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A House on Fire
The cigarette business isn’t what it used to be – savvy distributors are looking for ways to stay profitable amid a sea of change
By Jennifer Korolishin
Cigarettes are a critical part of the convenience distribution business. But, there’s been significant change in this already complex world. Cigarette prices are up, state excise taxes are at an all-time high and manufacturers’ terms, programs and return policies have changed, leading to strained relationships with distributors, just to name a few of the most pressing issues.
Consumer demand for cigarettes still exists. Retailers still want to stock a mix of brands. Distributors still want to provide retailers what they want. Manufacturers still want to sell product. Those goals seem to be in alignment, but the reality is a bit different. Nobody wants to abandon the cigarette business, but everyone agrees there must be a better way.
Some context for the current conditions: since the Master Settlement Agreement (MSA) was signed in 1998, pricing pressure on the major cigarette manufacturers has increased sharply. Premium brand prices rose, and many states raised excise taxes to offset deficits.
Since 1993’s "Marlboro Friday," which closed the price gap between premium and discount brands, major manufacturers had increased prices once or twice annually to help grow market share for premium brands (which account for about 72 percent of volume) and ensure profitability in an industry that has declined at an average annual rate of 1.5 percent volume over the last 20 years. But, in April 2002, the top manufacturers — Philip Morris, R.J. Reynolds and Brown & Williamson — ceased those yearly price increases.
Price and tax increases reached a point where consumers began looking for bargains, and a new class of deep discount "fourth-tier" cigarettes emerged.
"When the major manufacturers took this price increase in April 2002, that seemed to be the break point — the consumer just didn’t want to pay anymore," says industry expert Kit Dietz of Dietz Consulting. "We started seeing more sales going to fourth-tier companies while the premium category was staying relatively flat. Major brand discount cigarettes were declining, and that’s where the majority of the fourth-tier sales came from."
Share-Based Programs Prompt Tough Choices
To counter the rise of fourth-tier brands, major manufacturers invested in price promotion. However, due to increased discounting, volume declines and volume shifting to fourth-tier, major manufacturers struggled to match past earnings.
"What drove us to make changes to our programs were some of the objectives we had relative to our brand portfolio in the marketplace," says Rick Baker, divisional vice president of trade marketing development at Brown & Williamson Tobacco Corporation. "Rather than have huge sums of money flowing through discounting mechanisms, we have taken a position to what we believe is appropriately pricing brands in our portfolio to try to get a good base price that’s attractive to consumers."
Reduced promotional programs changed the business for wholesalers. "Wholesalers tended to count on the price increases for incremental profitability and a little more penny profit on every carton," says Dietz. "It’s a self-healing business model — price increases gave you an increased value of your inventory and then if you made a bad decision on pricing, over time it would fix itself because you had increased margin."
Manufacturers began looking for profit elsewhere, including slashing operating costs and examining their returns from wholesale and retail incentive programs.
"It’s driven in large part by the need for all manufacturers to get a lot more efficient with their spending and to optimize the resources they had to deploy against consumer discounting and promotion," says Baker. "If you look at all your costs, there aren’t a lot of things that you have to go after anymore because we’ve been going through cost-cutting for a number of years."
Last year, Philip Morris took its terms discount (the industry standard 3.25 percent) and moved it into a share-based program. Thus, the wholesaler’s discount rate for premium Philip Morris products would depend on market share, differentiating the cost of goods dramatically between high and low program performers.
For many wholesalers, participating in major manufacturer share-based programs meant choosing between selling premium and fourth-tier brands. The more fourth-tier products a distributor sells, the more its premium share diminishes; the lower the distributor’s premium market share, the more they pay for those products.
"R.J. Reynolds and Philip Morris have had market share programs for some time, but there wasn’t that big of a discrepancy, usually a quarter or 30 cents between a wholesaler that paid the highest price and a wholesaler that paid the lowest price," says Scot Shanks, president of L.P. Shanks Company. "All of a sudden it changed and now it’s around 80 cents. We just can’t afford to do that. I have basically had to give up my fourth-tier business. I’m in a growing fourth-tier market, so it’s a tough spot to be in."
Many distributors feel caught between a rock and a hard place. They want to provide retailers with the products consumers want. But if fulfilling fourth-tier demand means paying higher premium prices, distributors’ competitive abilities are diminished.
"Share based programs are a big challenge for us," says Jode Bunce, Eby-Brown Company, vice president of merchandising. "They’re a big burden and we don’t feel it’s our responsibility to have to monitor share at retail. We just want to sell our retailers what they want, which is what the consumers want. A lot of times we have to turn business away or direct customers to people that carry fourth-tier products."
That’s a sentiment echoed by Joe Bowlin, president of McCarty-Hull, Inc., who says, "The number-one issue for us is the inequity in pricing to various distributors due to manufacturer programs. We have goals that we just don’t have any control over attainment of, so we pay a lot more for our product than our competitors do."
"It’s almost to the point where you have to select your customers based on what they’re going to buy from you," says Patrick Carrico, president of Richmond-Master Distributors, Inc., and AWMA chairman.
Last year, a group of distributors filed suit against Philip Morris over share-based programs, which resulted in Philip Morris pulling its wholesale program for the balance of 2003. The program was reinstituted in a reduced form in January 2004. Today, due to program changes, distributors make approximately 42 cents less profit on premium brands than at this time last year, prompting some to raise prices to stay profitable.
However, the choice between fourth-tier and premium may not be so tough going forward. While fourth-tier brands now account for 10.25 percent of industry volume, the segment’s profit potential is waning. States are putting pressure on fourth-tier manufacturers to pay into the MSA, and as a result, prices are rising.
"The advantage of having fourth-tier products is disappearing, particularly as the MSA escrow requirements are being enforced," says Carrico. "We’re seeing that the margin in fourth-tier is disappearing and the prices are going up, about $2.00 a carton in the past year."
As price advantages dissolve, consumers are reverting back to major manufacturers’ discount brands. "A good example is a mid-priced product like Pall Mall, which is being heavily promoted through point-of-sale and good signage," says Carrico. "It’s a couple bucks higher than fourth-tier, yet it’s growing dramatically because it’s perceived as a quality product."
The Point of "No Return"
Two other major challenges for distributors are product stamping and returns. As Dietz notes, "stamping of product is archaic at best," using 1950s-era equipment that often crushes or rips cartons.
This used to be frustrating, but not devastating, because distributors could return damaged products, and those returned from retail, to the manufacturer. However, for the most part, the major manufacturers no longer accept returns.
"The absence of return policies [by some of the major manufacturers] is a problem for us," says Bunce. "There’s product that will get old in our warehouses and sooner or later it has to start coming back from retail because the consumers are going to start getting old product. It’s an issue that’s costing us money."
Many states have also eliminated terms and require cash payment for tax stamps, or have made it more difficult to obtain bonds for credit, creating a cash flow crunch for distributors.
"You can give certain states a bond for your outstanding A/R for cigarette stamps and get 30-day terms," says Carrico. "But the cost of the bonds is much larger since prices have increased over the last two years. Illinois eliminated any distributor terms on stamps. You have to pay cash at the time of purchase, so that took a million dollars out of our cash flow."
Threats from Internet and Native American Sales
Distributors face direct threats to their cigarette business from two additional sources: the Internet and Native American sales.
Internet sales are troubling for several reasons. It’s impossible to confirm proof of age over the Internet. Overseas-based Internet retailers are shipping cigarettes into the United States free of federal and state tax and MSA payments. Foreign sales also often involve products not intended for sale in the United States.
Native Americans are permitted to sell cigarettes on reservations to other Native Americans without charging federal or state tax. However, many tribes sell tax-free cigarettes to all consumers through brick-and-mortar reservation stores and reservation-based Internet sites.
New York state, which has a $15 a carton excise tax, loses an estimated $900 million annually in uncollected tax revenue due to Native American sales. In the Buffalo area alone, 55 percent of all cigarettes are sold on Native American reservations.
"A study by FACT (Fair Application of Cigarette Taxes) found that in New York state, 45 percent of all cigarettes are sold through illegal channels — cross-border, Internet and Native American sales," says Dan Finkle, president of Finkle Distributors, Inc. "You work hard enough in the cigarette industry to get whatever cartons you can and to me that’s dooming, plain and simple."
Laws allowing New York to collect taxes on Native American cigarette sales to non-Native Americans are largely unenforced due to the political sensitivity of the issue.
"We want to address the issue upstream because the reservations buy from distributors," says Finkle. "If you made it mandatory for anything going out from a distributor to have a tax stamp and made them liable if product goes out without it, you take care of the problem — everyone’s paying the same price and there’s no advantage. Native Americans could apply to get a tax refund under this method, so you’re not infringing on their sovereignty."
The Native American sales situation illustrates a larger problem: skyrocketing illegal sales, prompted by consumers seeking ways around excessive cigarette taxes. Residents of high-tax states have the opportunity to cross the border and purchase product in low-tax states, often for resale.
There’s a growing phenomenon in New York City, which recently doubled its excise tax, in which people will go to a low excise tax state, buy a large quantity of cigarettes, and resell them on the street or in bodegas.
"There’s about $1,700 a case difference between buying in New York City versus North Carolina," says Dietz. "There’s a lot of opportunity even for small-time criminals to bring a couple cases back a week. That could be their total livelihood."
Protecting the Business
So in light of all these issues, what can distributors do to protect the cigarette business, stay afloat and make a profit?
"The real problem for distributors is there are too many of them," says Dietz. "The industry’s been declining and they need to do some acquisition and consolidation. Everybody’s fighting for a bigger piece of a smaller pie and the way they fight is lower prices. A very thin margin business continues to be so because distributors cannibalize each other’s sales."
Dietz suggests that because the industry encompasses several distinct types of companies that reach varying consumer populations, consolidation would serve to focus the industry rather than simply wipe out small distributors.
"Everybody feels they compete with the largest distributors," says Dietz. "That isn’t necessarily the case because you have to look at what’s important to the branded manufacturers. They want to make their product broadly available to all consumers. Consolidation isn’t all going to flow to the largest distributors because there are some very distinct segments of the business."
Understanding customers well is also a priority for distributors. "Having a better understanding of their profit on individual customers, the impact of volume and mix and other categories is the real answer to the profitability issue with distributors," says Dietz.
But one of the central issues to be solved is repairing the trust between distributors and retailers.
"Manufacturers have to be more sensitive to the changes they make and understand the impact it has on distributors and retailers," says Dietz. "I'm sensing some of that from some of the major manufacturers after these recent changes. They understand that they may have been able to approach that a little bit differently or done a better job of communicating why they need to make the changes."
Taking a more collaborative approach can help manufacturers and distributors to achieve mutually beneficial goals. For example, manufacturers changed return policies because it was too expensive and products were going out of date. However, Dietz notes that distributors could help manage the problem using an inventory management system at retail; manufacturers could reward distributors for being the system’s executor, as it would cut down on out-of-stocks.
For their part, major manufacturers understand that any business shift is potentially difficult for all involved.
"There is a downward spiral of trade investment and I think that distributors are being forced to look at a different model for pricing and selling their products," says Baker. "Distributors need to start pricing and selling all their products for a profit."
"Hopefully the relationships can be healed," says Baker. "There’s a long history of manufacturers and distributors working in concert in the best interest of our mutual businesses and I think that as long as we keep having discussions and keep trying to identify those things that we can work on together to optimize our businesses and optimize everybody’s sales and profits, that’s a positive thing."
Jennifer Korolishin is a Philadelphia, PA-based writer and editor with extensive retail and food industry experience and is a former member of the National Association of Convenience Stores (NACS) communications staff. She can be reached at 215-836-4339 or jmkcommunications@comcast.net.
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