By David Bishop
Shrinking volume, growing taxation, expanding smoking restrictions and emerging retail sales bans are all creating headwinds for cigarette manufacturers. On the flip side, however, convenience retailers continue to grow during these tough times by being the destination of choice for tobacco products.
While total cigarette industry volume has declined in the United States at an average rate of approximately 3 percent since 2001, the negative effect for convenience retailers has been lessened to a degree since they continue to garner an increasingly larger share of the overall business. (See chart 1.)
One result of ongoing volume declines: Convenience retailers reported that in 2008, only 16 percent of their in-store gross profits were derived from cigarettes. This is nearly 10 percentage points lower than 2001 when it reached 25.9 percent, according to NACS State of the Industry data. (See chart 2.)
At the same time, retail gross margins compressed to 15.3 percent in 2008, as compared to 16.7 percent in 2007, which is due in part to lower program dollars from manufacturers, as well as retailers being more aggressive with prices. However, cigarettes remain the dominant category for most in the convenience retail business, contributing roughly one out of every three dollars spent inside the store. And, the largest component of the cigarette business is still driven by the premium subcategory, which contributed 84.3 percent of the category dollar sales, according to Information Resources Inc.
Retailers intuitively understand the importance of capturing the adult smoker: If you get a smoker in your store, you likely capture additional sales. Balvor examined more than 1.2 million customer transactions made in April 2009, which included a cigarette purchase, and discovered that a typical retailer gains approximately $3 in additional sales related to items sold with cigarettes during the same transaction. More importantly, the ancillary sales help to generate gross profit dollars nearly equal to that of cigarettes in the same transaction. (See chart 3.)
Convenience retailers also know it’s increasingly more difficult for adult smokers to smoke. Today, approximately 37 states have enacted some form of a state wide smoking ban. What’s also alarming, beyond how rapidly the bans have expanded since 2002, is that the focus has shifted from public places to include private areas, such as apartments and even automobiles. The cumulative effect of these bans means that nearly 70 percent of all adult smokers now face restrictions on when or where they can smoke.
Taxation is another issue that doesn’t seem likely to diminish in the near term, as states face increasing pressure to find additional revenue to plug budget shortfalls. While recent tax increases have had little success in raising the expected revenue, they have given adult smokers a financial incentive to shift to lower-cost alternatives, which includes stores on Indian reservations, the Internet, other states or even cigarettes smuggled into the state, depending on the geographic market.
In states like New Jersey, the savings associated with buying outside the state, in Delaware for example, can equate to more than $750 a year for a pack-a-day smoker. Consumers in New Jersey now pay $2.58 per pack in state excise taxes, which is up from 80 cents per pack in 2001, according to information compiled by Balvor.
Some convenience retailers are reportedly growing their cigarette business from an unlikely source since the 62-cents per pack federal excise tax increase took effect — other convenience stores. Anecdotal evidence captured in late April reveals that some retailers, who’ve maintained a breadth of assortment, are indicating growth in secondary brands. These beneficiaries believe new cigarette customers came to them from other stores that discontinued their preferred brand due to an increasing cost of carrying inventory.
Many convenience retailers expect further volume gains in 2009, anchored by the belief that market share will shift into convenience as other trade channels de-emphasize or even exit the cigarette business completely, according to an April 2009 Balvor retailer survey.
However, if you listen to what some retailers said in a July 2008 Wall Street Journal article on the topic, the major national retailers are not on the top of that list. When asked if Walmart would stop selling tobacco, CEO Lee Scott replied, “There are still a tremendous number of our customers who smoke…We’ve got a market to serve, and second, we’ve got shareholders to think about.”
Many believe that drug stores are more likely to exit the business given their focus on health and wellness. But surprisingly, it doesn’t sound like drug stores will voluntarily exit this business either. Tom Ryan, CEO of CVS, said on the topic of tobacco: “It’s a big number from a dollar standpoint…We’ve had internal battles and discussions. I wouldn’t rule it out at some point down the road.” And, while some like to interpret his last sentence as a signal that CVS might actually get out of cigarette sales, all we have to remember is that CVS — like Walmart — has a duty to its shareholders.
This isn’t to suggest that other retailers won’t exit the business for the reasons Target did in 1996 — the cost became greater than the benefit. In New York in particular, supermarket retailers such as Wegmans and DeCicco Family Markets have discontinued the sale of tobacco in their stores, due in part to public pressure from anti-tobacco groups and the fact that tobacco represented a very small portion of their business. Other supermarkets, such as Price Chopper, have taken steps to de-emphasize the category by removing all tobacco-related advertising and concealing display fixtures with an opaque plastic film.
Some in the industry speculate that other low-volume cigarette retailers will exit soon, as payment of the floor stock tax will prompt further debates about staying in the business. All of this is in addition to what we’ve already seen: retail sales bans in cities like Boston and San Francisco or bans considered, but defeated, in New York, where statewide retail bans were almost imposed on stores with pharmacies.
While many estimates project that the impact of the increased federal excise tax will range between a 5 and 10 percent decline in cigarette volume nationally, it’s really too early to gauge until we have a few months of data to adjust for short-term changes in consumer purchasing behavior.
In the meantime, fear about impending legislation that would give the FDA authority to regulate tobacco — the Family Smoking Prevention and Tobacco Control Act — might change things entirely. (For more information about the current state of FDA tobacco regulation, read “Smoke Signals”)
While many retailers are concerned that this oversight will impose stricter advertising and display restrictions on retailers, all we need to do is look at New York, Boston or San Francisco to realize restrictions can occur at a state or even local level without a federal mandate.
On the other hand, there’s retail hope that Congress will pass the Prevent All Cigarette Trafficking Act, which would help level the playing field for traditional, bricks-and-mortar retailers. Beyond closing many existing loopholes that benefit Internet retailers, this legislation has the potential to return a sizable portion of volume to the convenience store while also helping states generate the tax revenue they so desperately need.
For example, a smoker — including an underage smoker — can buy a carton of premium cigarettes online for half the price as purchasing in a New York City store. And, while the amounts saved vary based on state and local excise taxes, the industry and the state governments would benefit from this piece of legislation since it would make it much more difficult to obtain cigarettes via the Internet.
However, it’s important to remember — especially if you are a small operator — to stay informed on state and local issues that can have potentially dire affects on your business. This is especially true for stores operated near city, county or state lines where consumers can easily avoid higher costs by purchasing their cigarettes and other items across the border.
And, even though cigarettes may be an industry in decline, it still is and will remain a very vital component of the convenience retail business in the foreseeable future.
David Bishop is the managing partner at Balvor LLC, a sales and marketing consulting practice located in Barrington, Illinois.