While the longer-term forecast for cigarettes and the tobacco category at large may remain uncertain, those looking at 2017 see stability and, as a result, speak optimistically about the coming months.
Take Frank Armstrong, whose business has been on the upswing, especially in pipe tobacco, cessation products, premium cigarettes and roll-your-own products. While attending the annual Tobacco Plus Expo (TPE) in Las Vegas earlier this year, Armstrong, president of Blue Ridge Tobacco, a tobacco retailer based in Winston-Salem, N.C., talked about the growing, lucrative trend of higher-end products.
“People have a limited amount of time to smoke, so they’re interested in the quality of that smoke,” Armstrong said. “We’re fortunate, though, in that [my markets] have not had tax increases, but I know others are under a lot of pressure.”
Louis Gigliotti, a lawyer representing Westport Trading, Fort Mill, S.C., concurs with Armstrong’s optimistic, yet cautious, perspective. “A lot of what’s going to happen around government regulations are in a state of flux,” he said. “While tobacco does need regulation, the FDA (U.S. Food and Drug Administration) requirements can be unnecessarily burdensome and you don’t know [what rules] are going to continue.”
Analysts tracking the category predict lower volumes for 2017 but nothing unexpected. Nik Modi, an analyst for RBC Capital Markets, New York, said the projected 3.5% drop in volume for 2017 is more of a course correction after “strong” volumes the past two years. In his company’s recent report, Beverages, HPC & Tobacco—The Playbook for 2017, he dubbed this year a “normalization” period following the surge and ebb of electronic cigarettes; falling gasoline prices, which led to a rise in premium-tobacco sales; and improved employment among core cigarette consumers.
Concurring with Modi, Bonnie Herzog, managing director for beverage, tobacco and c-store research for Wells Fargo Securities, New York, told TPE attendees consumer confidence was up, gas prices remained low (though slowly rising) and tobacco users were still trading up to premium options.
Amid this optimism, Armstrong still stressed caution: “Traditionally, we’ve not been under fire, but states like California and Minnesota and cities like Chicago are under a lot of pressure. Those who have that national perspective react as we need to react.”
Pivotal Factors
In predicting a more normalized decline in tobacco volumes of 3.5% for 2017, Modi said multiple “swing factors” will influence his forecast, with significant uncertainty coming from taxes and regulation.
For the most part, Modi predicts a moderate tax scenario, due to the new Republican administration at the federal level and similar political environments in a majority of states.
Republicans hold 68 of the 98 state legislative chambers, which is a record high, according to the National Conference of State Legislatures, Washington, D.C.
“Our analysis suggests that Republicans are most likely to take a more benign approach to tobacco taxation,” Modi said in RBC’s report.
On a federal level, most recent excise taxes under Republican presidents rose by only 20% of what has occurred under Democratic administrations (16 cents total under Presidents Ronald Reagan and George H.W. Bush and 77 cents under President Barack Obama).
Modi also provided some thought on California’s $2-a-pack tax increase, which voters approved in November 2016. The boost would mean a 36% price increase at the retail level, leading to a potential drop of 10% in volume, Modi estimates. Still, he expects manufacturer promotions and a relatively docile consumer reaction to a recent federal tax increase will mitigate the blow.
In terms of regulation, Modi pointed out that tobacco wasn’t on the list of Donald Trump’s campaign promises, and the new president has been outspoken about reducing taxes and regulation to drive jobs. Modi also said that Vice President Mike Pence voted against the 2009 Family Smoking Prevention and Tobacco Control Act, which gave the FDA authority over tobacco.
In light of Trump’s focus on job creation and with most economic indicators trending up, Modi said consumer confidence will likely remain strong in the near term. (See graph below.)
One of the more dicey factors coming into play will be gasoline prices. C-store retailers benefited from low gas prices as consumers had more spare change to spend on gas, food and merchandise at their stores, even upgrading to premium products in many categories, including tobacco. However, last November, the Organization of the Petroleum Exporting Countries (OPEC) capped production, which helped stimulate oil prices. While prices on the street have risen only modestly, “movement in oil in either direction due to supply/demand issues or policy decisions could weigh on or be a boost to our existing [consumer-confidence] estimates,” Modi said.
Pending Arms Race?
One of the more stable factors affecting the tobacco category appears to be the major tobacco manufacturers themselves, said Herzog of Wells Fargo. A few years back, Richmond, Va.-based Altria Group and Winston-Salem, N.C.-based Reynolds American Inc. (RAI), which was recently bought by London-based British American Tobacco (BAT), were battling for market share. In recent months, “the big guys have been playing nice, with neither interested in rocking the boat,” Herzog said.
Where she does see a competitive “fire” is with alternative nicotine-delivery methods. These “risk-reduction technologies,” including electronic and heat-not-burn devices, have ignited an arms race of portfolio development and global consolidation, Herzog said.
In discussing BAT’s buyout of RAI, Herzog said the pressure to cut costs, expand into lucrative markets such as the United States and take the lead on innovation and emerging product technologies are driving consolidation among the major manufacturers. But the biggest motivator is winning the race of tobacco’s next incarnation.
To that end, Herzog expects New York-based Philip Morris International (PMI) and Altria to merge in some form within the year, expanding PMI’s “heat-not-burn” product, iQOS, into the lucrative U.S. market. The technology has performed well in Japan, having seen large consumer-conversion rates and market-share growth.
Referring to recent comments from PMI CEO Andre Calantzopoulos, Herzog said, “When you have [Calantzopoulos] publicly stating that the future of [PMI] is [smoke-free] and that [eliminating] combustible tobacco is the goal, I absolutely think this is the future.” She predicts companies will have multiple lines of risk-reduction products that appeal to different consumer demographics and situational uses.
Herzog even alluded to the Chinese National Tobacco Corp., Beijing, as a potential player that’s “big enough to acquire both” entities with BAT-RAI and a possible PMI-Altria combination. Another manifestation of the big getting bigger is Altria’s recent acquisition of New York-based Nat Sherman, which gives Altria strong, growing lines of premium cigars and cigarettes.
Improving OTP
As the category evolves, Armstrong said he’s doing all he can to engage the customer and improve his merchandise mix and bottom line. Taking OTP, for instance, he told TPE attendees it’s “a lot about merchandising, where product is positioned, how it’s priced, where it’s visible and communication with our retail associates.”
Building upon Armstrong’s thoughts, Kelly Michols, CEO of Tucker, Ga.-based Scandinavian Tobacco Group, who also spoke at TPE, said c-stores have seen less expensive cigar and cigarillos growing in their space for some time. If operators want to take the next step into more expensive, higher-quality cigars, they’ll have to make a considerable commitment in time and shelf space.
He recommended making room for a small cigar humidor. “It gives the consumer a feel that there’s a quality offer here,” Michols said. “The [lower] turn rate may be an impediment, but consider the added profitability, especially if you’re over-SKU’d on three-for-99-cents cigars.” Taking a chance on something new or different is a recurring theme among retailers and tobacco observers. But David Bishop, managing partner of Balvor LLC, Barrington, Ill., told TPE attendees to keep abreast of all developments, be it on the legislative or competitive front.
“Retailers can’t be too informed,” Bishop said. “But they can be too ignorant in this highly regulated business.”
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