Getting Littler?

Taxation, loopholes biting into sales of little cigars.

By
Jeremy Seth Davis, Freelance writer

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In the late 1990s, Phil Seefried, an investment banker involved with the merger of cigar manufacturers Consolidated Cigar Corp. and Altadis USA, was attending a celebratory dinner after the merger was completed.

When Seefried, now chief executive of Headwaters MB, a Denver-based bou­tique investment bank, spoke recently with CSP, he recalled that at the time another investment banker stood up and announced that the number of cigar customers was declining by 5% annually, but yearly profits were growing by 5%. The banker then lightheartedly predicted, “At this rate, in a few years we’ll all have one customer smoking a $100,000 cigar.”

The bustling cigar industry was a remarkable success story at that time. What a difference a decade or two can make. Although these heady years are still in the recent memories of industry veter­ans, the transformed industry landscape can make it feel like ancient history.

When Jacksonville, Fla.-based Swisher International Inc. announced in May it would lay off 15% of its workforce, the news prompted speculation that the cigar manufacturer might be acquired by another industry operator. As recently as 2010, the company dominated the U.S. cigars category. According to a Euro­Monitor report, Swisher held 35% of the country’s market volume.

Industry experts have proposed that Swisher’s troubles do not bode well for the little-cigar segment. In light of recent industry trends, ongoing tax increases and the expected regulatory changes to cigars that will come as part of the expan­sion of the Food and Drug Administra­tion’s control of tobacco, it seems likely that it will become harder for little-cigar makers to thrive.

Indeed, three years after passage of wide-ranging tobacco taxes, including an especially punishing blow to cigars, was delivered to underwrite expansion of the Children’s Health Insurance Program Reauthorization Act of 2009, questions are circulating concerning little cigars’ long-term prognosis. (The federal tax on little cigars soared 25 times to more than $1 per pack.)

A Bad Wrap

According to John Geoghegan, director of strategic planning and brand develop­ment for Moorpark, Calif.-based Kretek International, sales of little cigars have been shrinking. Cigar sales in c-stores were $2.47 billion for the 52 weeks ending July 8, 2012, according to Chicago-based SymphonyIRI Group.

Few industry observers would have foreseen a possible decline in the little-cigar market several years ago. As recently as the mid-2000s, the market was growing steadily following the cigar sales boom of the 1990s. In 2004, the Cigar Association of America announced that little cigars made up 35.4% of overall cigar sales. In 2003, 2.5 billion little cigars were sold, up from 2.3 billion in 2002.

And then little-cigar sales fell 86.4% from 2008 through 2011, with use declining to just 0.8 billion, according to the Centers for Disease Control and Prevention. This drop has occurred even as the market for non-cigarette com­bustible tobacco products—including pipe tobacco, roll-your-own tobacco and cigars—increased 123.1% over the past decade, surging from 3.4% to 10.4% of the tobacco industry as cigarette con­sumption flagged.

“The Federal Alcohol and Tobacco Tax and Trade Bureau,” says Thomas Briant, executive director of the National Associa­tion of Tobacco Outlets (NATO), “defines a little cigar as weighing 3 pounds or less per 1,000 units and must have a wrapper that is approximately two-thirds or more tobacco [that] retains its tobacco charac­teristics of taste, aroma and identifiable chemical components and which has a color consistent with that of the natural leaf tobacco traditionally used as a wrap­per for American cigars.” The result of defining little cigars based on weight is that manufacturers can slightly increase the weight of their products and avoid the heavy little-cigar taxes.

Geoghegan shares a more nuanced per­spective: “The problem is that you cannot pinpoint market shifts on a per-customer basis.” Many cigarette smokers who switched to cigars to reduce their smoking “have cut down on their use of tobacco products by as much as 90%,” he says.

With the potential for additional FDA regulations in the coming months, cigar manufacturers could face significant challenges in absorbing the increased costs of staying compliant with the FDA. Unlike cigarette makers, smaller cigar manufacturers do not sell enough vol­ume to offset expected regulatory costs.

That challenge was greatly exacerbated three years ago. Expansion of SCHIP leg­islation created a sharp increase in the federal tax on roll-your-own tobacco and small cigars. “What you’re seeing in the cigar industry,” says Seefried of Head­waters MB, “is that they’re being hurt at their most profitable items, because little cigars had higher margins. When you get a big bump in taxes on a premium cigar, it doesn’t really hurt those guys much.” In 2009, Headwaters completed a strategic transaction for Navajo Manufacturing Co., a company that creates merchan­dising programs for c-stores and mass-market retail channels.

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