A SPECIAL State of the Category Report Topics included on Page | Editor's Note: Tobacco Watch | | Profits Attacked By Five Forces| | A Tobacco Backgrounder | | CTS: More of a Threat Than You Think | | Legislation Driven | | State of the Category? | | About the Author |

Why? Because the companies in the top 25 percent will have proactively educated themselves about all the new challenges to the cigarette category and figured out a way to compete aggressively and successfully.

In contrast, operators in the bottom 25 percent will have taken a passive approach, ignoring these dynamics and, as a result, will sustain significantly lower profits or even losses.

Figure 1 Cigarette Industry Volume Billions of Cigarettes Per Year - U.S.

Right now, the c-store's profits from its number-one merchandise category are under attack from at least five separate forces:

1. FDA and local legislation. The financial resources c-store operators will expend this year to comply with February 28th's and August 28th's FDA legislation (not to mention the increasingly stringent requirements of state and local authorities) will be enormous. And another, perhaps less obvious, cost associated with compliance is the opportunity cost. Although difficult to estimate, the revenues lost while top management works on compliance issues (instead of income-producing activities) are sure to be significant.

2. Cigarette/tobacco stores (CTS). A fairly new "category killer," cigarette/tobacco stores make up two percent of all locations selling cigarettes in the United States while generating 12 percent of the cigarettes industry's total sales volume! If the current trend continues, and the c-store industry reacts too slowly or not at all, CTS locations will control 25% of tobacco sales by the year 2000. (See Figure 3)

3. Native American stores. Because Indians are exempt from paying state and local excise taxes, they can sell a pack of cigarettes for $.40 to $.60 less than c-stores can. In theory, only other Native Americans are supposed to benefit from the tax exemption but, in practice, many non-Natives shop the reservation stores and pay the lower, tax-free price.

Members of the New York Association of Convenience Stores (NYACS) and the National Association of Convenience Stores (NACS) have been fighting the state of New York for years to minimize the Indians' competitive advantage and re-establish a level playing field-- and if they hadn't, this situation would be unchanged today.

At press time, the New York State Department of Taxation was planning to begin enforcing the collection of excise taxes on purchases of cigarettes and gasoline made by non-Indians on April 1, but at least one interested party (a tobacco wholesaler) was seeking a preliminary injunction to block that action. Stay tuned­ it's safe to presume there will continue to be new developments in this ongoing "war."

4. Retailer complacence. A c-store operator recently told me, "I can't afford not to get my 25% margin on cigarettes."

This determined hold-out and many others who haven't yet felt the impact of cigarette/tobacco stores think they're safe from injury. They'd better think again.

"The category is not going to come back [in terms of profitability] as we knew it," Gus Ferracane, president of Fleming Companies' Marshfield, WI, division, believes. The c-store division of this $18-billion-a-year wholesaler advises its retailer partners to "find additional categories that the consumer wants and develop new points of difference."

5. The pricing dilemma. This is the c-store's "Catch 22": When cigarette/tobacco stores or competing c-store chains lower their cigarette prices to attract value shoppers, c-stores and other retailers often follow suit to retain precious traffic. The market price falls, and consumers win immediately. Then, in some instances, the local and state licensing authorities decide to raise their excise taxes on tobacco. The final result: Everybody wins or breaks even except the c-stores. We lose critical margin dollars.

The current situation will not correct itself and it's not going away. Some praiseworthy retailers have already taken steps to combat these five threats and protect their share of market (SOM) since the publication last July of CSP's cover story, "Birth of a Crisis, Death of a Business."

Some examples include: An effective brand-switching campaign initiated by Plaid Pantries; the store-within-a-store concepts implemented by a number of operators; and the "state minimum" pricing strategies enacted by other operators, which are designed to discourage cigarette/tobacco store operators from creeping into retailers' backyards.

Even so, the jury is still out on what strategies will work (or will not work) to protect our share of the cigarettes market in the long run. How do we attack these enemies? To my mind, any strategy you undertake must include two important ingredients-- education and action. They're our only hope. Consider this article the first phase of your cigarettes category education-- a tutorial on some of the basics, along with some new thinking on emerging cigarette/tobacco store trends. (The events of the last nine months have demonstrated that these category killers are long-term realities, even if they evolve into some hybrid format of today's configuration.)

Figure 2

Cigarette Retail Dollar Sales

Billions of dollars per year - U.S.

A TOBACCO BACKGROUNDER

Despite all the recent anti-smoking hoopla, Figures 1 and 2 show that tobacco consumption is holding steady. It mirrors the experience of the Prohibition era, through which we learned that if people really want to consume something-- even (or especially) something that's considered harmful to their health-- no amount of legislation is going to change their habits. In spite of that, the FDA and other agencies continue to try to restrict access (even adult access) to these products and class-action suits against tobacco manufacturers persist. Will we ever be accountable for our own actions?

Share of market. Figure 6 shows c-stores are the number-one retail segment in tobacco sales, and Figure 4 serves as a warning to our industry.

In 1985, supermarkets held an almost 40 percent share of the cigarette market, but over the last decade, they've forfeited more than half that share. And they're likely to lose another 10 percent in the next three to four years.

It's interesting to note that as c-stores once benefited from the supermarkets' (and drug stores') indifference to tobacco sales, cigarette/tobacco stores are today reaping share of market as a result of c-stores' complacency.

Take another look at the growth trend for cigarette/tobacco store share of market in Figure 3. Out of nowhere, these category killers have rocketed to a 12 percent share of market in 1996 (with only two percent of all tobacco outlets) and it seems likely that they'll double their share of market by the year 2000.

Figure 3

Share of Cigarette Industry Volume Major U.S. Trade Class Trends		convenience/gas
		supermarkets
		cigarettes/tobacco
	Supermarkets forfeited share of market to c-stores; now it seems likely that c-stores will forfeit share of market to cigarette/tobacco outlet stores.

Different concepts? The explosive growth of cigarette/tobacco outlets can probably be attributed to value and volume. These are the same two retailing themes that enabled Wal-Mart to lead the discounters' "massacre" of traditional marketers in the last 20 years.

Value is, of course, a consumer issue and a pervasive one, but volume involves suppliers. Ask yourself this question: If you were a tobacco manufacturer enjoying an equal share of market from c-stores and cigarette/tobacco stores, wouldn't you favor outlets that sold 900 or more cartons of your product every week (see Figure 4) over those averaging only 130?

Make believe it's gas! If the competing c-store at 10th and Elm rolled back the price of unleaded regular by two cents a gallon last night, your company isn't likely to let him steal your gas customers for any longer than it takes to change the pole signs. But few retailers respond similarly to competitors' aggressive pricing on cigarettes.

A couple of reasons for this could be that the per-pack price differences tend to be greater and are therefore harder to swallow, and that to fully understand the short- and long-term impact of such a change requires a lot more investigation. Competition is, in my opinion, central to all the threats to the c-store cigarettes business, so for the balance of this article I'll be focusing on (a) why cigarette/tobacco outlets will continue to lure customers away from c-stores, and (b) how c-stores themselves sometimes frustrate tobacco customers by mis-managing the category.

CTS: MORE OF A THREAT THAN YOU THINK

When I first started looking at this segment last year, I thought it consisted primarily of ugly storefronts in poor neighborhoods catering to low- income consumers. And since the concept began on the West Coast, I thought maybe it would stay out there or move further west.

Now, however, after I've visited some of the locations, read a lot more about the concept and studied its can't-fail simplicity, I know that neither of my preconceptions was correct and I see clearly the enormous potential of the cigarette/tobacco store.

CTS outlets are not all ugly and they don't all count on walk-in neighborhood traffic. And while a small percentage of these stores prosper because of border pricing, they can pop up in any market-- virtually overnight. Press coverage of outfits like Cigarettes Cheaper, which told Forbes in May 1996 their goal is to acquire a ten to 20 percent share of market before the year 2000, has reinforced the impression that we have a tiger by the tail.

Site selection isn't rocket science for cigarette/tobacco stores. Here's how I think they do it: They survey a market, looking for an opportunity to push volume at state minimum pricing where retailers are looking at 25% margins prior to retailer distribution allowances (RDAs). Then they look for a 1,000-to-1,200 square-foot space for rent in a nice strip mall and sign a short-term lease with multiple renewals and an economical exit clause.

They put up good looking but easily installed fixtures; limit store hours to the daytime only, 9:00 AM to 6:00 PM; utilize a modern point-of-sale system with scanning and automatic reordering to simplify record keeping; and take less than a day to train the manager on how to handle inventory, cash and customers.

How easy and attractive is this business? Ask yourself if you'd miss the gas drive-offs, lottery shortages, out-of-stocks, illegal purchases by minors (and the repercussions), not to mention the dubious joys of retail and cost accounting, multiple coverage and round-the-clock operation.

Is this a fad? No . . . not any more than self-service gasoline was. You probably recall that when it was first introduced, some consumers were slow to fill their own tanks. But now, thanks to a technological and cultural revolution, educated consumers are accustomed to--even enthusiastic about-- searching for value and niche locations.

Today, we shop outlet malls, Sam's Club and K-Mart, and specialized oil and muffler shops as a matter of course. Why not low-cost tobacco outlets? And, while some (though definitely not all) cigarette/tobacco store locations could be considered undesirable, increasing competition within the segment will, I predict, spawn a new breed of tobacco boutiques (including humidors) and other hybrid formats. Consumers will demand it and, as usual, they'll get what they expect!

LEGISLATION DRIVEN

Adults-only outlets like Cigarettes Cheaper, Bonkers and others promote and capitalize on their "smoker friendly" environment, whereas c-stores are cross-examining consumers before they dare sell them a pack of cigarettes--out of fear of selling to minors and getting slapped with a fine or worse. Once tobacco consumers experience the pleasurable difference of buying cigarettes in a non-threatening environment, and discover they can save about $5.00 carton at the same time, convenience stores can kiss that traffic good-bye.

CTS outlets welcome the FDA's proposed ban on self-service displays and in-store advertising (August 28). Most of the restrictions simply won't apply to their adult-restricted locations. In fact, they're likely to employ even more point-of-purchase materials to attract tobacco customers to their baseball jackets, key rings and brand-name trinkets. Meanwhile, c-stores will be forced to hide cigarettes behind the counter, resign themselves to colorless signage to promote them and suffer a loss of impulse sales resulting from absent counter displays. Ouch!

I hesitate to add another hardship but by now, I'm sure, many of you have already envisioned what could come next: It's probably just a matter of time before these adult-restricted locations also begin to sell beer, lottery tickets and adult magazines. Ouch again!

STATE OF THE CATEGORY?

If the results of a recent cigarette dependency survey I just completed for the National Advisory Group (NAG) in any way reflects NACS' 1997 State of the Industry (SOI) data (reporting 1996 results and due out in June), then c-stores' 1996 financial results have already begun to feel the pinch from CTS outlets.

I found that the average 1996 "going in" gross profit percentage reported by 35 NAG c-store chains comprising over 1,400 stores was approximately 22 percent. This is a 3-percentage-point reduction from the 25 percent average gross profit percentage reported in NACS' 1996 SOI Report (reporting 1995 results).

Cigarettes represented 26.7 percent of total merchandise sales for this limited sample in 1996-- a gain of 1.4 percentage points from the 25.3 percent of total merchandise sales reported in last year's SOI. One glaring statistic that emerged from the NAG survey was that 33 chains reported that they sold an average carton equivalent of 171 cartons a week. This figure is about 30 percent higher than the one acknowledged by the tobacco industry (which maintains that the average number of cartons sold per week by c-store and gas outlets is 130). If the results of the NAG retailers prove similar to those soon to be reported in the NACS 1997 SOI, it would seem that more c-store chains have become more competitive in the tobacco category in the last year.

Figure 5

Competing for traffic. The article I wrote on cigarette dependency for CSP's November/ December 1996 issue was still generating feedback at the NACS Leadership Assembly, particularly on the subject of "co-existence."

Several retailers who had "exclusive" RDA agreements with a single cigarette manufacturer have now expanded into arrangements with at least one other company to promote the range of top brands their customers want.

Retailers who study raw market share data (available from tobacco manufacturers) on the top ten full-price and savings brands (see Figure 5) will be able to quantify what they'll forfeit in traffic and sales by not giving the customer what they want and expect.

To make a long story short, contrast the way you manage the cigarette category with the way you manage the beer and soda categories. If you agree that you'd lose customer traffic by not promoting both Coke and Pepsi and both Bud and Miller, shouldn't you apply the same strategy to cigarettes? This very valid comparison should highlight the need to promote the top full-price and savings brands of cigarettes. (For your information, RDAs make up only 15% of average gross profit dollars from tobacco sales in c-stores, yet they seem to be the primary retailer focus for this category. Maybe it's time to re-focus.)

So what's the solution? It seems that new challenges (and new solutions) are arising every day. And some will no doubt surface at this month's NAG meeting. The questions and answers succeeding my presentation, as well as the ongoing dialogue with retailers, is sure to be healthy and educational, and produce new marketing ideas.

There's no question ongoing FDA activity will help determine our future strategies, including whether c-stores will even be able to consider store-within-a-store concepts (as of this writing, FDA had not approved them) and whether all the August 28th mandates will survive tobacco and c-store industry appeals.

As time goes on, smart retailers will continue to take proactive steps to protect their businesses while others accept the consequences of their inaction. I recommend that a discussion of the tobacco category feature prominently on your weekly Executive Committee meeting agenda, at least through the end of the summer. And, if you haven't done it already, maybe your marketing adviser can deliver a "State of Your Company's Cigarette Category" report at next Monday's meeting.

Editor's note: Dick Meyer's "Troubling Trends," a three-part series of articles featured in the November/ December 1996, January 1997 and February 1997 issues of CSP, generated a great deal of interest and feedback from our readers. The strong reaction to Part One, "The Big Picture & Cigarettes' Impact," demonstrated what we think is a widespread need for more education on the tobacco category. In response to that need, next month we're introducing a new regular column called Tobacco Watch. In the next few issues, it will feature the viewpoints of major cigarette/tobacco manufacturers on the issues raised in this article. Look for it!

About the author: Dick Meyer is president of Meyer & Associates of Waunakee, WI. A Big Six CPA by background, his last 20 years have been spent in executive positions as a c-store retailer, supplier and turnaround specialist. His firm serves a variety of supplier and retailer clients. Dick can be reached at 608-849-5354 or Internet: rmeyer@waun.tdsnet.com.

Figure 4 1996 Average Weekly Carton Volume Per store - U.S. by class of trade

As c-stores once benefited from the supermarkets' & drug stores' indifference to tobacco sales, cigarette/tobacco stores are today reaping share of market as a result of c-stores' complacency.

Figure 6

It's estimated that CTS outlets will gain about 25% of cigarette sales by the year 2000-- they'll take much of that volume from c-stores!

SOURCE: IRI (INFORMATION RESOURCE INC.)