Rolling with the Punches

While piquing retailer interest, RYO machines take a hit from regulatory bodies.

By  Linda Abu-Shalback Zid, Senior Editor

Article Preview: 

When RYO Machine Rental LLC debuted its rollyour- own (RYO) cigarette machine in 2008, it never planned on such machines garnering so much national attention so soon.

The Cincinnati-based company’s inaugural year was slow; it produced only 10 machines. But when the feds came in, so did the orders from retailers.

The State Children’s Health Insurance Program (SCHIP) took effect in 2009, and RYO tobacco taxes skyrocketed 2,400% from $1.01 per pound to $24.78 per pound. Meanwhile, pipe tobacco merely doubled, going from $1.09 per pound to $2.83 per pound.

To circumvent the crippling tax on RYO, some manufacturers allegedly began labeling RYO as tobacco, used in the machines as pipe tobacco.

And RYO Machine Rental was an unexpected beneficiary. “We had nothing to do with that,” company president Phil Accordino says. “The federal government created the market with SCHIP, and that’s when our machines took off.” In its four years of operation, the number of machines has soared to 1,700, despite the $32,000-per-unit price tag on the jukebox-size contraptions, which are about 55 inches high by 40 inches wide. But the company’s offering is actually at the heart of two debates: one centered on the alleged mislabeling, and the other that classifi es owners of large RYO machines as “manufacturers” who should therefore be subjected to manufacturing regulations.

Pay the Piper

“It would be like if you went to the store to buy wine, and two out of every three bottles of wine actually was beer,” says Paul Creasy of Ft. Lauderdale, Fla.-based Commonwealth-Altadis Inc. about the purported RYO mislabeling. Creasy, the company’s general manager of the pipe tobacco division, who also is chairman of the Washington, D.C.-based Pipe Tobacco Council, estimates that 90% of what is being sold as pipe tobacco today is really RYO, but it has been adjusted to bypass the SCHIP tax. (Many packages can be discerned by verbiage that mimics cigarette labels—such as “menthol,” “fullfl avor” or “regular,” he says.)

“I’m not upset in the sense that I can completely understand why people would do what they have to do,” he says, “but we’re worried about the ramifications of this down the road. Is this going to lead to calls to Congress to equalize the tax on all tobacco products?”

Another concern, he says, is pipe tobacco’s reputation potentially going from the benign “what grandpa smoked” to the “tax-dodge smoke.”

Creasy has taken his concerns to the U.S. Treasury Department’s Alcohol and Tobacco Tax and Trade Bureau (TTB), where he submitted comments on behalf of his company and the council on a proposed defi nition of pipe tobacco. “I feel that when the TTB does finally act to make the distinction between the two products, that will solve the problem,” he says. “Now, when they act is the question.”

Mark Tucci, president of 7 Valleys Custom Blends, a seven-store tobacco chain with units in Pennsylvania and Virginia, is not shy about describing his own feelings about the issues surrounding the machines. He says he wouldn’t touch RYO machines “with a 10-foot pole,” and that they have “thrown the entire tobacco industry into disarray.”

“Why the federal government doesn’t crack down on it, and take some kind of action and retroactively get their money back, is beyond me,” he says.

Tucci has been selling traditional RYO products since 1993 and plans to do so “forever”—without mislabeling it as pipe tobacco, a practice he considers a moral issue that could affect his legacy. “I want to be legal and I want to be in business for the rest of my life, and my children’s lives and for other generations,” he says.

Meanwhile, he doesn’t fault customers for taking advantage of the savings using the so-called pipe tobacco in the machines. When he fi rst lost a few customers to RYO machine shops, he says, “I’d say, ‘Hey, man, I don’t blame you. Economic times are tough.’ ”

For tubes and tobacco at his stores in Pennsylvania, customers might pay $27, still a substantial savings over manufactured cigarettes. (The cost of a carton of Marlboros in the state, for example, is roughly $55.) If he were to “slap a pipetobacco label” on his tobacco, he could charge as little as $18 for the tobacco and tubes.

Nine times out of 10, he says, his customers came back anyway, when the quality wasn’t what they were used to and the experience wasn’t as rewarding as sitting in front of the TV at home and rolling their own.

The real danger, Tucci says, concurring with Creasy, is the potential effect on taxes. (During a recent earnings call, Ron Bernstein, CEO of Durham, N.C.-based Liggett Vector Brands, estimated that the Federal Treasury has been denied more than $1 billion in taxes it expected to collect since April 2009, and that number could exceed $1 billion for calendar year 2011 alone.)

“Now states are talking about ramping up pipe-tobacco tax,” says Tucci, “so that’s going to hurt pipe-tobacco consumers. … There couldn’t have been a bigger hand grenade into the industry.

“It’s so ridiculous, because it’s so much money and it’s happening right in front of everybody and nothing is happening about it.”

Not surprisingly, a number of traditional manufactured-cigarette makers also are fuming over the effects of the issue.

During his earnings call, Bernstein of Liggett called the industry to the carpet for “evading federal taxes by knowingly mislabeling roll-your-own tobacco as pipe tobacco.”

“While this appears to be a clear and blatant violation of U.S. tax law,” he said, “Congress and regulators have been slow to address the problem, and it continues to grow at an alarming rate.”

Bernstein asserts that the mislabeling increased pipe tobacco sales by 350%, following SCHIP’s passage: “It now represents almost 19 billion cigarette equivalents per year, as compared to 2.5 billion cigarette equivalents in the year prior to the tax increase.”

At Winston-Salem, N.C.-based Reynolds American, the phenomenon is internally referred to as “pipe-your-own tobacco” (PYO).

And during a recent investor’s day, a company presentation showed that pipe/ cigarette RYO has an estimated 5.2 shareof- market equivalent, up 1.3 points vs. a year ago.

“These low-priced alternatives are clearly affecting the reported decline of cigarette industry volume,” said Andrew Gilchrest, president and chief commercial officer of R.J. Reynolds Tobacco Co. Without the growing “pipe-your-own” category and a 0.2 share equivalent increase in large cigars, industry cigarette volume would be down about 2% to 2.5% this year, he said, vs. the reported decline of about 3.5% to 4%.

 During CSP’s recent Tobacco Update CyberConference, UBS tobacco analyst Nik Modi said of the PYO phenomenon, “The bottom line is, I don’t think this trend is going to go unchallenged next year; I would expect a lot of activity behind this.”

And major tobacco companies are supporting the challenge, he says: “The reality is, I don’t think you should be planning for significant space allocation of pipe tobacco in the risk that the government really clamps down in a meaningful way.”

From Making to Manufacturing

In addition to the pipe tobacco/RYO “loophole” issue, the TTB issued a Sept. 30, 2010, ruling, indicating that retailers who give customers access to the RYO machines are subject to the same licensing rules as other cigarette makers. In December of the same year, however, a federal district court judge issued a temporary injunction against the enforcement of the TTB rule, and the matter was on appeal to the U.S. Circuit Court of Appeals at press time. RYO Machine’s Accordino calls the TTB’s ruling a “bizarre allegation,” adding that a carton of cigarettes in his machines takes about 15 minutes to make—hardly reminiscent of the capabilities of the Big Three.

“A cigarette manufacturing machine can do in one minute what it would take our machine 48 hours nonstop to produce,” he says. “It couldn’t be further from what we designed our machine to do; it is strictly for individual personal consumption. The only difference is, it’s available in a store.”

He likens the machines to using a coffee-bean grinder in any store: “That doesn’t make you a coffee manufacturer, and you’re not going to grind enough to be a manufacturer.”

Meanwhile, Matt Ryan, owner of Roll With It Colorado, based in Lockwood, Colo., has two locations with Accordino’s machines, which also carry about a dozen types of pipe tobacco. Sixty-three percent of his customers are women, he says, ages 40 to 55.

“We like saving them money and they seem to like our product,” he says.

Also, 63% of customers say they come to the store focused on the price. (The others prefer the all-natural, chemicalfree tobacco and cite other reasons.) Customers can make a carton of cigarettes for $25 at his store vs. the $33 for the cheapest discount brand of manufactured cigarettes nearby.

With that high of a percentage, if the cost advantage were to be taken away, he says, “that would have an immediate impact on our business for sure. Now, do I think that’s going to happen? I don’t think it’s going to happen all that soon.”

Tucci of Custom Blends, however, contends that the proponents saying the machines are no different from traditional RYO is “complete and total garbage. … There couldn’t be anything more different between rolling your own cigarettes at home and standing in front of a machine and watching it make them for you. That really is an insult. … They’re trying to make as much money as possible, as quickly as possible, before the loophole closes.” And much like Accordino’s coffee metaphor, the legal grind continues, playing out across several states, including New York, Wisconsin, West Virginia and New Hampshire.

“You will see more states come out with revenue rulings that codify the TTB’s ruling at the federal level that these outlets are cigarette manufacturers and ought to be subject to the same regulatory burdens as a manufacturer,” says Corey Fitze, NACS’ director of government affairs.

To avoid a state-by-state logjam—and the potentially hefty sum some retailers using the machines could face in back taxes—NACS is pushing for a federal solution. “Big money is on the table for both convenience stores and for the taxing entities,” Fitze says.

Meanwhile, Ryan of Roll With It Colorado sounds quite cheerful when discussing his business, despite the fact he is currently paying rent on, but not using, two additional spaces in which he plans to open shops.

 Ryan is waiting to hear back from the state, which recently contacted him about being considered a manufacturer. “We don’t want to anger the state, so during this time we said we wouldn’t open any more stores,” he says. “How long we can continue to do that, I don’t know.” Ryan’s machines weren’t the first in the state, and he says, “I never would have opened up the store had I known that the state even had a problem with it at all.”

But he is hopeful when it comes to the two unused locations as well as four other locations he’d like to open—and happy with the results at his current locations in the meantime: “I wouldn’t open up six more stores if we weren’t doing extremely well.”

Ryan also points out that from his own surveys, about 20% of his customers come from convenience stores, and 30% come from traditional tobacco shops. (The other 50% don’t say.)

Others have contended that the RYOmachine situation could be costing those retailers as much as thousands of dollars a week in manufactured-cigarette sales.

 “Customers who purchase cigarettes frequently purchase other ancillary items,” says Fitze of NACS. “If our members lose the foot traffic that cigarette sales generate, they are losing much more than just the sale of a pack or carton of cigarettes.”

Because of that competitive environment, Fitze says NACS also has heard from several members “currently evaluating the environment and deciding whether they can afford to take the gamble and purchase an RYO machine.”

He cautions: “Although these machines drive an enormous amount of foot traffic … if the TTB is victorious in court, retailers will have to retroactively pay almost $25 per carton sold in state and federal back taxes. … We are very concerned that the TTB’s ruling might cause entrepreneurs that are currently operating in a very gray area to close down their stores due to the fact of the retroactive tax burden.”

Steve Loehr, vice president of operations for Kwik Trip, La Crosse, Wis., is one retailer waiting to see what happens in his state before considering the machines. “I don’t think it’s affected our sales [of manufactured cigarettes] a great deal at this time,” he says, “but it certainly has potential to do so.” In Wisconsin, he says, the RYO shops might retail a carton for just under $30, while it’s as much as $65 to $70 for a premium brand.

“It’s in the courts, but we’re obviously very interested in what the outcome will be,” he says. “If they rule that yes, it’s legitimate, then we certainly would take a look at the roll-your-own category.”

For now, he says, “We’re kind of sitting at the sidelines waiting to see what they decide. We’d sure look at it because we need to be competitive, and Kwik Trip is all about giving our customers a good value in everything we sell.”

Lou Maiellano, a tobacco consultant with TAZ Marketing & Consulting Group, Sevierville, Tenn., says he’d be cautious about jumping on board with the machines at mainstream stores, but the machines do warrant consideration. “If I’m a retailer and I have someone come and show me a way that I can drive traffic to my stores, I’m probably all ears about it,” he says. Of the potentially “slippery slope,” however, “I think that there’s opportunity for retailers to take advantage of the situation, but there’s the caution: It all could come crashing down. It all could disappear.” Meanwhile, as Loehr points out, cigarettes are a declining category as a whole, and his company continues to look at other categories, such as hot prepared foods, to replace cigarette volumes. However, when it comes to cigarettes, he says, “We’re not going to stand idly by and just let other competitors take our market share, either.”  

Click here to download full article