Taking Tobacco's Temperature

Deep-discounts suffering, majors could launch smokeless products

NEW YORK -- The tobacco category has taken its lumps over the years, but Bonnie Herzog, tobacco analyst for Smith Barney, said the segment seems to be regaining some steam of late if the business fundamentals of the major manufacturers are any indication.

The fundamentals [for the major manufacturers] are the best that they've been in over two years, Herzog told the audience of a CSPNetwork cyberconference titled Tobacco 2005: Evaluation to Opportunities.

To view the complete cyberconference On Demand, click here.

Herzog noted that several positive things are happening in the tobacco segment these days. Manufacturers have regained pricing power, allowing them to raise prices and capture more profits. At the same time, sales of deep-discount brands, also known as fourth-tier brands, are on the decline. These events, coupled with what Herzog expects to be modest7% to 9% on averageincreases in state excise taxes could prove positive for the category.

Deep-discount products are in decline, Herzog told attendees, because the price gap between premium and deep-discount cigarettes continues to shrink. Many deep-discounters are raising their prices as they are being forced to make payments into the Master Settlement Agreement, the massive 1998 settlement between cigarette-makers and the U.S. government.

The gap is still more than $1, but this is much lower than it has been in the past. The gap is relatively narrow and in the range of what premium manufactures feel is [enough] to stem the down-trading pressures, Herzog said.

Deep-discount products today account for about 12% to 15% of the overall cigarette market. I don't think this industry is nearly as attractive to new entrants today as it was several years ago, Herzog said. However, she added that there will always be some demand for these products.

The bad news for retailers is that promotional spending by the major manufacturers is declining. Herzog said that a survey of retailers taken during the second quarter of 2005 revealed that there has been a slow-down in promotional spending by the majors. The reduction is an attempt by the majors to recapture profits that for the past several years have been thin.

The move appears to be working. Although Herzog acknowledged that retailers suffer when promotions are slashed, she is not seeing noticeable reductions in cigarette volumes when it occurs. Some retailers may be suffering, Herzog said, but others I've heard from have taken up pricing more than they need to to improve their own margins.

Herzog said major manufacturers R.J. Reynolds and Phillip Morris USA could both broaden their horizons from cigarettes and enter such other tobacco product areas. As soon as next year, Herzog said, both R.J. Reynolds and Phillip Morris USA could launch products in the moist smokeless category. Think about Marlboro in a tin, she said.

Herzog also told retailers to keep an eye on three new products from Phillip Morris USA that Herzog thinks the company could eventually market as reduced-risk cigarettes. The products, being tested in Atlanta, Tampa, Fla., and Salt Lake City under the name Marlboro Ultra Smooth, contain special carbon-containing filters.

This could be a huge competitive advantage, Herzog said. However, she added that the company has not yet made such a claim. They have never said that this is a reduced-risk product, she said. However, there is carbon in the filter and part of what harms the smoker is the carcinogens they inhale. So this is possibly one way to do it.