smoke screen

With an increase in smoking restrictions and the threat of increased taxes, retailers and analysts express serious concerns for cigarette profitability.

Convenience stores, backin the good old days beforethey offered the types foodserviceand products thatcould rival other retail segments, wereknown mostly for three things: Cokes,smokes and gas. But despite the industry’sonce-strong foothold, cigarette salesare slumping. With major cities banningpublic smoking and state and federal governmentsshoveling an ever-growing pileof taxes on the product, the cigarette cashcow is offering less milk for retailers thanit once did.

Add in the fact that consumers are findingother outlets to find cigarettes, and itbecomes apparent that c-store retailersmay be in danger oflosing one of theirbiggest draws, leadingthe industry to take a collective look atthe product’s future of the industry.

The Taxman

According to the NACS 2007 State ofthe Industry Report, cigarettes made up18% of the gross margins for c-stores in2006, down almost a percentage pointfrom the year before. While NACS stillreports cigarettes as the largest segmentfor in-store sales—pulling in more than34%—that’s only on a national level. Forstores in states with particularly high stateexcise taxes, such as New York and NewJersey, the percentage is much lower, hurtingnot only the segment itself, but alsodamaging other in-store sales segmentsas well.

According to Jim Calvin, president ofthe New York Association of ConvenienceStores (NYACS), keeping the cigarettesegment profitable has been a fleetingtask over the past several years. In thestate of New York, it’s been estimated thatcigarettes only make up 20% of in-storesales, that low percentage caused primarilyby smokers scared off by high excisetaxes who often find other sources topurchase cigarettes.

“More than halfof the cigarettes soldin New York stateare purchased withoutthe collectionof any state excisetaxes,” said Calvin.“Thos e purchas eare going primarilyto one of threeplaces: the Internet,Native American reservations or theblack market.”

The problem has been steadily growingin the state over the past 15 years,pulling business away from c-stores. Thereal damage didn’t begin to occur until2000 when, in a two-year span, the stateraised the excise tax from 56 cents perpack to $1.11 per pack and then a staggering$1.50 per pack. Add those taxes to localand state taxes and the total price tag fora pack of smokes could float between $6and $8. “Those taxes fueled the cigarettetax evasion phenomenon, driving many thousands of c-stores customers to the taxfreeside of the fence,” added Calvin.

Tax-dodging dealers aren’t the onlyproblem dragging cigarettes away fromthe convenience store. Information compiledby analysts at UBS Securities foundthe average cigarette sales per store perweek are expected to reach only $4,119from 2006 to 2010, a huge drop from theaverage per store per week of $7,072 forthe 1997 to 2005 period. Much of the causestems from an aging customer base. Thereport showed that the fastest growingconsumer segment from 2005 to 2015are baby boomers ages 55 and up. Muchof this segment has been satisfying theirshopping habits in the drug store channel,which over recent years has recommittedto the cigarette segment.

Though competing with other legalchannels is a matter of dueling pricepoints—a game where the c-store industryis very well versed—it faces a muchbigger challenge when competing withthe prices offered by tax-avoiding outlets.While manufacturers like Philip Morrishave filed lawsuits against Internet-basedsellers, other outlets like Native Americanreservations, lead to a bigger challenge,according to Calvin.

“NYACS supported 2005 legislaturethat would have required other outletslike Native American reservations topay taxes on the cigarettes they’ve sold,”explained Calvin. The bill went into effectin March 2006, but was not enforced byformer Gov. George Pataki. Current Gov.Eliot Spitzer promised to enforce the lawas he was set into office in January 2007,but has yet to do so almost a year later.“We now have a governor who refuses toenforce the law, and because of that, literallybillions of dollars in gross sales arebeing drained away from law-biding, taxcollectingc-store retailers.”

The problem doesn’t end with just lowcigarette sales, added Calvin.

“Those customers who used to come infor cigarettes would purchase other productsas well, and now retailers are alsolosing out on those sales. By not taxingthese other cigarette sellers, the governmentis decimating overall c-store sales,”he said

Innovating a Segment
Though things are looking considerablybleak in states like New York that notonly have to battle excisetaxes but also public smokingbans, cigarette sales asa whole aren’t going anywhereaccording to BonnieHerzog, tobacco analyst forthe Citi Group.

“In my opinion, cigarettesales will never die,”said Herzog, who feels thata slowing momentum forcigarettes isn’t anythingthe industry hasn’t alreadyseen. “Cigarette sales havebeen decreasing for closeto 40 years now, so this isnothing new. There areplenty of reasons for it, like advertisingrestrictions, pricing and social stigma, butthe fact is that there are 45 to 50 millionsmokers out there, and, as I see it, as longas they enjoy smoking cigarettes, they willcontinue buying them.”

Herzog explained that while there area number of threats that may put the cigarettemarket place at risk, she feels thatcigarettes and smokers will always find away around them to thrive in the future.

“From what I’ve noticed, innovationis going to play a large role in changingthings for cigarette smokers,” she said.

New Opportunities
Though there’s no telling what kind offuture is on its way for the cigarette industry,some retailers are making innovationsof their own to compete with the obstaclesgetting in the way of cigarette sales.Many stores like Smoker Friendly, basedin Boulder, Colo., have been keeping akeen eye on the changes in their markets.Since Colorado and many of the otherstates that the 100-store chain serves issuelocal and statewide bans on public smoking,Smoker Friendly has been takingadvantage of the recent surge in smokelessmomentum.

“We’ve had double-digit growth in themoist smokeless tobacco (MST) and othertobacco products (OTP) over the past fewyears,” said Mary Szarmach, vice presidentof trade marketing for the store anda member of the National Associationof Tobacco Outlets (NATO). She addedthat since many smokers are confinedoutdoors during the notoriously harshwinters of the Rocky Mountain area, manysmokers have been reaching for an alternateway to get tobacco without facing thecold weather. “We’ve benefited from a lotof dual users who purchase cigarettes andsmokeless tobacco at the same time. Thepouches, in particular, are very popularwith cigarette smokers since it’s cleanerand easier than MST.”

As far as smokers being warded offby the tax-induced high prices, SmokerFriendly stores have found a way to provideits customers with tobacco at a lowerprice, thus keeping their gross marginsup: roll-your-own tobacco products.

“Our stores in states like Montanaand Colorado, where cigarette taxes arehigher, have really seen a boom in the rollyour-own segment,” said Szarmach. “Wewere sure to be prepared and were ableto accommodate our customers with boththe products as well as lessons to helpthem out. Even though traditional c-storeoperators may not have to time to showcustomers how to roll their own cigarettes,it’s still an excellent opportunity in thesegment.”

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