Declining cigarette consumption is a story that has been covered by everyone from NACS to the Centers for Disease Control and Prevention. But there’s a lesser-publicized phenomenon that’s having as much—if not more—of an effect on a c-store retailer’s tobacco business.
In happier days, Big Tobacco aided retailers’ efforts by flushing the markets with buybacks, marketing allowances and other promotional spending.
“Promotional allowances help a retailer’s bottom line because they are designed to offer discounts on cigarette prices, thus boosting cigarette volume, since consumers should, in theory, see the benefit of lower prices,” says Judy Hong, a tobacco analyst for New York-based Goldman Sachs. “The programs have also allowed for payment to retailers as incentives to promote higher sales or preferred product placements.”
How times have changed: Today those once-plentiful marketing dollars have eroded—and, with them, retailers’ bottom lines.
“From a cash-flow perspective, [heavy promotional spending] was much more beneficial for retailers,” says Bonnie Herzog, a senior analyst covering tobacco and the c-store channel for Wells Fargo, New York. “The lower amounts that are now coming in have been challenging, to say the least— and have continued to squeeze margins.”
All of which has left operators in a bind: Cigarettes are as important as ever to the c-store operator—Herzog describes them as “absolutely critical to the channel”—yet the segment’s profits continue to plummet.
“Cigarettes represent the largest portion of [convenience] in-store sales, at over 38% in 2012, but declined 140 base points as a percentage of total sales vs. the year before,” says Hong. “Cigarettes also carry the lowest gross margin of all in-store merchandise at around 15% in c-stores.
“Despite a decline in gross margins, [they] account for over 18% of in-store gross profit.”
Which leaves the c-store channel to ponder: Where have all the promos gone, and are they ever coming back?
Promos for Profits
As tough as it is to be a tobacco retailer, manufacturers haven’t exactly had it easy in the modern era. Their operating costs have steadily risen thanks to a variety of challenges.
“I think a good frame of reference is pre- and post-MSA, using 1998 as your inflexion point,” says David Bishop, managing partner of Barrington, Ill.-based sales and marketing firm Balvor LLC.
Before 1998, tobacco companies did not have the burden of hefty Master Settlement Agreement (MSA) payments and added expenses. With the 1998 MSA signing, costs went up seemingly overnight. Settlement payments escalated to almost $9 billion a year at their peak, and they now average more than $7 billion a year. The MSA payments alone cost tobacco manufacturers roughly 50 cents per pack, according to Bishop.
But it didn’t stop with the MSA: Now there are also payments associated with FDA user fees, state-by-state regulatory fees and increasing dividends.
“You collectively have almost a 60-cents-per-pack increase when you look at those things combined,” says Bishop. “All of that has to come from somewhere.”
Yes, tobacco manufactures can—and have—raised prices to help offset these costs. But that’s only part of the equation.
“You’ve got a category that continues to decline year over year,” Herzog says. “There is pricing power, no question. But the levers that tobacco companies can pull are not only list price increases, but promotional spending.”
Pricing goes only so far with the current state of cigarette sales, leaving less room for marketing spending. As publicly traded companies, these manufacturers are thinking not only about their own profits but also their stock value.
“The manufacturers are in a situation where they have increased costs of doing business that they have to cover,” says Bishop. “They have to satisfy their shareholders, but they don’t have to pay those rich back-end moneys.”
In other words, those promo dollars aren’t being spent elsewhere; it’s simply a luxury the tobacco companies no longer have. However, this fact doesn’t make it an easier pill for operators to swallow.
“Even though retailers are obviously not thrilled about the idea of losing that profit margin, there’s not a lot they can do,” Bishop says. “The retailer is going to manage this. They all are intimately aware of the dynamics at play.”
Retail Reality
Manage it they must: The importance of managing lower promo dollars to keep cigarettes priced competitively cannot be understated.
“[Pricing] has a material impact because of the ability to drive foot traffic into the store with a competitive price,” says Bishop. “If the retailer doesn’t have that, they lose not only the tobacco sale, but the ancillary sales that go along with it—which generally is about a quarter of the basket ring in a cigarette sale, but half of the gross profit that’s generated.”
With that in mind, most retailers have adopted a price-per-volume strategy when it comes to cigarettes, similar to the way they price at the pump. Instead of looking to salvage margins on the segment, they keep cigarettes priced competitively and rely on profits from add-on purchases.
“It’s not a loss leader, but in many ways it’s very similar to the way grocery retailers price milk,” Bishop says. “Get the person in the store and sell all the other items that have the higher margins.”
Thanks to increased interest in OTP, Hong believes retailers often don’t have to look outside the tobacco category to recoup some of these profits.
“Retailers can reclaim some of the lost margins on cigarettes by allocating more shelf space to these other tobacco products and working with the manufacturers to come up with more effective merchandising plans,” Hong says.
Herzog agrees: “The trend has been going on where certain areas of OTP have higher margins and better growth. Retailers should absolutely be looking to other segments in tobacco to reclaim that margin.”
This is good news, but also a challenge given the space limits of the backbar. Bishop says OTP would have to grow at almost twice its current rate for retailers to offset the profit declines from cigarettes. “It’s a hard thing, but that’s what they need to do,” he says. “Retailers are very enterprising. I’ve always been amazed at how resilient and creative they are at coming up with solutions, given all the adversity they’ve faced.”
Future Relief?
Fortunately, retailers may see some relief in the near future: As Bonnie Herzog shared with retailers attending CSP’s Convenience Retailing University in January, the costs for tobacco companies are about to drop, thanks to the end of the federal buyout fee in fourth-quarter 2014. This, coupled with shrinking MSA payments, has Herzog cautiously optimistic that we’ll see a more benign pricing environment this year.
“Tobacco companies won’t need to let as much of the pricing stick because, quite frankly, they won’t need to take as much,” she says. “And maybe they’ll let [retailers] take a little of that profit.”
Not that cigarette margins will magically bounce back to the pre-1998 heyday. But between promotional allowances and pricing, retailers hope retail margins won’t be further squeezed.
“We are not seeing significant market-share disruptions among key brands right now,” says Hong, “which should also allow for a bit more rational, albeit still competitive, pricing environment.”
And the lack of promo incentives hasn’t been entirely bad: Bishop argues that the lack of money from Big Tobacco has actually made operators more independent and able to pursue different strategies.
“Retailers have to work harder for what they make, but less of the money is tied to incentive-driven programs,” he says.
Looking ahead, while there is little doubt sales of combustible cigarettes will continue to decline, don’t expect anything seismic. That also means premium cigarettes will continue to drive the combustible segment for the coming years.
“It’s three-quarters of the business today, it was three-quarters of the business yesterday. … Will it go down?” Bishop says. “The major manufacturers will work very hard and come up with strategies to prevent that, because that’s where they make the majority of their money.”
Promo dollars or not, moving forward, there will likely be plenty of give-and- take between tobacco companies and retailers. Herzog, for one, sees this as necessary for the health of the industry, given the important relationship between Big Tobacco and the c-store channel.
“It’s a symbiotic relationship,” she says. “There’s always going to be tension between the two, but it needs to be healthy to be successful both the manufacturers and the retailers.”
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