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Smoke 'Em If You Got 'Em!

By Bonnie Herzog

Smoke 'em if you got 'em! Yes, that’s just what consumers continue to do. Despite sharp state and federal excise tax increases as well as heightened awareness surrounding the health risks of smoking, consumers continue to demand cigarettes.

The category has evolved significantly over the years and will continue to do so as consumers’ preferences change in the face of higher taxes and FDA regulation. However, there’s no denying that the cigarette category is still one of the most important categories for retailers and is likely to remain as such for the foreseeable future.

According to NACS State of the Industry data, cigarettes represented approximately 36 percent of total in-store sales contributions in 2009, up 5 percent from 2008 and almost double the contribution size of the next largest category, foodservice.

More importantly, the cigarette category continues to generate the highest gross profit margins within stores —and this trend is growing. The gross profit margin on cigarettes was an impressive 154.7 percent last year and over the past four years, gross profit margins for cigarettes have increased 38.6 percent, one of the fastest growth rates in stores.

Despite declining volume trends (total industry cigarette shipment volume decreased 8.4 percent last year), demand for cigarettes in 2010 is expected to improve, even with the most recent price increase, which was led by Philip Morris a few weeks ago. According to Leo Vercollone, president of the 20-store VERC Enterprises, based in Duxbury, Massachusetts, "demand seems to have leveled off since consumers are now getting used to higher price points."

Sharp Prices
It’s all about pricing for most branded consumer products, and the cigarette category has had more than its fair share of pricing pressure from ongoing threats of high taxes. However, pricing power has been a key factor in the success of the cigarette industry for many years. In fact, cigarette demand appears to be more inelastic now than in previous years, which is very encouraging considering the sharp state and federal excise tax increases.

According to Campaign for Tobacco-Free Kids, the current average state excise tax on cigarettes is approximately $1.42 per pack and the federal excise tax is $1.01 per pack. Combined, excise taxes represent approximately 46 percent of the retail price for a pack of cigarettes. Despite higher taxes, manufacturers have not shied away from taking price increases, most notably a recent modest list price increase initiated by Philip Morris.

Although retailers aren’t necessarily used to seeing a manufacturer price increase during the spring, most indicated that they aren’t completely surprised and are thankful that manufacturers increased prices in the form of a list price versus reducing off invoice promotions, which would be less beneficial for retailers’ margins.

Consumers have certainly complained about the higher price for a pack of cigarettes, but they’ve seemingly been conditioned to these higher price points because retailers are still getting the sale. However, given sharp price increases, wide price gaps between high-end and low-end brands, and the sluggish economy, consumers are trading down in price.

Although brands and image are still important for many consumers, they have been reaching for cheaper brands —consistent behavior with other product categories in these tough times. However, in the next couple of years, higher expenses from FDA regulation will probably place more pressure on low-end brands. As a result, retail price points on these brands will likely rise, narrowing the price gap between premium and discount brands. Many of the discount, or low-end brands, will likely falter so retailers should start considering today how much shelf space to allocate for the lower-priced segment of brands in the future.

One segment within the cigarette category that remains hot is menthol, which continues to grow faster than the overall category. The menthol segment currently represents approximately 30 percent of the overall cigarette category, up from 27 percent in 2005.

While there has been some concern that the FDA will ban menthol as a flavor, most don’t believe this potential threat will become reality. So it’s no surprise that competition within the menthol segment has intensified over the last few years with several new brands and styles hitting the market, such as Camel Crush and Marlboro Blend No. 54.

Heavy Promotional Activity
Despite being a mature category, cigarettes remain highly competitive. The heightened promotional activity surrounding the cigarette category is expected to continue but eventually level off, especially since there just isn’t enough room for more promotions. Winton Jennette, vice president for the Camel Brand with R.J. Reynolds, expects "the industry to sustain the current level of promotional activity on the cigarette category through the end of the year."

In an effort to maintain, or ideally increase share, cigarette manufacturers will continue to implement several different types of promotions, most likely focused on leading brands and on new products or brands in an effort to drive trial.

However, given the constantly changing promotions on cigarettes, it’s been hard for manufacturers to execute accurate signage. Interestingly, the limited use of signage to advertise different promotions makes it difficult for consumers to distinguish what’s on sale or promoted during a given time period. According to Andrea Myers, category manager with Kocolene Marketing, which owns 12 convenience stores and 21 tobacco outlets in Indiana and Kentucky, consumers often ask, "Do you have anything on sale right now?"

Intense Innovation
Looming FDA regulation is undoubtedly propelling innovation. Tobacco manufacturers have been flooding the market with numerous new line extensions, brands and packages before June 22, 2010, the date by which the FDA must review all new tobacco products before they hit the shelves.

Although cannibalization of products from line extensions is quite high, close to 80 percent, new products have bolstered cigarette sales. According to Steve Sandman, vice president of sales and marketing at Republic Tobacco, "Hefty promotions of these new products definitely helped to drive trial." Given the proliferation of new products, it has been daunting for retailers to ensure that they have the appropriate number of styles on their shelves and are stocked up with high demand products. In the future, FDA regulation will likely encumber innovation and the number of SKUs should decrease significantly.

Manage Brands As Franchises
Overall, retailers should continue to embrace the very profitable cigarette category, which still represents the vast majority of total tobacco sales. The category’s piece of the overall tobacco pie will continue to shrink, however, as other tobacco categories, such as smokeless, continue to grow at a faster pace.

Retailers should seriously consider managing the tobacco category in its entirety and start thinking of individual brands as major franchises consisting of different products that compete in all segments of the tobacco industry. Tobacco manufacturers have led this move by developing and introducing line extensions on their popular brands to compete in each segment of the tobacco industry. No doubt, this trend will continue in the future.

Bonnie Herzog is the founding principal and senior consumer analyst for Herzog’s Consumer Insights, an independent research firm. Previously, she worked with Citi Investment Research as managing director covering the beverage and tobacco sectors. She can be reached at