Feel the Burn

Citigroup's Herzog bullish on tobaccoboth cigarettes and smokelessin 2007

NEW YORK -- The smokeless-tobacco segment has far fewer consumers than its big brothercigarettesbut it may represent the category's greatest growth opportunity, said Bonnie Herzog, tobacco analyst for Citigroup Investment Research,at a CSPNetwork CyberConference.

Between five million and seven million adult Americans consume smokeless-tobacco products, compared to the 45 million to 50 million smokers, according to Herzog. But innovative, new productswith major tobacco companies expected to fully embrace the moist-smokeless segmentand new ways for consumers [image-nocss] to enjoy tobacco have Herzog and the industry bullish on what could be a vastly changed category by this time next year. [Click here to view an OnDemand replay of the CyberConference.]

In addition to opportunities within the non-cigarette segment, Herzog addressed the outlook for cigarette tax increases in 2007; expected strategies of major tobacco manufacturers Philip Morris USA, Reynolds American Inc. and Lorillard Tobacco Co.; and other industry trends that will ultimately affect sales of the convenience-store industry's most vital in-store category.

Prices. Herzog expects a per-pack price increase to occur by the end of the year. The increase is expected to be slightly higher than the 2007 step-up in Master Settle Agreement (MSA) payments, at about six cents per pack. As has happened with price increases from the past few years, industry leader Philip Morris is expected to lead the charge.

Taxes. From the end of 2005 to Jan. 1, 2007, seven states will have increased excise taxes on cigarettes to an average of nearly $1 per pack, a 9.3% increase in the weighted average excise tax. After several ballot initiatives failed in 2006, however, it appears as though major increases in state excise taxeswhich had been widely anticipatednow seem unlikely, according to Herzog.

No states are expected to propose extremely large excise tax increases in the near future. Californiaa state that hasn't increased cigarette excise taxes since 2002 and accounts for nearly 9% of industry volumecould pass a significantly smaller tax hike than the proposed $2.60 increase proposed earlier this year.

Differentiation. Herzog said she believes Philip Morris should and will start viewing itself as a total tobacco company, not just a cigarette company, so it can leverage its core competencies, such as distribution, high-speed manufacturing and relationships with consumers and retailers. Differentiation will likely come through a more aggressive push into the moist-smokeless segment and reduced-risk technology. She said she believes the company is more likely to develop its own new products rather than acquire them.

Philip Morris and Reynolds have an opportunity to leverage the tremendous power of cornerstone brands such as Marlboro, Camel and Kool to blanket the moist-smokeless market. Smokeless remains a darling of the tobacco category, with wholesale shipments up 6% in 2005. Volume is expected to be up 4% in 2006, driven predominantly by growth of less expensive brands. Premium brands are likely to decline 2% for the year due to significant disparities in price ($5.04 per roll of premium smokeless vs. $2.29 per roll of discount smokeless in second quarter 2006).

Technology. Tobacco companies have made significant research and development investments to reinvent the way consumers smoke. This trend is expected to continue, driven by moves made by Philip Morris and Reynolds American Inc. Philip Morris has test-marketed Marlboro Ultra Smooth, which has a high-technology filter, while Reynolds could re-market its Eclipse product, which heats rather than burns tobacco, reducing second-hand smoke by as much as 80%.

Reduced-risk technology may take some time to catch on. But if the technology is applied to a company's entire cigarette portfolio while mirroring the taste, drag and burn of a traditional cigarette, it could become a long-term sustainable advantage, said Herzog.

Steve Burkhart, vice president and assistant general counsel for BIC USA Inc., Milford, Conn., preceded Herzog to advise retailers of liability issues related to selling cigarette novelty lighters and other potentially harmful merchandise manufactured by less than reputable vendors. He explained how one retailer sent letters to all store managers, authorizing them to sell only lighters that met certain industry standards and requirements. Such measures can help shield retailers against unnecessary product-liability lawsuits.

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