As cigarette prices rise, margin stress on retailers remains.
By Howard Riell, Associate Editor
With cigarette consumption likely to continue to decline in the mid-single-digit range, pricing remains a crucial factor for retailers, and one that convenience store operators are watching with great interest.
The Big Three U.S. tobacco manufacturers—Lorillard Inc., Philip Morris USA and R.J. Reynolds Tobacco Co.—recently raised their list prices by seven cents per pack. List price is what wholesalers pay manufacturers for their products.
The increase applies to all Reynolds brands; to Lorillard’s menthol and non-menthol styles of Newport, plus Maverick, Old Gold, Kent and True; and all Philip Morris brands, except L&M.
For the 52-week period ended Nov. 2, 2014, cigarette sales in the convenience channel were $52.2 billion, a drop of .65%, according to Information Resources Inc. (IRI). Year over year unit volume was down 2.34%.
Recent price increases have nudged many smokers to lower-cost brands, such as Marlboro Special Blend or Reynolds’ Pall Mall, and still others to alternative products like roll-your-own, filtered cigars and electronic cigarettes.
Indeed, a recent national health survey conducted by the Centers for Disease Control and Prevention found that 17.8% of U.S. adults, or roughly 42.1 million people, were “current cigarette smokers” in 2013—the lowest percentage since the annual survey began keeping track in 1965.
What it all means is that c-store operators need to double down, finding ways to keep cigarette revenue flowing even against the tide of consumer tastes.
PREDICTABLE PROCESS
Why the price increases now?
“The manufacturers need to build up their earnings per share for their shareholders,” said David Bishop, managing partner at Barrington, Ill.-based analysis firm Balvor LLC. “Price increases are one of the ways in a declining segment in the U.S. that manufacturers are able to deliver that to those shareholders. It’s a fairly predictable kind of process that manufacturers have been going through in the last few years, so it’s not as though it’s a surprise to the retailers, obviously.”
Bishop pointed out that the manufacturers have publicly stated that the pricing environment still supports price increases. “That is, that consumers are still willing to pay more for those products. And again, the entire market is moving in the same direction, so the relative spreads between premium and discount kind of maintain themselves.”
“The seven cents a pack will likely translate to 10 cents at retail,” predicted Steven Montgomery, president of b2b Solutions LLC in Lake Forest, Ill. “That being said, this is now a small amount on what cigarettes cost in most of the country and is not likely to have any real impact on demand.” Demand, Montgomery noted, is far more impacted by two offerings that have caught so many smokers’ attention—electronic cigarettes and vaping.
Operators can lessen the impact of the increase in two ways, Montgomery explained. “First, where legal, consider a discount on a multi-pack purchase. We used to recommend three packs, but given the current pack prices we are now recommending two-pack deals.” Those who have made the switch to a two-pack pricing tactic have seen positive improvement in gross margin dollars generated by the category, Montgomery said.
A second strategy is to be ready to meet the consumers’ changing smoking habits by stocking e-cigs and those items necessary to vape, he added.
“Yes, (the price increases) will hurt sales simply because of higher prices,” suggested Dan Gallagher, chief operating officer of The Cigarette Store Corp., based in Boulder, Colo. “Retailers need to increase prices more than the manufacturers increase in order to grow margin on declining unit sales. If it is in the best interest of manufacturers to increase margin the same holds true for retailers.”
Cigarette Store has experienced year-over-year dips in units between 3-5%, Gallagher said. The year ahead will likely see continued unit decline, he added. “Again, retailers need to take higher margins on the decreased units.” Gallagher recommended that c-store operators need to continue to look for high-margin items while remaining cautious of inventory levels versus turns.
BORDER SKIRMISH
Manufacturer price increases aren’t the only factor contributing to margin pressure.
“Put it this way: yes, prices go up and I’m going to have to deal with it,” said Dean Mielke, president and owner of ADIUM Oil Co. in Avon, Minn., which operates more than 10 Petro Plus Convenience Stores in the Minnesota cities of Brainerd, Detroit Lakes, Pillager, Randall, Starbuck, Taylors Falls. “At least, as long as I’m competitive with everybody else and I’m not at a disadvantage. I don’t like price increases, but everybody seems to make them.”
Taxes are another matter, however. One of Mielke’s stores is on the border of Wisconsin; when the Minnesota legislature recently raised taxes on cigarettes it cost him about $129,000 in lost profits.
“When it comes to taxation, that’s a problem for me,” Mielke said. “Taxes here went up 30-cents a pack on July 1, 2013. That impacted me 82%. I was moving 600 cartons a week, and you can take 82% of that away. I ran some numbers on that. I ended up losing because of that, compared to the previous year starting July 1, $129,000 of profit because of that change.” Taxes in Wisconsin are 30-cents less per pack and $3 less per carton, he added.
In the wake of this loss of revenue, Mielke said he has simply continued to run his business as best he can. “We’ve done what we always do, try to make the best of it and remain competitive, as we always are. There’s not much I can do; I mean, I’ve just got to live with it. What can I do?”
Running more promotions could help generate more sales, Mielke conceded.
“But the promotions can never be good enough to offset the difference in tax monies,” Mielke said. Transitioning cigarette customers to other products, such as smokeless tobacco and electronic cigarettes, is likewise not a long-term strategy. “We do have offerings of that, but I’ve found you either want to be a cigarette smoker or an e-cigarette smoker.”
FOGGY FORECAST
The increases should serve to heighten the price sensitivity that consumers already have with cigarettes, Bishop said.
“That means having competitive cigarette pack prices is going to be that much more important, which is what convenience retailers already know,” Bishop said. “What that will do is motivate or force, depending on which verb you like to use, more retailers to sign up for some of the price-leadership programs. Obviously, no one wants to lose the foot traffic and the dollars associated with a cigarette consumer at convenience.”
Bishop said he does not believe the price increase is going to accelerate the sales slide.
“Major changes in demand generally are driven by large FET (Federal Excise Tax) increases or an avalanche of state excise taxes,” Bishop said. “We don’t have any of those necessarily on the horizon, so I don’t anticipate there being any acceleration in decline. But at the same time, I don’t see necessarily a slowing down of it.”
The picture that emerges for the cigarette category in 2015 isn’t well defined, Bishop said. “That’s a really hazy crystal ball right now because of the pending and anticipated merger between Lorillard and Reynolds, and the redistribution of some of those brands from Lorillard/Reynolds over to Imperial. So until that happens, a lot of things could be in play. But again, Phillip Morris controls roughly half the cigarette business, so I’m not anticipating that there is going to be any major changes other than programs that retailers may be participating in post-the-finalization, or at least clarity, on the direction that Reynolds/Lorillard/Imperial goes.”
Not surprisingly, taxes will continue to exude pressure.
“Unfortunately,” said Montgomery, “I think taxing authorities will continue to see anything related to nicotine delivery as a target for increased taxes. I am not sure what (retailers) can do about this other that working with local governments to slow or stop further increases.”
