Burning the Cigarette at Both Ends

By David Bishop

To make the most of the number-on category in convenience stores, retailers are managing cigarettes to maximize profits while also leveraging the category to drive foot traffic. Success requires a vigilant balancing act between these two €" sometimes competing €" goals. And, with all the changes occurring in the marketplace, this is becoming a more complex and challenging task for retailers.

Pricing is still a critical success fac­tor to driving traffic into the store. En­suring product availability is vital to closing the deal and keeping customers coming back. Merchandising in an effec­tive manner is also important to demon­strating commitment to the category. And, excelling at customer service is more imperative today than ever to not only remain in business, but to build it.

Category Performance
Convenience store operators recognize the significance of winning the adult smoker; the cigarette category fuels the economic engine for their inside sales. Cigarettes drove nearly 36% of in-store sales and generated more than 17% of gross profit dollars in 2010, based on NACS State of the Industry data.

And for the 12 months ending Sep­tember 2011, NACS CSX data shows that monthly dollar sales per store for ciga­rettes averaged $40,482, 1% lower than the preceding 12-month period. Below-average price inflation in the category is a likely reason for the slight downturn.

According to Consumer Price Index (CPI) data, cigarette prices increased year-over-year slightly less than 2.8% during this period, which isn€™t enough to offset the secular volume trend that is declining at more than a 3% annual rate.

Gross margins as a percent of sales ranged between 14.8% and 15.6% dur­ing the second and third quarters of 2011, generating $5,616 and $6,746 in profits per store month. The category€™s gross margin is averaging 15.3% from April through September, similar to full-year levels reported in 2010 of 15.2%, according to the NACS State of the Industry data.

Pricing Trends
Although November 2011 CPI data shows that cigarette prices are up only 2.6% versus last year, this figure doesn€™t reflect the price increases that manufac­turers announced in December 2010.

Examining trends on a full-year basis based on data from The Tax Burden on Tobacco and the CPI, retail cigarette prices have increased on average 6.1% to 7.5% each year from 2001 through 2010. In comparison, the average infla­tion rate for beer (off-premise) €" an­other important category for many convenience retailers €" has gone up only 2.5% annually during the same pe­riod, based on CPI figures.

Even adjusting the long-term average to exclude the effect of the federal ex­cise tax increase in 2009, which con­tributed greatly to retail prices rising by 22.1% and 24.5% that year, the annual inflation rate for cigarettes would still average 4.3% to 5.6%.

Consequently, the cost of consump­tion has increased by more than $2.50 per pack for smokers since 2001, landing around $5.90 a pack today and motivat­ing some retailers to evaluate whether it€™s more effective to communicate price, savings or a combination of the two. In either scenario, retailers are sensitive to pricing and analyze opportunities to ad­just upward or downward based on weekly and sometimes daily sales trends.

Looking At The Basket
Attracting and retaining adult smokers means more to a convenience store than simply selling a pack of smokes€" this de­mographic is a lucrative convenience store shopper. Construction workers, for example, have a smoking prevalence rate 1.6 times higher than the national average of 19.3%. Other blue-collar occupations, such as transportation and maintenance workers, also have high smoking rates, based on the U.S. Centers for Disease Con­trol and Prevention€™s (CDC) 2010 Na­tional Health Interview Survey (NHIS).

One retailer indicated that cigarettes are included in more than one out of every four in-store transactions, rein­forcing the strong connection that adult smokers share with the conve­nience store channel.* (*Because of the sensitivity of some topics in this article, retailer comments and perspectives are all masked.

In addition to cigarettes, smokers boost profits in other categories. Of the more than 1.3 million cigarette transac­tions analyzed by Barrington, Illinois-based sales and marketing firm Balvor, for every $3.00 an adult smoker spends in a convenience store on cigarettes, he spends another $1.00 on non-cigarette items during the same visit. And while the non-cigarette items represented only one-quarter of the dollar ring, those items contributed nearly half of the gross profits for the transaction.

Balvor€™s analysis also found that smokers are more likely to purchase a beverage €" the dominant cigarette "go with" purchase item. Specifically, and cold dispensed beverages are pres­ent in one out of every five cigarette transactions, and packaged beverages (non-alcohol) are included in about one in every seven cigarette purchases.

Targeting Adult Smokers
Since 2001, total cigarette consumption in the United States has declined by 3% annually, based on a review of data com­piled by the economic consulting firm Orzechowski and Walker. As a result, retailers and manufacturers are focused on growing market share to build their respective businesses.

Many leading retailers are working with manufacturers or executing their own direct mailing campaigns to reach a broader base of adult smokers in their markets. This strategy of offering exclu­sive discounts via coupons on select brands as a way to "deal" smokers into their stores is becoming a more valuable tool for retailers.

Retailers using direct mailers indi­cate that these promotional activities are generating very strong consumer re­sponses. In fact, redemption rates have increased in the last three to five years for many retailers. One retailer com­mented: "I believe the consumer looks for these [types of] savings, considering the cost of the product and the overall economy today in our country."

Retailers are also using external sig­nage to attract smokers into their store. "We use the outside pole signs to high­light low prices on key brands," said one retailer. Others rely on promotional messaging on electronic reader boards, while some highlight their cigarette prices via signage hanging from fuel is­land canopies.

Closing The Deal
After attracting smokers into the store, retailers need to ensure that they have the right assortment and product avail­able on the shelf. Several chain retailers observed independents in their respec­tive markets discontinuing the sale of slower selling cigarette SKUs. Although this tactic may reduce demand on work­ing capital due to the escalating cost of carrying inventory, the result can trans­late into the loss of a valuable customer.

As one retailer described its position­ing: "We have maintained strong and massive cigarette and OTP sets so that when the tobacco consumer enters our store, they know we are in the tobacco business and we€™ll most likely have their product available too." The good news is that more retailers are reducing out-of-­stock occasions by executing "guaran­teed in-stock" strategies or investing in computer-assisted ordering systems that help ensure a stable supply of products.

Retailers obviously understand the importance of staff training to check ID and provide excellent customer service. (See "We Card. You Bet.") Synar data shows that retail­ers continue to demonstrate their abil­ity to responsibly sell cigarettes €" with retailer violation rates at a record low of 9.3% since 1997.

Some retailers have also created new store-level positions or assigned spe­cific responsibilities for maintaining the category, which can help improve over­all execution by immediately address­ing operational issues and providing store support.

Looking Forward
Pricing is a strong theme in the cigarette category €" and for good reason. In fact, some cigarette manufacturers suggest that pricing will become the number-one factor smokers use to determine where they shop.

In one respect this statement is trou­bling because it could mean further margin compression at retail. However, successful retailers have long recog­nized the benefit of "pricing for volume" for cigarettes, as it ultimately drives stronger profit dollars for both the cate­gory and the store.

Pricing can be expressed in terms of what a consumer pays or saves and the shopper€™s frame of reference changes almost as often as the prices at retail. Therefore, how a retailer reaches the adult smoker and positions the category will become even more important in the future.

David Bishop is the managing partner at Balvor LLC, a sales and marketing firm located in Barrington, Illinois.


Smoker Profile
Of the 44.1 million adult smokers, more than three-quarters are daily smokers, according to 2010 NHIS data. Males are more likely to smoke than females, representing slightly more than half of the smoking population in the United States. And, more than 60% of the adult smokers report annual household incomes of less than $50,000.

In the past decade, the NHIS data shows that smoking rates have continued to decline, going from 22.8% in 2001 to 19.3% in 2010. Smokers smoked an average of 19 sticks per day in 2010, which is about six sticks (24%) lower than in 2001, based on an analysis of by Balvor of consumption and prevalence rates. Although many factors affect this rate, changes in smoking restrictions since 2001 are likely a major driver of the downtrend.