Even halfway through the year, we knew 2015 was shaping up to be a great one. Gas prices remained below $3 per gallon and even dipped to $2 by the holidays; unemployment numbers dropped to 5%; housing starts reached post-recession highs, thereby generating more construction jobs; and consumer confidence skyrocketed to 97.6% in August. Compare that to the meager 50% consumer confidence of November 2009.
Convenience-retailer confidence was also way up, with 63% of respondents to a September CSP/RBC Capital Markets retailer survey reporting improvement in c-store traffic (up from 25% in March 2014 and 50% in June 2015).
As the ball dropped on a new year, retailers were left holding their collective breath, wondering if 2015’s good fortunes could possibly carry over into 2016.
Nik Modi, tobacco analyst for New York-based RBC Capital Markets, says every indicator suggests it was just the beginning.
“Gas prices remain low,” he says. “Given some of the oil forecasts, that should continue to be the case, at least for the near term.”
More important than gas, the outlook for the core c-store consumer is very good.
“The low-income consumer is going to have many, many years of tailwinds because we’re starting to see a shortage of skilled workers,” he says. “Wage inflation, I think, is really going to start to help consumption patterns.”
Unfortunately the tobacco category is never as simple as mere economics. Even in the best of times, regulations, consumer attitudes, mergers and contracts all play a role in how the category performs. So we’ve asked Modi to share his predictions for the category in 2016 and beyond. His expectations? Category contractions, more Big Tobacco growth and the perennial legislative migraines.
Infinity & Beyond
Given what Modi jokingly describes as his “infinite years” covering the tobacco category, it takes a lot to surprise him. But the impressive cigarette sales of 2015 did just that.
“It was a great year in terms of cigarette volume declines in that it was much lower than what we’ve normally seen across the category,” Modi says. He points to the minuscule 0.5% declines anticipated for 2015 as opposed to a historical decline of 3% to 4% annually. “This was obviously a very, very strong year.”
Lower gas prices and unemployment rates helped cigarette sales. But Modi also describes a “shifting back” from previous tobacco trends—namely the movement from cigarettes to smokeless, roll-your-own (RYO) and other lower-cost alternatives at the start of the recession and the “hysteria” around electronic cigarettes and vape in 2013 and 2014.
“I think a lot of these things reversed themselves in 2015,” helping to move more dollars back to the cigarette category, he says.
Alas, Modi does not anticipate these numbers to be sustainable in the long run—or even the short run. Projections from RBC Capital Markets have cigarette volumes back to 3% declines by the first quarter of 2016 and as low as 6% if trends were to normalize on a two-year average basis.
“We’ll see how things pan out a year from now, but I think we all should be expecting the category decline rates to go back, maybe closer to 3% given that we still have a lot of economic tailwinds,” says Modi.
Another massive tobacco story of 2015 was the acquisition of the No. 3 tobacco player, Lorillard Inc., Greensboro, N.C., by No. 2 Reynolds American Inc., Winston-Salem, N.C. As we enter 2016, one of the biggest questions is how this “new” Reynolds will perform. Modi’s take? The company will get even bigger.
“From a geographic standpoint, the portfolios of Reynolds and Lorillard are obviously very complementary,” Modi says. “When you think about the broader sales coverage Reynolds has [and] the fact that Reynolds is picking up about 50,000 urban retailers, where Newport had a lot of cachet, there’s a lot of potential cross-sale opportunities. “The question becomes, will the brands translate?”
Though the merger went through in July 2015, Newport was not added to Reynolds’ everyday low price (EDLP) program until November, and a provision of the merger included a standstill agreement in which Reynolds cannot expand its retail space requirements for a set amount of time. In other words, we haven’t even begun to feel the full effects of the merger.
What we do know is that after just one quarter with Newport in its portfolio, Reynolds was able to grow the brand’s share by 3%—and that was without including the brand in its contracts.
“We’ll see what the uptake in the EDLP program is (after adding Newport),” Modi says. “That in itself should help, particularly with Pall Mall.”
The performance of the other player in the Reynolds-Lorillard deal—the newly formed ITG Brands LLC, Greensboro, N.C.—is another unknown for 2016. The new Big Tobacco player acquired a number of brands divested from Reynolds and Lorillard, including Winston, Salem, Kool, Maverick and blu e-Cigs in a $7.1 billion transaction.
How ITG will do with these new brands remains to be seen. Modi anticipates the company will attempt to maintain and grow share through heavy promotions, at least in the near future.
“They have a very targeted and specific promo and buy-down plan that I actually think could work,” he says.
Regardless, don’t hold your breath waiting for Reynolds and top-dog Altria Group Inc., Richmond, Va., to react.
“I don’t think Winston, Kool or Salem are big enough to disrupt the pricing environment,” Modi says. “At the end of the day, Marlboro is really the one that can upset the apple cart from a promotional standpoint.”
Evaluating E-Cigs
The great promise of electronic cigarettes is not what it once was. In a September CSP/RBC Capital Markets tobacco survey, only three cig-alike brands (Vuse, blu and Logic) were cited as coming close to meeting retailers’ expectations, and 90% of respondents described their vapor business as slowing down—or never getting started in the first place.
“There’s a lot of fear about taking on new products, given the history here and the fact that many companies aren’t taking back the product,” Modi says of his interactions with retailers.
The problem isn’t just a lack of product returns but also the products themselves.
“The category cannot provide the same efficacy,” Modi says. “Investments need to be made in research and development. You need to figure out a way, as a manufacturer, to get the nicotine to absorb into the bloodstream the same way as a cigarette.”
Throwing a wrench in the innovation process are the impending deeming regulations, which will give the U.S. Food and Drug Administration (FDA) authority to regulate e-vapor products.
While the regulations had not been finalized at the time this story went to press, Modi expressed his concerns over the premarket tobacco product application requirement, which stands to be “difficult and very costly.”
“I wonder how many companies will actually be able to complete it, let alone fund the process,” he says. “It could stifle innovation. Unless we have clarity and unless [manufacturers] believe they can get a return on their investment, it’s hard for me to understand why they’d invest significant amounts of money back into the category.”
Only time will tell. “My advice to retailers is to remain cautious,” Modi says. “Make sure you partner with the right companies and make sure there’s a clear understanding of the return policy.”
Marijuana's Buzz
Who would have predicted 10 years ago that legal marijuana sales would be a hot topic for tobacco retailers?
“It may not be as relevant, but I’ve been getting a lot of questions from retailers and wholesalers,” Modi says of recreational marijuana. “There’s been some very interesting developments, even in the last month or two.”
With Colorado, Washington, Oregon, Alaska and Washington, D.C., all passing recreational-marijuana laws (and a slew of other states permitting medicinal use), we’re starting to see some concrete results.
Take Colorado, where cannabis has been legal the longest. Marijuana-tax revenues reached $44 million in 2014 (when retail marijuana sales weren’t legal until July 1) and jumped up to $60 million as of June 2015, far exceeding expectations. Just as important, crime rates went down in the legalized environment: Colorado reported a 2.2% decrease in violent crime, a 9.5% decrease in burglaries and overall property crime down 8.9% in 2014.
“There’s evidence that there could be some good out of [legalization] from a tax and societal perspective,” Modi says. “At the end of this year, marijuana will be the No. 1 cash crop in Colorado.”
Modi says numerous states—including Massachusetts, California, Hawaii, Arizona, Missouri, Maine and Nevada—could all have recreational marijuana on their ballots in 2016. That’s hardly surprising, given that Gallup reports 58% of Americans support legalization.
But don’t count on seeing marijuana revitalizing the c-store backbar anytime soon—at least not as long as marijuana remains illegal federally.
“Right now, it has to be a completely cash business because the banking system can’t get involved,” Modi explains. “It could be interpreted as money laundering.”
Also, the laws in Colorado and Washington are written so that no “traditional” retailer can get into the marijuana business. To obtain a license to sell marijuana, a retailer cannot sell any items not related to marijuana, effectively excluding c-stores. For now, at least.
“I don’t think anyone at this point has really tried to push the envelope in selling recreational products in a c-store-like environment,” says Modi. “It’s going to come down to federal legalization of recreational marijuana. At that point, it will create an easier environment for traditional retailers to get in the game.”
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