a volatile mixture

With gas prices reaching obscene levels, sales of premium cigarettes could suffer in the short term.

The past 10 months have been a pretty wild ride for Julie Van Alyea.Van Alyea, retail merchandise manager for Redwood Oil Co. (Santa Rosa, CA),has noticed a significant change in her most important instore category: cigarettes.While she has heard rumors that premium cigarette sales are supposed to havetaken back some of the share they lost to lower-priced brands, she just hasn’tseen that happen in her company’s 20 Chevron-branded stores.

"We break the tobacco category into distinct segments: premium cigarettes, tobacco (cigars, etc.), generic cigarettes and chew," she says. "Overall, the four segments are down 25,000 units to date. But when we look at the premium segment, that’s down, too. Selling cigarettes is an ingrained part of the convenience store industry. What I don’t know is if people are smoking less in Northern California. If they’re still smoking the same amount and going somewhere else, then that’s a big concern."

In Redwood’s stores, sales of smokeless tobacco and "other tobacco" items like cigars are up over the same period from last year. Meanwhile, sales of "generic" cigarettes—Liggett and Basic represent Redwood’s biggest movers in this space— are down nearly 12,000 units for the year to date. Van Alyea doesn’t yet understand why. Wholesale costs of one of her stores’ best-selling lower-priced brands recently increased 10′ per pack. She passed the increase on to the consumer, but she doesn’t think that’s enough to account for such a significant drop in volume.

"Cigarettes are not a loss leader for us," she says. "If costs go up we typicallyraise our retail by the same amount. Our convenience store competitors are veryvisible. However, the markets we operate in are distinct and spread out. Wehave adjusted our retails in certain locations to accommodate consumer demand."

While some of the markets in which Redwood does business aren’t terribly competitive, others are much tighter—especially near the Oregon border. Oregon’s state excise tax rate stands at $1.18, compared to California’s 87′.

"In our northern stores in Crescent City, Fortuna and Eureka, competition is extremely tight," says Van Alyea. "At four locations we dropped prices of four major brands by about 40′ a pack just to stay competitive, and we promote the heck out of them. Gas margins are a little higher up there, so competitors might be compensating by dropping their tobacco prices. It’s almost a role reversal."

A few exceptions
Farther south, in the city of Fresno, Johnny Quik FoodStores has had a slightly different experience. Joanne Thibodeaux, merchandisingmanager for the 22-store chain, says her company’s cigarette volume has beentrending down slightly but is consistent with last year.

Johnny Quik Stores has a strong representation of Philip Morris brands but also carries brands including Camel, Newport, Capri, Winston, Kool and Misty. So far, she has shied away from adding lower-priced or "fourth-tier" cigarette brands, but with costs rising she has begun to consider a few exceptions.

"The cost of cigarettes is so high that we really have to utilize the spaceand put in nothing but the best sellers," Thibodeaux says. "You can’t have everybrand known to man, but anything’s possible. We’ve been approached by a coupleof different tobacco companies, and with the price of gas going up customersmight start looking for lower-priced alternatives to the other things they buy."

Shifting dollars
In Colorado, Bryan Hutchins says it would take a fewyears of consistently high gas prices to have a significant impact on salesof the major brands in relation to lowerpriced brands. Hutchins, marketing managerfor Colorado Springs-based Bold Petroleum dba Acorn Food Stores, worries that,in the short term, obscene gas prices— combined with the escalating costsof smoking—could have a draining effect on the cigarette category as awhole.

"I have seen people that were brand loyal go away, and that has more to do with the price than anything else," says Hutchins. "A lot of people are quitting smoking. You also have a lot fewer people that aren’t starting to smoke because of the costs. It’s getting too expensive."

Despite the challenges, Hutchins sees some opportuntiiesto drive sales. He says it’s critical to manage the category-store to store, paying particular attention to demographicsand marketing opportunities by brand. In the low-cost segment, brands like Sonoma and USA Gold continue to perform solidly in Acorn stores.

"We’re seeing some [sales] increases in lower-priced cigarettes, and that hasto do with the area more than anything else," he says. "Aurora, for example,is strong in Newport and Kool. Then we have stores that sell onetenth of whatAurora sells with those same brands. That may increase with the cost of gasoline.We’re seeing people buying $5 or $10 worth of gas instead of filling up. Thosepeople might have used to spend $25 to fill up the tank. I filled my van today,and I used to be able to do that for $20. Today I spent $25 on a quarter ofa tank."

Regardless of the challenges he sees in relation to rising prices, he’s thankful that his seven convenience stores and travel plazas market in Colorado. The state’s excise tax stands at 84′, which compares quite favorably to states like Rhode Island ($2.46 per pack), New Jersey ($2.40) and Washington ($2.025), among others.

"We drove back through New York a couple of years ago," he recalls. "I paid $75 for two cartons."

Awaiting recovery
As of press time, Johnny Quik had made the decisionto implement a lower-priced alternative to complement its premium cigarettemix. Initially, the chain is dipping its toe into the segment with only threerows of product.

With the country still struggling to find its economic kickstart, 2005 hasnot been the best year for convenience store tobacco sales. Of the top 10 brandfamilies in the cigarette category, eight were down in c-store unit purchasesfor the year to date.

Trend Trakker

C-store Units Purchased (Cartons), Year to Date
With Promo Totals

Brand Family
Prior YTD
YTD
YTD Change
YTD Growth
Marlboro Total
70,901,886
66,326,454
-4,575,432
-6.45%
Newport Total
11,039,766
11,686,090
646,324
5.85%
Camel Total
8,526,548
9,907,816
-1,124,590
-10.19%
Doral Total
7,242,173
7,157,754
-1,368,794
-16.05%
Winston Total
4,350,628
6,583,556
-658,617
-9.09%
Basic Total
lign="center">3,845,398
4,077,617
-273,011
-6.28%
Kool Total
3,061,923
3,434,624
-410,774
-10.68%
Salem Total
3,061,923
2,801,217
-260,706
-8.51%
Parliament Total
2,496,188
2,747,244
251,056
10.06%
Virginia Slim Total
2,959,409
2,533,954
-425,455
-14.38%
Source: 2005 Wholesale Purchase Data

Despite the less than encouraging numbers, there remains a certain bullishness over the long-term prospects of the category and, specifically, the premium tobacco segment, since smokers of premium cigarettes remain the engine that drives the convenience store channel.

The prevailing thinking among the retail community is that once the economyrebounds and gas prices return to more "sane" levels—prices are expectedto drop to a more stable price range by the end of September— consumerswill return to their normal buying patterns. That means that with an economicupswing, consumers would invest more of their dollars in branded premium cigarettes.

On the tobacco front

  • The Federal Trade Commission’s annual report on cigarette sales andadvertising reveals that the major cigarette manufacturers spent $15.15billion on advertising and promotional expenditures in 2003, an increaseof $2.68 billion (or 21.5%) from 2002—and the most ever reportedto the commission. The total number of cigarettes sold or given awayby those manufacturers dropped by 19.8 billion cigarettes (or 5.1%)from 2002 to 2003. In 2003, price discounts paid to retailers or wholesalersto reduce the retail price of cigarettes was the single largest categoryof expenditures reported by the manufacturers, accounting for $10.81billion (71.4% of total spending). Together, the four categories ofpromotional expenditures totaled $12.72 billion (84% percent of allspending). The two next largest spending categories in 2003 were retail-value-addedinvolving free cigarettes (i.e., "buy two packs, get one free" typesof offers, where the free cigarettes are given out at the point of purchase)and coupons, which accounted for $677.3 million (4.5% of total spending)and $650.7 million (4.3%), respectively.
  • With North Carolina relinquishing its title as home of the nation’scheapest cigarettes on September 1, customers lined up to buy theirlast cartons of cigarette packs taxed at only 5′ each. The taxrose to 30′ a pack, but the region’s smokers won’t have far totravel to find cheaper cigarettes. At 7′ a pack, neighboring SouthCarolina has assumed the throne as the state with the nation’s lowestcigarette tax. The average cigarette tax in the Southeast is 32′a pack; the nation’s highest cigarette tax is in Rhode Island, at $2.46a pack.
  • Last month in Rochester, NY, a police task force threatened to arrestretailers if they didn’t stop selling blunts and blunt wrappers. Underthe auspices of the Greater Rochester Area Narcotics Enforcement Team(GRANET), police claim these products serve no purpose other than tosmoke marijuana and therefore should be treated as "drug related paraphernalia"under the law. GRANET has been visiting stores, showing retailers theproducts they consider to be drug paraphernalia, ordering them to removethose items from the shelves, and requiring them to sign a statementthat they have been advised of "the products in my store that are inviolation." The New York Association of Convenience Stores (NYACS) cautionedits members to confer with legal counsel before signing any such statement,since there is no legal basis for concluding that anyone has violatedthe law. GRANET threatened to arrest retailers under Section 851 ofNew York state’s General Business Law, which makes it a civil offenseto sell drug-related paraphernalia.

NYACS President Jim Calvin pointed out that the state’s Public HealthLaw includes cigars, rolling papers and "other tobacco products" in itsdefinition of tobacco products that are legal for licensed establishmentsto sell as long as they are not sold to persons younger than 18.

"With all due respect, these are legal tobacco products that our membersare licensed by the state of New York to responsibly sell to adult customers,"said Calvin. "No one questions [GRANET's] commitment to fighting drugabuse, but they are clearly overreaching."

Room for growth

Cigarettes gained some steam in 2004, up 0.2% to 34.7% of total in-storesales, according to the NACS 2005 State of the Industry Report. Premiumtobacco seemed to have regained some share—thanks to aggressivepromotions and price discounts from major manufacturers, as well as priceincreases affecting some lower-tier brands—but lost a little groundlast year. After increasing to 83.08% of all cigarette sales in 2003—aspike of nearly 1%—over the prior year, premium brands dropped slightlylast year to 82.65%. Branded discount smokes were up about 1% to 10.16%of total category sales, according to the SOI.

Another small but promising segment of the category that appears to havegrowth potential is super-premiums. With legislation, competitive pressures,tax increases and other factors affecting how, what and where legalageconsumers smoke, some people may be choosing to smoke less but switchto what they perceive as a higher quality cigarette. Also, there is acertain segment of the cigarette smoking population that remains unaffectedby price and simply wants a super-premium product, according to DarrenThibodeau, director of marketing for Kretek International, whose super-premiumbrands include Djarum and Dreams.

"Our customer is in the age group of 25 to 40, is within an upper incomelevel and is a member of the upper middle or upper class—and they’revery discerning in what they smoke," says Thibodeau. "This is the samecustomer that goes to Starbucks and drinks vitaminwater or other alternativebeverages. These kinds of products attract an affluent customer that typicallyprovides a higher profit margin and a higher basket ring."

The retail on many super-premium products can be as much as 25% higherthan premium domestic cigarettes, but the margin is "significantly higher"as well, according to Thibodeau. The main challenge to the segment, hesuggests, lies in increasing its visibility.

"Consumers need exposure to these products," Thibodeau says. "It goesback to the old adage: No one goes into a gas station to get a haircut.But if you put a barbershop out front of a gas station and promote it,I guarantee people will get their hair cut there."

On the tobacco front

  • A federal judge in Tennessee dismissed a lawsuit challenging PhilipMorris USA’s Wholesale Leaders program. In the suit, the plaintiffsalleged the program—which gave participants the opportunity toearn higher payments based o
    n market share—constituted illegalprice discrimination and violated federal antitrust laws. The courtdisagreed, finding instead that the program "is available to all customersusing a nondiscriminatory formula" and that wholesalers were free tochoose whether or not to participate. The Wholesale Leaders programis equally available to all wholesale customers, according to DeniseKeane, executive vice president and general counsel for Philip MorrisUSA, an operating company of Altria Group Inc.
  • Twelve percent of retailers in the U.S. illegally sold cigarettesto minors in 2005, down from 12.8% in 2004 and from 40.1% in 1996, accordingto the Substance Abuse and Mental Health Services Administration (SAMHSA).SAMHSA said that 49 of 50 states met the legislative goal of cuttingillicit sales to minors to 20% or less; 43 states had noncompliancerates of 15% or less, and 21 states had noncompliance rates of 10% orless. Only Kansas— with a 38% noncompliance rate—missedthe 20% goal. The state has pledged to direct more resources towardscurbing sales to minors in a bid to avoid losing a portion of its federalblock-grant funds. The figures are based on unannounced inspectionsof tobacco retailers.
  • A federal grand jury indicted eight smoke-shop operators for defraudingthe state of Washington of nearly $56 million in cigarette taxes. Thedecision wraps up a four-year investigation and charges the smoke-shopoperators, from Idaho and Washington, with money laundering, mail fraudand contraband cigarette trafficking, reports the Associated Press.The investigation ended in May 2003 when authorities raided shops onIdaho’s Coeur d’Alene Indian Reservation and the Puyallup and Yakamareservations in Washington. Since 2001, 19 of the state’s Native Americantribes have signed compacts obligating them to collect a tax equal tothe state’s cigarette excise tax. Tribes that did not sign a compactmust charge taxes on sales to non-tribal customers.

In Oregon, an online cigarette vendor was found not guilty of "racketeeringand computer crime" for selling cigarettes through the now-defunct Inexpensivesmokes.com,reports The Oregonian, but was convicted of conducting businessas a cigarette distributor without a license and failure to comply withstate sales requirements. A small percentage of the 7,500 people who purchasedcigarettes via the site have been billed for the unpaid tax by the OregonDepartment of Revenue.

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