Value Vexation

Bottom-tier cigarette makers struggle as gap tightens between premium and discount.

Linda Abu-Shalback Zid, Senior Editor

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Back in its heyday, Roger cigarettes used to be a “bell ringer” of fourth-tier cigarettes in the United States. David Redmond, CEO of Portland, Ore.-based Carolina Tobacco Co., says his company’s brand sold about 1.2 billion sticks a year in the early 2000s, with the next-closest fourth-tier competitor at about 400 million.

Flash forward to today in the United States and, ironically, all is not OK for the brand that was named for the military slang that means, “I understand you, OK.” In fact, you can’t even buy a pack of Rogers here, although they are still available primarily in the Middle East.

One reason for Carolina’s withdrawal from the United States is the Master Settlement Agreement (MSA) from more than a decade ago, which forced participating tobacco companies to pay billions of dollars to the states to settle claims that smoking-related illness caused large health-care bills.

Nonparticipating manufacturers, such as Carolina, pay roughly $5 per case into an escrow account, rather than paying directly to the states. The money stays in escrow for up to 25 years as a state decides whether to pursue legal claims. “It’s supposed to be identical state-to-state,” says Redmond, “but there are variations and interpretations, and many states are not refunding our overpayments of tobacco taxes.”

Having that money tied up hinders Carolina’s (and other lower-tier manufacturers’) ability to offer a competitive price advantage. But that’s only part of the reason why Carolina Tobacco withdrew from the United States. Other issues, such as increased competition and costly regulations, are also setting up a blockade that few lower-tier manufacturers can overcome.

Playing the Majors

Despite a difficult economy, the shift from the premium end to lower-tier cigarettes of late hasn’t been substantial, according to John Mayer, product director for cigarettes and tobacco for Temple, Texas-based McLane Co. Premium, he says, is down only 1.8% since 2009. “To me, that is minor,” he says, “especially when the [federal excise tax] increases were coming into play and many were saying, ‘Woe is the industry, this is going to kill premium pricing, and all the business is going to go to discount.’ That never happened.”

He points to the recent success of Santa Fe Tobacco’s American Spirit products and Lorillard’s Newport, both premium brands: “Those two manufacturers are not only gaining share, they’re gaining cartons—and that combination is not easy to do in a category that is selling fewer and fewer cartons every year.”

Also, Mayer says, you can view cigarettes as a consumable. “You’re not going to eat it and you’re not going to drink it, but you’re going to taste it,” he says. “When it comes to a consumable, the consumer has a taste preference and an expectation that includes what they will pay.”

Major manufacturers, he says, also have been promoting much more on premium brands. According to Bonnie Herzog, managing director of beverage, tobacco and consumer research at Wells Fargo Securities LLC, Charlotte, N.C., the relative price gap between premium and deep discount has tightened from about 36% to roughly 32% to 33%.

Mayer says, “They’re attempting to give the consumer less of a reason to want to purchase a discount brand, and I think to a large degree that’s working.”

Rick DiDonato, vice president of sales for JT International USA, Teaneck, N.J., concurs. “The greatest challenge in the value category is that we are now seeing big-equity brands discounting down to our levels,” he says. “They are implementing programs and increasing their promotional offerings to reduce the retail cost of their products to the consumer.”

Fred Faulkner, sales and marketing manager for Bakersfield, Calif.-based Jaco Oil Co., says his company is participating in Altria’s Marlboro Leadership Price option, which essentially narrows the gap between the lower-tier cigarettes and premium Marlboros.

“The MLP program has effectively made the premiums more competitive, since we have to line up pricing by [gross profit dollars] or [gross profit percentages],” Faulkner says. His premium sales have improved overall, while sales trends of his third- and fourth-tier cigarettes are actually negative year-to-date. “I think consumers are cutting back on smoking, and so when they do smoke they are opting for better brands and taste.” Competition is also coming from the major tobacco companies in another form. “Besides the repositioning of former premium brands, we are now seeing major manufacturers introduce lower-priced brands,” he says. “This level of competition has intensified over the past two years and is at the greatest level I have ever seen.”

Scott Lojas, merchandising manager for The Hartley Co., Cambridge, Ohio, points out that the bigger brands also have loyalty on their side. “I still see business going to that third and fourth tier, but there’s still those loyal Marlboro smokers that are still purchasing Marlboro,” he says. Premiums continue to dominate at his stores, accounting for 62,000 cartons for the first three quarters of 2011, although third- and fourth-tier brands are not far behind, at 51,000 cartons.

Lojas sells Marlboros for $5.28 at Hartley’s 22 Starfire company operations. But a $12 buydown on Marlboro 72s and Special Blend means they sell for $4.28—a $1 price difference his customers are taking notice of. “There’s certainly people that will never change a brand; there’s other people who will look for the cheapest price there is,” he says. “If they find a comparable smoke in a lower brand, they’ll do that.”

The lower tiers also are facing additional competition from other tobacco products, according to Lojas. “As the government and everybody keep raising the prices up, I figure people are going to try another alternative,” he says. Santa Fe little cigars, for example, cost $1.49 a pack at his stores. “Some people say that is comparable. They still get to smoke and their satisfaction, but it’s not as high a price.” With many consumers turning to rolling their own cigarettes to save money, he also has purchased a roll-your-own machine, which at press time he hadn’t installed yet.

To Lojas’ point, Ross Haynes, director of sales and marketing for Russell Springs, Ky.-based Tantus Tobacco, also says that other tobacco products have been competing with the third- and fourth-tier cigarettes, which he can see even within his own company.

Tantus sells four value cigarette brands (GSmoke, Main Street, Berkley and 24/7) in MSA states and two (Berley, Sport) in non-MSA states, to ensure pricing remains consistent across each brand. And while the company’s cigarettes have experienced a slight decline, it has seen increases in both filtered cigars and pipe tobacco. (Following FET tax increases in 2009, many customers have started using pipe tobacco, taxed at a lower rate than bulk cigarette tobacco, in roll-your-own machines.) “I think there’s just been a trend to go to the lowest cost available,” Haynes says.

Lou Maiellano, a tobacco consultant with TAZ Marketing & Consulting Group, Sevierville, Tenn., also has noticed the trend. “Consumers are looking for how they can get deeper satisfaction at a reduced cost,” he says. “There are folks that are looking for value—whether it be through a deep-discount offering or roll-your-own or some other tobacco alternative—and those that are providing value are seeing that business grow, and seeing it become very lucrative.” He also mentioned that in regard to roll-your-own, many users believe they get a “better smoke.” Maiellano says that retailers should “religiously evaluate” their offerings, and he offers some advice: “Consumers are looking for the value proposition; retailers need to make sure they are focused on meeting that consumer need.”

Regarding Regulations

Costs to comply with upcoming U.S. Food and Drug Administration regulations also are “obviously a concern” for smaller manufacturers of lower-tier cigarettes, Haynes says.

 “[The majors] can spread out their FDA costs among larger volume than we can, so it might have a greater impact on pricing for lower-tier brands,” he says.

Tantus even maintains a full-time staff to ensure proper handling of FDA issues. “I think it will cut down on mistakes and keep us in the market because we’re doing things correctly,” he says. Competitors without that support are “not well-equipped to handle what’s coming. They might struggle.”

DiDonato says complex testing and reporting requirements could become “cost-prohibitive” and that potential long-term players “better be prepared to dedicate a great deal of resources to ensure compliance.”

Another challenge regarding regulation, he says, is that raising prices to cover the costs might be a manufacturer’s first reaction, “but some of these smaller brands exist only because they are the cheapest cigarettes in the store. If your primary selling point is price, and not quality or equity, passing on the cost to the consumer will result in volume declines.”

And that can spur a vicious cycle, DiDonato says: “Loss of revenue follows volume declines and then the inability to comply with costly regulations. Unfortunately, when this happens, we see retailers and wholesalers stuck with products that are no longer allowed to be sold due to delisting or other noncompliance issues.”

For Carolina Tobacco, changing to the new FDA-mandated health warnings was another reason for withdrawing from the United States. Redmond estimates it would cost about $1 million to go from his company’s five-color packaging to 10 or 12 colors. “It’s a matter of can it be done, and then what is the cost?” he says.

Also, because his company typically prints six months to a year’s supply at a time as a cost-saving measure, it would mean the company could have to destroy that much packaging. “And we’re not particularly interested in doing it,” he says.

Ironically, however, the current U.S. health warnings have benefited Carolina Tobacco in its duty-free, tax-free sales. Calling them the “Rolls-Royce in the world,” he says, “The perception in various countries is that the U.S. government has actually inspected or been involved in the quality process, so it enhances the value.”

Another FDA effort that caused some concern for Redmond is the agency’s examination of menthol, which accounts for 28% of Carolina’s business. “I’m not aware of any country except the U.S. considering outlawing or restricting or monitoring it,” he says.

Still, despite the various challenges facing lower-tier cigarettes, Redmond says, “My mantra is the fourth tier is here to stay. States continue to add more tobacco excise tax annually, and there are 24% smokers and 76% nonsmokers—these bills pass. That means the consumer continues to look for better and better pricing.” 

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