Pondering Premiums

January/February 2008

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They’re far from being the category killers they once were, but premium cigarettes still have profit powers.

Remember the days when premium cigarettes ran the roost? Most tobacco outlets in business for 10 years or more certainly do—but they also know that times have changed.

“I still remember with fondness all the contract payments we used to get from the majors,” says Shon Ross, vice president of Nothin’ Butt Smokes in Lubbock, Texas. “But now I have to change the way we do business—it is part of evolution. If we don’t change with the times, we’d have to leave, and we’re not planning on going anywhere.”

He is referring to diversification, or more specifically, a re-prioritizing of tobacco merchandise mixes, away from cigarettes and their drastic rise in taxes—and their equally drastic drop in profit margins.

“If we had stayed with our cigarette model of the ’90s, 95-plus percent of our stores would be out of business today,” states Terry Gallagher, president of leading tobacco outlet Smoker Friendly International, based in Boulder, Colorado. Smoker Friendly has become a big proponent of RYO/MYO, premium cigars and smokeless tobacco as a means to grow with the tobacco times.

Most forward-thinking outlets are following that lead. An imminent federal excise tax increase of 61 cents a pack has been factored in to a declining cigarette forecast in the c-store industry—certainly an indication of how it will also play out for tobacco retailers. According to Convenience Store News Market Research, 2007, taxes per carton will be as high as $18.62 by 2008, a jump of almost 50 percent. Total convenience industry carton volume at c-stores is forecasted to decline by 2.4 percent to 1.2 billion cartons in 2007, followed by another decline of 2.5 percent to 1.17 billion cartons in 2008. On a per-store basis, the report calculated that to translate to declines of 5.2 percent in 2007 and 5.5 percent in 2008.

Clearly, diversity is the industry trend—even the big tobacco manufacturers recognize the desperate need to branch out beyond their traditional premium cigarettes as American smokers buy fewer sticks. Philip Morris USA (soon to be split apart from Philip Morris International by parent, Altria Group, Inc.) recently purchased cigar maker John Middleton; it also started testing Marlboro-branded snus in the Dallas-Forth Worth area and Marlboro-branded chewing tobacco in Atlanta.

In similar diversity fashion, Reynolds American Inc. bought smokeless tobacco company Conwood Co. in May 2006; it has reportedly seen strong results from the Grizzly brand of moist snuff. R.J. Reynolds Tobacco Company, Reynolds American's largest subsidiary, is also conducting market tests on a Camel-branded snus product, according to David Howard, spokesperson.

The most recent manufacturer news announcement comes from Lorillard—the cigarette subsidiary of Loews Corp. will reportedly be its own entity by mid-2008. As a result, analysts expect it, too, will aggressively look to replace cigarettes as a major source of revenue. Loews executives have already stated that Lorillard will soon being testing its own snus under the brand name, Triumph. This product is part of a joint venture formed in October 2006 with Swedish Match North America (SMNA) to develop smokeless tobacco products.

This doesn’t mean there is no positive news for premium cigarettes. In the scheme of excise tax increases, they are predicted to come out ahead in front of fourth tier. “As excise taxes go up, smokers will actually shift to premium cigarettes more,” believes Nik Modi, a tobacco analyst with UBS. “While total industry volumes take a hit, discount cigarette manufacturers get hit the hardest by per pack excise tax increases. So the question is: do tobacco outlets have the optimal mix of discount, premium, and super premium in light of that?” Modi thinks adjusting the mix just right over the next three years will be critical.

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Beyond category tax advantages, a sub-segment of premium worth noting currently is menthol. “Retailers are seeing menthol growing, and many are adding incremental space to the segment—but there’s still lots of room to go,” believes Modi.

Those retailers in high-growth ethnic areas are expected to do especially well with menthol. “African-American and Hispanic consumers are set to double the pace of the average U.S. population by 2010, and menthol is highly indexed to these consumers,” notes Modi. “The ‘flavorization’ in America is being driven by this group, and it’s why we’re seeing a wholesale shift from non-menthol to menthol. This hasn’t just occurred in the last year or two, it’s an ongoing dynamic.” He adds that “ethnic was usually a coastal-driven dynamic, now it is shifting inward. That’s why these markets are starting to rise in the category. There’s a lot of opportunity left for retailers to devote more shelf space to menthol.”

Of all the menthols, Newport is the “best way to play menthol,” according to Modi. Industry data shows that Newport menthol is doing quite well despite the overall decline in cigarettes and has been dubbed “the fastest growing cigarette in the country,” by industry observers.

There was also menthol news in the Kool brand when it recently went national with the distribution of its “XL” styles. “Kool is the first menthol brand to provide adult menthol smokers with a wide-gauge cigarette,” says Howard. “These styles have been popular among adult menthol smokers, and it gives the brand an opportunity to continue to grow market share.”

Beyond menthol and the ethnic population, another good demographic for premium growth is women. Camel is focused on this group with a new packaging design—rounded corners, black and teal graphics, as well as a light blend, available in regular and menthol styles that Howard says has received “very positive feedback from adult women smokers.” He adds, “We worked closely with adult women on the products and in developing the packaging. Most told us they liked Camel, they knew about it, they liked what it stood for—fun, irreverent style—but they didn’t feel it fit with their gender—so now we do.”

In an effort to better promote some of these brands, RJR is “going to be back in the fixture business in 2008 with a wide array of fixtures to accommodate the merchandising needs of different tobacco retailers,” according to Howard. It is his contention that the company is looking for a stronger partnership with tobacco retailers moving forward. “Through our reps, we want to work more closely with the retailers and have constant interaction. We want to share information and we want to know what their customers are saying to them about our brands and the cigarette category. We believe that by really listening to the adult smokers of today we can work together to have the right brands in the right stores, ultimately growing category sales for the stores and for our brands.” •