In the late 1990s, Phil Seefried, an investment banker involved with the merger of cigar manufacturers Consolidated Cigar Corp. and Altadis USA, was attending a celebratory dinner after the merger was completed.
When Seefried, now chief executive of Headwaters MB, a Denver-based boutique investment bank, spoke recently with CSP, he recalled that at the time another investment banker stood up and announced that the number of cigar customers was declining by 5% annually, but yearly profits were growing by 5%. The banker then lightheartedly predicted, “At this rate, in a few years we’ll all have one customer smoking a $100,000 cigar.”
The bustling cigar industry was a remarkable success story at that time. What a difference a decade or two can make. Although these heady years are still in the recent memories of industry veterans, the transformed industry landscape can make it feel like ancient history.
When Jacksonville, Fla.-based Swisher International Inc. announced in May it would lay off 15% of its workforce, the news prompted speculation that the cigar manufacturer might be acquired by another industry operator. As recently as 2010, the company dominated the U.S. cigars category. According to a EuroMonitor report, Swisher held 35% of the country’s market volume.
Industry experts have proposed that Swisher’s troubles do not bode well for the little-cigar segment. In light of recent industry trends, ongoing tax increases and the expected regulatory changes to cigars that will come as part of the expansion of the Food and Drug Administration’s control of tobacco, it seems likely that it will become harder for little-cigar makers to thrive.
Indeed, three years after passage of wide-ranging tobacco taxes, including an especially punishing blow to cigars, was delivered to underwrite expansion of the Children’s Health Insurance Program Reauthorization Act of 2009, questions are circulating concerning little cigars’ long-term prognosis. (The federal tax on little cigars soared 25 times to more than $1 per pack.)
A Bad Wrap
According to John Geoghegan, director of strategic planning and brand development for Moorpark, Calif.-based Kretek International, sales of little cigars have been shrinking. Cigar sales in c-stores were $2.47 billion for the 52 weeks ending July 8, 2012, according to Chicago-based SymphonyIRI Group.
Few industry observers would have foreseen a possible decline in the little-cigar market several years ago. As recently as the mid-2000s, the market was growing steadily following the cigar sales boom of the 1990s. In 2004, the Cigar Association of America announced that little cigars made up 35.4% of overall cigar sales. In 2003, 2.5 billion little cigars were sold, up from 2.3 billion in 2002.
And then little-cigar sales fell 86.4% from 2008 through 2011, with use declining to just 0.8 billion, according to the Centers for Disease Control and Prevention. This drop has occurred even as the market for non-cigarette combustible tobacco products—including pipe tobacco, roll-your-own tobacco and cigars—increased 123.1% over the past decade, surging from 3.4% to 10.4% of the tobacco industry as cigarette consumption flagged.
“The Federal Alcohol and Tobacco Tax and Trade Bureau,” says Thomas Briant, executive director of the National Association of Tobacco Outlets (NATO), “defines a little cigar as weighing 3 pounds or less per 1,000 units and must have a wrapper that is approximately two-thirds or more tobacco [that] retains its tobacco characteristics of taste, aroma and identifiable chemical components and which has a color consistent with that of the natural leaf tobacco traditionally used as a wrapper for American cigars.” The result of defining little cigars based on weight is that manufacturers can slightly increase the weight of their products and avoid the heavy little-cigar taxes.
Geoghegan shares a more nuanced perspective: “The problem is that you cannot pinpoint market shifts on a per-customer basis.” Many cigarette smokers who switched to cigars to reduce their smoking “have cut down on their use of tobacco products by as much as 90%,” he says.
With the potential for additional FDA regulations in the coming months, cigar manufacturers could face significant challenges in absorbing the increased costs of staying compliant with the FDA. Unlike cigarette makers, smaller cigar manufacturers do not sell enough volume to offset expected regulatory costs.
That challenge was greatly exacerbated three years ago. Expansion of SCHIP legislation created a sharp increase in the federal tax on roll-your-own tobacco and small cigars. “What you’re seeing in the cigar industry,” says Seefried of Headwaters MB, “is that they’re being hurt at their most profitable items, because little cigars had higher margins. When you get a big bump in taxes on a premium cigar, it doesn’t really hurt those guys much.” In 2009, Headwaters completed a strategic transaction for Navajo Manufacturing Co., a company that creates merchandising programs for c-stores and mass-market retail channels.
Putting Up a Fight
Little-cigar makers are not writing their obituaries. They are countering with new product and sales innovations to drive the market in spite of high taxation rates and the threat of increased FDA restrictions. José Blanco, senior vice president of Joya de Nicaragua S.A., told CSP that more companies are relying on machine-made sticks instead of higher-priced hand-rolled cigars to keep costs down and profit margins up.
Cigar companies are also reducing the size of their cigar packs in reaction to the slow economy. Jane Green of Swisher says the company’s biggest challenges are the strains from a tough economy. “Higher taxes force higher prices at a time when consumers have less money in their pockets,” she says. To combat this, Swisher has responded with smaller pack sizes, especially two or three cigars per pack. Single-sale boxes continue to be a staple on the other tobacco products (OTP) set, she says.
In addition to greater machine use and smaller pack sizes, flavored cigars are a growing category within the little-cigar market.
The Centers for Disease Control, which has accused cigar companies of using flavored cigars to target youth and young adults, may influence the FDA’s regulatory policies. This claim infuriates cigar makers. “That’s just not true,” says Craig Williamson, vice president of the Cigar Association of America. “Many of these flavors have been around for over 100 years.”
Kretek’s Geoghegan sees flavor regulations having significant consequences on the little-cigar market. “It could be very difficult for certain companies to maintain their current market share if the FDA makes the move to ban flavors in little cigars,” he says.
If the agency, whose laboriously slow pace on policy has been roundly criticized by the tobacco industry for spurring enormous uncertainty, goes that route, it will be a significant undertaking. “If the FDA is going to ban flavors in little cigars, they will need to figure out how they will define flavors and how they plan to regulate that,” Geoghegan says. For instance, would industry staples such as wine and grape—or flavors such as cognac and pipe, which have existed in cigars for more than 200 years—suddenly be barred? Other industry observers, including Blanco, feel the changes might affect only how little cigars can be marketed to the public. “The expectation that many observers have about flavors is that the FDA will make manufacturers shift from using names of specific descriptive flavors such as vanilla, chocolate or cherry, to using ‘concept names’ such as, for instance, ‘purple passion,’ ” he says. “This will be fine if you only make a few flavors, but if you’re a company like Phillies [which makes a large number of flavors], this will make it a lot more difficult for you.”
Because of disparities in the federal taxation of tobacco products, little-cigar manufacturers have seen cost-conscious consumers spend their money on less heavily taxed large cigars over the past couple of years. A study on tobacco taxes titled “Tobacco Taxes: Large Disparities in Rates for Smoking Products Trigger Significant Market Shifts to Avoid Higher Taxes” was performed by the non-partisan federal Government Accountability Office (GAO) and released April 18, 2012. According to the study, little-cigar sales fell from 430 million cigars in January 2009 to 60 million cigars in September 2011. Over the same time period, large-cigar sales more than doubled, soaring from 411 million to more than 1 billion cigars sold.
SCHIP and Tobacco
The problems with tax discrepancies and FDA regulation began in 2009 with the passage of the Family Smoking and Tobacco Control Act. Written into law in June of that year, the bill gave the FDA full power to regulate not just cigarette companies but also the entire tobacco industry, allowing it to control facets of the business from tobacco product ingredients to advertising. Before that, the Fair and Equitable Tobacco Reform Act (FETRA) was enacted in 2004, mandating industry assessments for the next decade to fund the improvement of big tobacco business. From 2004 to 2014, the cigar industry was estimated to pay $282 million toward the maximum $10.14 billion assessment, which is a steep price to pay, according to Williamson.
Blanco says the entire cigar industry achieves about $600 million in annual sales. By way of comparison, he estimates the cigarette industry is about $88 billion in annual sales.
As small as the little-cigar market is now, it continues to face ongoing challenges. In speaking with CSP earlier this year, Lou Maiellano, president of TAZ Marketing & Consulting, Sevierville, Tenn., said, “Every time another article is written on pipe tobacco and flavored cigars, local jurisdictions tax the living daylights out of them.” It remains to be seen whether little-cigar makers will fend off these challenges or fall victim to the onslaught of tax and regulatory challenges.
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