War on Value

SCHIP, FDA and contracts complicate the game for nonmajor cigarette companies.

By  Samantha Oller, Senior Editor/Special Projects Coordinator

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Consistency, quality, price and compliance: These are the selling points that nonmajorcigarette manufacturers hope will carry them through a minefield of federal and state tax increases, contract restrictions and value competition from the majors, as well as a slowly unfurling regulatory burden.

This is despite a year when, by most measures, discount, price-value and fourth-tier brands benefited from the double whammy of an economic malaise and a stiff federal-excise-tax increase, pushing consumers toward value. According to an analysis of tax, USDA shipment and MSAI data by fourth-tier manufacturer King Maker Marketing Inc., savings brands’ share of shipments grew 3% across all channels between fourth-quarter 2008 and 2009.

But while small and medium-sized manufacturers would be the primary beneficiaries of such growth in the past, today they have stiffer competition from the majors, whose heavy promotion of value brands is blurring the lines between the traditional price tiers.

A $2-per-carton differential used to be the common dividing line between premium, discount, third tier and fourth tier, says Bhavani Parameswar, president of King Maker, Paramus, N.J., which offers Ace, Checkers, Hi-Val, Gold Crest and SF Delux brands.

“Now, all of a sudden, you have the majors buying down their discount brands substantially,” she says, citing Reynolds American’s Pall Mall and Lorillard Tobacco Co.’s Maverick and Old Gold brands. “The price tiers have all gotten completely mixed up at this point in time. There is no brand that exists in a particular tier because it’s so heavily discounted.”

Indeed, in a fourth-quarter 2009 earnings call, Reynolds American reported that thanks to its pulse promotions of Pall Mall and consumers’ value mindset, the brand’s stick volume rose almost 71% compared to the year prior. Its share of total cigarettes sales, meanwhile, grew 2.1 points to hit 4.8%.

“It gets harder and harder to determine, what is a value brand? What is a premium brand? The segments are blurring,” said Reynolds American president and CEO Susan Ivey during the earnings call. “So I think that we have to see what happens as the economy improves. Do consumers trade back up, or do taxes and prices keep them searching for honest value?”

But for nonmajors, the Big Three tobacco companies—Altria, Reynolds and Lorillard—are well-known adversaries. A more mysterious force—the U.S. Food and Drug Administration— has the potential to knock weaker players out of business more efficiently than a decade’s worth of price wars. For those manufacturers with established reputations and solid financial footings, it’s an opportunity to retrench and claim a permanent stake in the value cigarette arena.

LASTING GROWTH?

UBS tobacco analyst Nik Modi says passage of the State Children’s Health Insurance Program (SCHIP) and resulting increase of the FET by 61 cents per pack in April 2009 benefited the opposite ends of the cigarette brand spectrum.

“There’s going to be some tradedown, with the middle getting squeezed, and some of those consumers did go down to fourth tier,” says Modi, citing Altria’s heavy promotion of its L&M discount brand, dropping it into competition with fourth-tier brands. He expects fourth tier’s share of total cigarette sales to ebb and flow based on the promotional activity of Altria, Reynolds and Lorillard value brands. Superpremium also performed well.

Nonmajor manufacturers have also seen a lift. David Redmond is president and CEO of Carolina Tobacco, Portland, Ore., which offers the Roger brand of price-value cigarettes, available in 41 states, and the private-label Kingsboro brand. Roger currently represents less than 10% of the total price-value category, which comprises about 45 brands nationwide, says Redmond.

“Mainly because of SCHIP and the huge tax increase, we have seen increases in our sales of Roger and Kingsboro and have seen professional competitors in the fourth tier also increasing their sales,” says Redmond. “I attribute that to economic conditions that crippled our nation—smoking consumers with less disposable income. They’re looking for a lower-priced brand and usually make one or two tries until they find a quality cigarette that tastes similar to what they were smoking.”

King Maker’s national Ace brand has performed well over the past year, while the company’s two exclusive brands have been weaker, says Parameswar, who declined to share specific growth figures because the company is privately owned. “At this point, exclusive brands are not doing as well as national brands,” she says. “Considering we’ve had a lot of SKU rationalization, a reduction in trade inventory because of the increased investment, I think a lot of people are favoring brands with a certain amount of footfalls that come with it, as opposed to using something unique at this point in time.”

Not everyone is seeing a significant shift. Despite higher prices, the national mix of premium to value sales has remained fairly stable at 70/30, says Rick Di Donato, national vice president of sales for JTI USA, Teaneck, N.J. JTI is the manufacturer of Wave and Export ‘A’ cigarettes.

“We see some downtrading—from premium to value—in specific markets, but for the most part, the success of new value brands comes at the expense of existing competitive value brands, and not premium alternatives,” he says via e-mail. At the same time, JTI’s super-premium Export ‘A’ brand has seen growth, Di Donato says.

The question of whether value cigarettes’ growth is long-lasting hinges on the depth of change in consumers’ buying behavior during the recession. Many of the nonmajor, discount manufacturers hope that, unlike previous price increases, wherein premium sales fell initially only to creep back up, this shift in sales will be permanent.

“My experience is, once the consumer moves to price-value and purchases a brand that is of a quality that is adequate for them, they won’t go back, even when economic times change,” says Redmond of Carolina Tobacco. He cites the United Kingdom as an example, where, about 8 years ago, price-value had roughly 18% share of the total cigarette market. Today, after a series of price increases and growing regulatory oversight, it commands 62% share of the market.

Bill Greiwe, CEO of Cheyenne International LLC, Grover, N.C., manufacturer of Cheyenne, Decade, Aura natural and Pulse menthol cigarettes, agrees that this time may be different.

“This a deeper, more profound recession that has gone on longer, with higher levels of unemployment than we’ve seen in the past,” says Greiwe.

“States … can’t print money, so they’re desperate for tax revenues, and they raise tobacco taxes every year, it seems like. So it’s not like [in] the past, where, yes, there’d be a big increase, and then nothing for a few years. Now it’s coming fast and furious.”

REGULATORY BURDENS

If excise tax increases could be considered a series of rough waves that small cigarette manufacturers have to navigate, FDA regulation is a veritable tsunami. Beyond user fees and increased documentation costs, three waves will hit manufacturers in the coming years:

Elimination of Advertising. FDA regulations will eventually limit promotion at the store, including a ban on outdoor signage and indoor signage that faces outward. In-store POS material, therefore, must grow increasingly creative, while manufacturers will get increasingly aggressive in their fight for display space.

Testing Burdens. FDA has ruled that new cigarette brands introduced after Dec. 31, 2007, must undergo the same level of testing as new over-the-counter or prescription drugs. “It means effectively it will be very, very difficult, and maybe cost-prohibitive, for small to medium cigarette manufacturers to bring in a new cigarette and pay for testing,” says Redmond of Carolina Tobacco. It will also raise the barrier to market entry. While the level of competition may fall, a more positive result, he says, is stabilization: no more in-andout brands.

Packaging Redesigns. Here, the cost of compliance—tied up in package design and printing costs—will weigh heavily on smaller manufacturers, including removing “light” and “ultra light” terminology on packaging by June 2010; black-and-white graphics; and, by September 2012, graphic health warnings that will dominate the top of packs. The result: a shakeout among those who can afford to absorb and who must pass along the associated increase in costs.

“I think the value segment will stay, but I think the number of players will be reduced because the cost will go up and [because of] the constraints smaller players will have to meet,” says Parameswar. Take, for example, a discount brand priced at $20 per carton. Then consider the additional cost of meeting manufacturing, product and testing standards, as well as packaging changes.

“If that cost per carton is at, let’s say, $2, it’s a 10% increase in cost for discount brands,” she says. “Whereas for major brands, they are already $38 or $40 per carton, and it’s going to end up being a 5% increase. In terms of percentages, the majors are going to be able to absorb it.”

Lou Maiellano, president of TAZ Marketing & Consulting, Sevierville, Tenn., and a former tobacco category manager for Sunoco, says it is “too soon” to know how FDA regulation will ultimately play out. “There is a lot of resiliency in the tobacco industry,” he says. “I do think there are some folks who will fall out of the picture.”

The effect, however, on the industry at large may not be as dramatic as many fear. Maiellano cites proprietary research on the menthol market and does not believe the evidence leads to menthol being removed from the industry. However, that doesn’t mean the FDA couldn’t decide otherwise.

“If menthol is to be banned, there will be an impact, but not to the degree that the menthol smoker will no longer smoke. The smoker of menthol cigarettes will continue to seek the satisfaction of smoking, albeit in nonmenthol brands,” he says. “Retailers who are struggling and don’t put a proper plan together will continue to struggle, and will end up losing share or sending it elsewhere. [Cigarette] volume is going to be a product of other things in the environment—the relative ability to smoke is one of the biggest parts.”

CRAFT A SURVIVAL PLAN

Through the impending chaos, all of the nonmajor manufacturers interviewed for this story believe they will be left standing, thanks to a focus on that perfect mix of quality and price: value.

“What we are doing now in part is exactly what we’ve done for 11 years: produce a quality cigarette in the price-value category without downgrading the package or product,” says Redmond.

“There are some products that sell based solely on low price, and those products can come and go. But we try to offer something more consistent, and that will be here over the long haul, so the hard work you put into building a brand is going to pay off over the long haul,” says Greiwe of Cheyenne. Compliance is also a heavily stressed buzzword, whether with the Master Settlement Agreement (MSA) or FDA’s Center for Tobacco Products.

Retailers are also at a crucial turning point, Maiellano argues. Before the framework of FDA regulation solidifies, they should decide on their long-term approach to both cigarette segments— premium and value. “Not knowing where things could be one or two years from now, is your business where you want it now?” Maiellano asks. “If I want to have a fourth-tier or price-value offering for my consumer, think about making it happen now.”

Of course, not every store or market area will support a strong value offering. Maiellano says there is no ideal minimum or maximum number of SKUs because it really depends on the retailer’s marketing objectives. Rather, a retailer needs to evaluate the competition’s offering and look out for brands, whether regional or national, that are gaining traction. Also consider that a certain cluster of stores may require a greater concentration of value brands than others. It’s what he refers to as “marketing to the environment.”

“There are ways in which retailers can make their tobacco business their tobacco business,” says Maiellano. “They can still have flair, a sense of creativity and excitement. There still is an opportunity for retailers to have ownership of the category.”

 —Additional reporting by Bill Donahue  

Fourth-Tier Partners

Consultant Lou Maiellano advises retailers to look for the following qualities when choosing a fourth-tier partner:

  • Pricing stability
  • Return procedures
  • Marketing support
  • Established reputation
  • MSA participant    

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