “modern smoke-free category” and is urging wholesalers and retailers to join the movement, says David Howard, director of communications.  Its Camel snus product is going national with the manufacturer supplying the refrigerated shelf unit for what it says is a fresher snus included in the contract. 

Dissolvable Camel sticks, strips and orbs are being test marketed in Columbus, OH, Indianapolis, and Portland, OR.  Unlike other OTP products, the dissolvables leave nothing to dispose, helping them to meet societal expectations, Howard notes.  They also offer good margins for wholesalers and retailers.

Working with distributors
“It’s important for our wholesale and retail partners to recognize that as adult consumer preferences are changing while they look forward to enjoying tobacco, these products provide alternatives,” Howard says.  Reynolds American is working closely with distributors to ensure they understand the importance of this category, that these products have a presence in the stores and that they are informing consumers of their availability.  They are a way for retailers to continue to realize profits from tobacco. 

Nat Sherman’s business is based on its relationship with its distributors, says Sherman, adding,  “we try to see that everyone makes money in every part of distribution.”  For the specialty category, it’s important for the distributor to have a wide assortment of products so they become known for that and are seen as the place for one-stop shopping, he says. 

Some of the new ways of working with distributors are detrimental and bad for their distributor base in Sandman’s eyes, citing reductions in discount terms, freight surcharges, increased minimums for prepaid freight and even direct shipments to retailers bypassing distributors. 

“Sometimes the best new thing is leaving things the way they are when they work for everyone in the supply chain,” he says.

Reynolds American offers opportunities for their wholesale and retail partners through incentive programs with varying levels depending upon how closely they work together. 

“The smallest retailer has the same opportunities to participate in the incentive programs as the largest,” Howard says. 

While manufacturers have long had programs designed to encourage distributors to work to promote products, those programs have taken a hit in recent years as manufacturers feel the squeeze of a declining domestic market and increasing Master Settlement Agreement expenses. These challenges come at a time when the larger, publicly traded cigarette companies are also feeling continued pressure to continue to grow earnings per share for stockholders.

This has resulted in a squeeze on distributors.  Manufacturers have tightened payment terms, requiring payment in advance of shipment of the product to distributors.  And they have made the highest levels of their distributor programs much harder to hit.  This has occurred at the same time distributors are facing much higher expenses – including the cost of borrowing increasingly large sums due to skyrocketing taxes.

“Distributors are by definition the middle men,” notes AWMA President Scott Ramminger. They are paying in advance for the product and then generally extending credit terms to their retail customers.  They are already operating on razor thin margins, so the prospect of having to try to borrow even more money to pay a floor stocks tax and pay for more expensive tobacco products is extremely daunting,” he says.

“AWMA is trying to help in a number of ways.  First, we continue to fight like mad against tax increases on tobacco and other costly legislative and regulatory actions like FDA regulation. Second, we have a very strong Industry Affairs Committee that has met several times annually with the major cigarette manufacturers to have a dialog with them about distributor concerns. And finally, we continue to try to help distributors operate more profitably and compete in a very tough environment,” Ramminger asserts. “Our Executive Program at the Wharton School of Business, and a recent Customer Profitability Analysis Tool we’ve created, are just two examples of that work.

“The bottom line is that it’s more important than ever for manufacturers, distributors, and retailers to work together – both on legislative issues and business process issues,” Ramminger continues. “When things get tough, the temptation is to go into a corner by yourself. But that is the worst thing that could happen for our industry.  And we at AWMA plan to direct a great deal of our energy at seeing that it doesn’t happen that way.”

Cecelia Blalock, a regular contributor to Distribution Channels, is based in Jessup, MD.

Tobacco Sources

Altria, Richmond, VA   (804) 484-2000
Arango Cigar Company, Northbrook, IL  (847) 480-0055
Commonwealth Brands, Bowling Green, KY  (866) 348-9604
Kretek International, Moorpark, CA  (805) 531-8888
Liggett Vector Brands Inc., Morrisville, NC   (919) 990-3513
Nat Sherman, Ft. Lee, NJ   (201) 735-9000
Republic Tobacco LP, Glenview, IL   (847) 832-1245
Trepco Sales Company, Oak Park, IL    (248) 546-3661