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The State of Tobacco
New smokeless entries and other trends reshaping the tobacco category; distributors hold on for the ride
By Jennifer Korolishin
Distributors should get ready for new smokeless offerings, some from major cigarette manufacturers, tobacco industry analyst Bonnie Herzog predicted at the AWMA REAL DEAL EXPO in March. Distributors were advised to prepare for new product innovation from cigarette manufacturers and increased offerings and competition in the smokeless tobacco category.
No action in the industry better exemplifies this trend than R.J. Reynolds Tobacco Company’s $3.5 billion acquisition of Conwood, the nation’s second largest manufacturer of smokeless tobacco products. The deal was finalized May 31.
The acquisition continues to be the lead in many of tobacco analyst Bonnie Herzog’s email newsletters. "We continue to believe this is a very strong acquisition for Reynolds and will provide the company with long-term revenue enhancements, a sizeable market share grab in a growing category, and several synergy opportunities," Herzog states in a recent issue.
About the same time, Philip Morris USA announced its intent to enter the smokeless market with tests of non-traditional smokeless, spit-free pouch products. These actions by both companies had been under speculation for months, and are sure sign that the OTP category’s growth and popularity is real – and that it’s likely headed for a shake-up.
Quick look at the products
Philip Morris’ entry, Taboka, comes in original and menthol versions and is designed for adult smokers interested in smokeless tobacco alternatives to smoking. It debuts this month with a test in the Indianapolis market, where it will be merchandised among the company’s cigarette brands.
Also launching this month is R.J. Reynolds’ test of three varieties of Snus, a Swedish product, under its Camel brand in the Austin, TX, and Portland, OR, markets. It’s unique in that it’s a pasteurized product (moist snuff is fermented) and will be refrigerated throughout the supply chain.
Both are premium products designed, in part, to appeal to smokers for use at times when they can’t smoke; municipal smoking bans are on the rise and there are fewer places where smoking is permitted. Thus, for many smokers, smokeless products supplement their tobacco usage, rather than replacing smoking.
Camel Snus were scheduled to launch prior to the finalization of the Conwood purchase, and the product carries R.J. Reynolds’ most recognizable premium brand name, signaling it’s serious about the smokeless market.
"These two entries are not geared to take people away from the traditional moist smokeless category, but to provide alternatives for smokers based on the increasing number of non-smoking regulations," says industry consultant Kit Dietz. "One indicator is with Taboka’s flavor profiles being regular and menthol, Philip Morris is lining up terminologies and flavors that smokers are familiar with; menthol is not a traditional moist smokeless flavor."
Snus and Taboka also mirror the cigarette market in that both are priced similarly to a pack of cigarettes. Smokeless growth has been strongest in the price value and sub-price value segments, but it appears that these new products are designed to capture premium brand smokers.
"These are premium products, and discount snuff is where the growth has been," says Frank Davoli, vice president of marketing for Buffalo-based Tripifoods, Inc. "Smokeless products are almost going through the same battles that cigarettes went through with fourth-tier products. It’ll be interesting how that plays out, but I still say a brand has value. People like premium brands and premium brand users usually stick by their guns."
Good for competition
Increased competition in the smokeless category isn’t all bad news for distributors and manufacturers. Many believe stepped-up competition will spark greater product innovation, resulting in more choices for consumers and increased premium sales, which return a higher margin.
"In addition to the Philip Morris and R.J. Reynolds entries, U.S. Smokeless Tobacco Company is actively innovating in the category and is introducing a new type of smokeless pouch as well, so there’s a lot of innovation in the category, and category growth is very strong," says Dietz. "While the pouch market makes up a small portion of the overall smokeless market, these new entrants are testing the waters with consumers to see if they can create the market."
For its part, leading smokeless manufacturer USSTC is comfortable with the heightened competition. It’s also launching a smokeless, spit-free product, Skoal Dry, in three styles. Its test begins this month in Louisville, KY, and Austin (where it will compete head-to-head with Snus), and is being heavily promoted at the point of sale, online and through direct mail and sampling events.
"We feel that the impact of the Philip Morris and R.J. Reynolds entries is going to be positive in the sense that it’s going to raise awareness of the moist smokeless tobacco category," says Mike Bazinet, USSTC communications director. "The entry of the cigarette companies into the category we’ve been in for a long time helps validate the category and its growth, which has been about 4-6 percent a year for several years. It also validates our feeling that adult smokers are looking for an alternative tobacco product. As a company, we feel very well-positioned to compete."
Should the tests prove successful, many in the industry predict that smokeless products will eventually become part of Philip Morris and R.J. Reynolds’ wholesaler and retailer programs.
What it means for distributors
"The big question in distributors’ minds regarding R.J. Reynolds buying Conwood and what effect that could have is will there be a wholesale program tied to cigarettes and the moist smokeless category?" says Dietz. "In the cigarette category, they’ve seen their margins and cash discounts decline and the programs are based on share of market requirements, so I think distributors are concerned about what does that look like in the long-term and will that affect the profitability of my moist smokeless business?"
Distributors are watching the new smokeless entries carefully. "I think it is way too early to tell what impact the PM and RJR entries will have, but my guess is that competition will heat up and prices will come down at the consumer level," says Jode Bunce, vice president of cigarettes for Naperville, IL-based Eby-Brown Company. "It won’t affect the other brands we carry right away, because it remains to be seen how the consumer will react to these new products."
This flurry of smokeless category activity reflects the overall strength and growth of the OTP market. In addition to smokers’ desire for new smokeless alternatives, that growth is driven by new product introductions and flavor innovation. Smokeless continues to lead the pack due to growth in the price value and sub-price value segments, which have chipped away at premium brand share – a trend the new Philip Morris, R.J. Reynolds and USSTC products may help reverse.
"The OTP categories continue to grow, but not at the rapid levels of years past. In the cigar category, new flavors continue to capture sales and shelf space, but many times at the expense of older flavors," says Mike Wierzbicki, vice president of merchandising for Eby-Brown. "Little cigars have experienced dramatic sales growth in the price value segment, particularly in states with higher OTP tax structures, but at the expense of premium-priced little cigars and some cigarettes. The RYO/MYO tobaccos are experiencing tremendous growth, but again, the majority of growth is in the price-value segments, and has been prevalent in states with higher OTP tax structures."
Low ignition propensity cigarettes
On the cigarette side of the tobacco business, one of the most pressing issues is state legislation requiring all cigarettes sold in that state to have low ignition propensity. Such cigarettes are manufactured with a special banded paper that acts like a speed bump; if left unattended, the cigarette will extinguish, making it less likely to start a fire.
New York was the first state to pass a low ignition propensity law, which went into effect in 2004. Vermont followed this year, with similar laws slated to go into effect in California and New Hampshire in 2007 and Illinois in 2008, while several other states are considering low ignition propensity measures.
While the intent is positive, there’s concern that such state-level legislation could create serious problems for cigarette manufacturers, distributors and retailers, who fear that a patchwork of state laws could mean 50 different – and potentially conflicting - sets of requirements. Philip Morris, American Wholesale Marketers Assocation (AWMA) and the National Association of Convenience Stores (NACS) are among those backing federal legislation that would supersede all state low ignition propensity requirements to create a national standard.
R.J. Reynolds, while agreeing with the goal of reducing fires, "continues to believe that ‘fire-safe’ cigarette regulations are not an effective means to address the problem of accidental fires attributed to the mishandling of cigarettes."
In May, AWMA members gathered on Capitol Hill in Washington, DC, to meet with their congressmen and urge their support of a national uniformity provision for low ignition propensity legislation.
Under the current laws, multi-state distributors shipping into New York must now stock nearly double the number of SKUs, as they carry traditional and low ignition propensity versions of popular brands. As a result, some third- and fourth-tier cigarette brands vanished from New York state markets.
"This issue is a top priority for AWMA. We think it has gotten some legs under it and that we will be seeing more and more states moving to require low ignition propensity product," says AWMA President Scott Ramminger. "Typically, when the requirement passes, distributors who sell in more than one state [which is most of them] have to carry double inventories – one of low ignition propensity product and one of regular product. That carries huge costs with it," he says.
Ramminger also notes that to date all of the states that have passed the legislation have stuck with the federal standard. But there is "no guarantee that will continue."
"Unfortunately, the issue is complicated by the fact that the people in Washington who are behind this legislation are so far 100 percent opposed to federal pre-emption. It is further complicated by the differing positions on the advisability of federal legislation held by the major manufacturers," Ramminger continues. "So there are both good old Washington politics and industry politics at play here."
"There were some brand styles, very slow moving ones, that either the manufacturer decided not to make in a low ignition propensity version, or the wholesaler decided not to carry because the majority of the brand’s volume is outside of New York," says Davoli. "That said, it’s a whole other stamping line for cigarettes – all new slots, all new item numbers – so you theoretically almost double the number of cigarettes that you carry as far as the SKU assortment."
Distributors doing business in California are already working to prepare their systems for the addition of low ignition propensity products. But the uncertainty that accompanies the transition is a challenge.
"The manufacturers aren’t sure of all the things they’re going to do, which items will be available and which ones won’t or when will they start shipping us the new product," says David Dresser, vice president, tobacco for Core-Mark International, based in South San Francisco, CA. "Some manufacturers are changing 100 percent of their UPC codes, some are only changing their cases, some aren’t changing them at all. It makes it extremely difficult to operate. I know for a fact the manufacturers are not going to make all brand styles for California, but they’re still making up their mind about what they will and will not make."
While it’s too early to determine the New York law’s full impact, Davoli says it hasn’t cut into Tripifoods’ cigarette business as much as anticipated, and for the most part, it hasn’t resulted in consumers seeking traditional cigarettes from alternative sources like the Internet. However, that doesn’t mean the legislation is without cost to distributors doing business in New York.
"It’s an added cost, and it creates inefficiencies in the operation. You have separate picking lines now, so you need more staff to pick the same amount of cigarettes. Multiple SKUs take up valuable warehouse space, and that’s a ripple effect all up and down the chain," says Davoli, who notes Tripifoods supports efforts to create a national standard to "put things on a level playing field."
The increased cost affects both manufacturers and distributors. "The cost for the manufacturers to produce product to different standards and for distributors to carry multiple inventories of the same item is very expensive for the distributors," says Dietz. "Let’s not forget, with Philip Morris, distributors pay three days in advance before they get the product, so if you double up inventory on multiple states, it’s a big expense and a space issue for distributors."
Manufacturers also face increased material and production costs. "The paper itself is more expensive, as demand is higher than the supply, though as more states pass this legislation, efficiencies of scale will likely reduce the price of paper," says Eby-Brown’s Bunce. "Also, if a manufacturer has to produce dual SKUs, it’s more expensive for them because it means more turnaround time at the plant."
Tax stamping efficiencies
Tax stamping of cigarettes is an everyday occurrence, but one that’s become riskier in recent years. Accidental damage to packs or cartons has always been part of the stamping process, but changes in Philip Morris and R.J. Reynolds’ return policies mean product damaged during stamping can no longer be returned for credit.
Given the high price of cigarettes, many distributors now hold less product in inventory than in the past, prompting them to operate in a post-stamp environment and creating a renewed desire for accuracy and efficiency. New equipment from Meyercord and R.E.D Stamp is helping distributors reduce damage, and new technologies from vendors like Tax-Right, are assisting in distributors’ efforts to better track inventory as it goes through the stamping process. Tax-Right’s product, a hardware/software combination that works with all R.E.D. Stamp and most Meyercord equipment, confirms the accuracy of the orders picked from inventory and ensures that the correct stamps are applied.
"All of the labor that goes into checking cigarette picking goes away with Tax-Right," says Steve Stomel, president of Tax-Right. "Most stamping operations have a full-time checker, which is thousands of dollars a year in labor. Those checkers only catch about 50 percent of picking errors, so with Tax-Right, distributors cut checking labor costs and ensure it’s done correctly. Additionally, Tax-Right prevents distributors from shipping wrong tax stamps to the jurisdiction, which happens to most stamping agents numerous times each year and is a very expensive mistake to fix."
Jennifer Korolishin is a freelance writer based in Flourtown, PA.
Herzog’s perspective
"Innovation will be a much larger focus for ’06 and’07, including the majors," Herzog said. "Companies will begin using technology to create reduced risk products. I think the future is all about this.’
Moreover, Herzog suggested that distributors should watch for "a lot of new products and packaging," as cigarette companies increasingly diversify their product portfolios and offer additional tobacco-based products.
"The industry is not dead," she said. "There is still way to much money to be made and way too many people who enjoy tobacco."
In fact, Herzog contended that current industry fundamentals continue to improve for the major cigarette manufacturers, and that margins are continuing to expand. "Pricing power should lead to higher margins," she said, suggesting that a "modest price increase" of around 5% is probably in the cards as companies seek to maintain the price gap between premium and cheaper brands.
Herzog said she does not expect hefty state tax increases on tobacco this year, although California and Texas, which represent 16% of total cigarette consumers in the U.S., are considering excise tax hikes. Eleven states have proposed increasing taxes, although none have passed as yet.
Herzog predicted that smoking bans will continue, noting that 11 states and the District of Columbia require smoke-free workplaces, including restaurants and bars. But, she said, "smokers adapt, and so do the bars."
"We have no doubt that increased smoking regulations are the future," Herzog said. "And as consumers adjust to the changes, we believe the companies will have to adjust as well. Manufacturers will continue to be providing you with products and ways to make money."
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