NEW YORK -- Although premium-brand cigarettes are getting most of the majors' attention these days, the entry of a new player into the U.S. market may revive two smaller but viable categoriessuper-premium and discount.
The recent announcement by U.K.-based Imperial Tobacco Group PLC that it was acquiring Commonwealth Brands Inc., Bowling Green, Ky., was the topic for a conference calllast weekhosted by Citigroup Investment Research's Bonnie Herzog and Adam Spielman. The two analysts anticipated not only increased tension in the super-premium and discount [image-nocss] categories, but also the beginning of what may be several consolidations between international players and small domestic manufacturers.
We think that the market for tobacco in the U.S. is going to bifurcate into more desire for super-premium and there's a big opportunity in discount, said U.K.-based tobacco analyst Adam Spielman. He noted trends in other consumer categories favoring super-premium goods, as well as strong sales for super-premium cigarettes such as Reynolds American Inc.'s Santa Fe natural tobacco brand. This provides a fertile environment for Imperial's Davidoff super-premium cigarette brand, which is currently born by cigars in the United States.
Spielman pointed to discount cigarettes as another natural growth area in Europe, the United Kingdom and when price gaps are wide enough, in the United States as well. It's also why the industry leaderclearly Philip Morrisfocuses so obsessively on price gaps and tries to narrow them, he said.
The result is a golden opportunity for Imperial to carve a niche in the U.S. market. Its main competitioni.e., PM USA, Carolina Tobacco Co. and Reynolds Americanare focusing most of their efforts on mainstream premium brands, said Spielman. They're reducing emphasis on discount, and their discount brands have been losing market share recently, he observed. And because their super-premium brands are comparatively small, it may well be that they will be putting less emphasis than Imperial or Commonwealth will be on Davidoff.
Herzog expressed surprise that PM USA passed by the opportunity to pick up Commonwealth, noting it does not currently have a stake in super-premium. The brand name of Davidoff is very well known in U.S. in the cigar business, and this could have been very interesting for Philip Morris, said Herzog. We'll have to wait and see how they respond if at all to the super-premium market.
She added that Reynolds does have a stake with the Santa Fe brand, which has grown 20% per year off a low base; of the three major manufacturers, it is most likely to be negatively impacted by the deal. But to put it in perspective, Commonwealth is still quite small, and given that Reynolds now has 30% of the U.S. market, they have much more power with the retailers and wholesalers, said Herzog.
A proprietary survey Citigroup conducted with some 80 retailers and wholesalers found mixed optimism about the outcome of the acquisition. Fifty-one percent of respondents believed Imperial would be successful pushing Davidoff through Commonwealth's existing distribution network, while 40% believed the network couldn't handle the influx of new products.
According to the same survey, 43% believed that Commonwealth's USA Gold brand volume will continue to decline, and 32% expected a slight price increase.
I think a lot of the trade is anticipating changes that will be made to contracts now that Imperial is involved with Commonwealth in terms of certain requirements they need to make with market share or contracts, in terms of paybacks or buy-downs, which will be interesting, said Herzog.
In review, Herzog called Commonwealth a sound transaction for Imperial, noting it decreased the British company's risk of entering the U.S. market thanks to Commonwealth's existing distribution network. She anticipates more consolidation in the future with international manufacturers picking up small domestic players in order to enter the profitable U.S. market, especially since the litigation risk has decreased.
On a separate note, when asked about the potential of future FDA regulation of tobacco, Herzog reiterated her belief that it is inevitable, but will likely not occur in the short term. Most of the senior management teams of companies I cover have echoed this thought, she noted. There are always bills proposed, but I'm not getting sense there's any traction right now.
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