The ash has fallen and the smoke has cleared on Big Tobacco’s big deal in 2015. What some called the deal of the decade was fınally consummated, creating a more powerful No. 2 to go up against Altria, and a new No. 3 in ITG Brands, Greensboro, N.C. Once approved by the Federal Trade Commission in a split vote, Reynolds American Inc. (RAI) had acquired Lorillard Inc. for $27.4 billion and the company’s coveted Newport line of menthol cigarettes.
The aligned Reynolds-Lorillard then jettisoned RAI’s Winston, Salem and Kool, coupled with Lorillard’s Maverick and blu eCigs brands and the company’s corporate infrastructure and manufacturing facilities to ITG Brands.
How will the wheeling and dealing affect convenience operators? Many echo the sentiment of Power Mart CEO Sam Odeh: “With this deal, it’s too early to tell. There’s not enough value driven yet from all sides.”
A lot could change in the coming months. RAI finished 2015 by honoring previous Lorillard contracts and has since added Newport to its Every Day Low Price (EDLP) voluntary retail program, which provides promotional allowances for brands to participants in exchange for aggressive pricing.
For the first five months of the deal, RAI continued to operate Lorillard’s old contracts, Newport remained in place, and ITG Brands kept obtaining facings for Winston, Salem and Kool in Lorillard’s old space, according to Nik Modi, tobacco analyst for RBC Capital Markets. In the current phase, which is expected to run through mid-November 2016, RAI and ITG are bringing out new retail contracts, RAI receives a minimum of square feet of spacing for its combustible share, Newport moves into RAI’s space, and ITG can negotiate with retailers for other available space. All restrictions disappear after mid-November 2016.
This timetable, in theory, gives ITG Brands breathing room to build up stock on its newly acquired brands. But retailers fear that with the standstill agreement expiring, RAI and Altria will command so much retail space that it will be virtually impossible for ITG Brands to secure enough tobacco facings real estate to grow its brands. In other words, we’re only now getting a sneak peek at what the new Big Three will look like—and whether the Big Three will swiftly become the Big Two.
Analyzing the Reshuffled Deck
Modi, for one, likes the deal.
“This is a great deal for the industry and will push the entire pro t pool higher over the long term,” he says. “Reynolds and Altria are the big winners, but even ITG benefits from bigger scale and greater share of the U.S. profit pool.”
Odeh of Chicago-based Power Mart, which operates seven corporate stores under the Power Market flag in Illinois and Georgia, remains mixed.
“It reminds me of the Exxon-Mobil merger from the late 1990s. We were all on pins and needles, but that turned out to be the best thing that ever happened to us because it gave us greater entrepreneurship and autonomy,” Odeh says.
Terry Gallagher, president of tobacco outlet chain Smoker Friendly of Boulder, Colo., insists that less competition is always worse. “Long term, this is bad for retailers. Smaller brands are pushed to less impactful space or have no space, and this definitely inhibits competition.”
Indeed, many fear the deal will put pressure on lower-priced brands. “Under EDLP, Pall Mall becomes the lowest-priced cigarette in more stores, thereby effectively raising the price of any cigarette that sells below the Pall Mall price point,” Modi says.
Ray Johnson, operations manager for Speedee Mart, with 20 c-store outlets throughout Las Vegas, recently declined to participate in RAI’s EDLP. “Reynolds now says they’re taking 32% of the rack if you want to be in their EDLP,” Johnson says. “The problem is that they only represent 18% of my sales.”
He says he still offers Reynolds’ brands, “but they won’t be on my rack and promoted. I haven’t seen any (performance) difference at all in Newport. I’ve had to raise my prices on Newport because I’ve lost all the funding I used to get, but it’s the least price-sensitive brand we carry.”
What differentiates Speedee Mart from many convenience chains is the operator enjoys unusually strong performance in the subpremium space. “My discount cigarette brands represent 14% of my sales, so I’d be giving my 14% up hoping that my 18% of Reynolds got better,” says Johnson.
Picking the Winners
Retailer sentiment aside, Modi ranks RAI as the biggest benefactor of the changed cigarette landscape, with Newport, Camel and Pall Mall standing to reap the rewards.
“Reynolds will outperform the industry in volume terms and will realize meaningful pricing. Newport and Camel benefit from each other’s geographic reach, while Newport and Pall Mall also benefit from linking Newport to RAI’s EDLP contract,” says Modi. “We are already seeing the impact to Newport with this past quarter trends accelerating to 0.5% of year-over-year share gains (up from 0.3%).”
During a CSP webinar last November, Modi said the portfolios of Lorillard and Reynolds are very complementary from a geographic standpoint, with Lorillard strong in the East but weak in the West, while RAI is strong in the West and weak in the East. “After transitioning the brand from Lorillard to Reynolds after just one quarter, Newport grew 3%. When you think about the broader sales coverage that Reynolds has, the fact that Reynolds is picking up about 50,000 urban retailers that Newport had a lot of cachet with, there’s a lot of potential cross-sale opportunities,” he said at the time.
Bonnie Herzog, tobacco analyst for Wells Fargo Securities, is equally bullish on RAI’s post-merger prospects. In a recent Wells Fargo Tobacco Talk Survey report, she indicated that RAI’s complete portfolio is positioned for faster growth, driving double-digit earnings per share for the next few years, due to several factors:
- RAI’s new EDLP retailer program—including Newport—is reaping stronger retailer participation (as high as 75% of industry volume) and higher than management’s target of 70% and above earlier participation of 60%.
- RAI’s retail shelf space allocation is expected to rise by an average of approximately 2% in 2016.
- Newport is predicted to gain nearly 0.8% of incremental share in 2016, thanks to increased visibility and promotional support.
Of course, both Herzog and Modi are reflecting on the business benefits for RAI. What about the benefit for retailers?
Jared Scheeler, managing director of The Hub Convenience Stores in Dickinson, N.D., likes that the merger will strengthen the Newport line. “Since the merger, they have mandated more Newport SKUs into our tobacco displays. I believe that they will bring more awareness to the Newport brand,” says Scheeler. “I always thought that was a missed opportunity by Lorillard.”
Also, a more robust No. 2 could help neutralize Altria’s dominant position and result in a more level playing field, many retailers interviewed said. Altria controls about 50% of the market, with RAI having 34.1% market share and Imperial—ITG Brands’ parent company—commanding 10%.
But if the RAI-Lorillard deal is making Altria sweat, the perspiration isn’t visible so far. In fact, retailer surveys conducted by CSP and Modi of RBC Capital have shown Altria enjoying rising customer service scores across the convenience channel.
Continued: Impact of the Bronze Winner
Impact of the Bronze Winner
Perhaps the greatest unknown has been, and remains, how the new No. 3 tobacco player will perform. While some believe ITG can be a viable third competitor, its strength is viewed as limited.
“ITG is likely to remain around the eight to 10 share-point level for the long run, with Winston and Kool taking share from the rest of their portfolio,” Modi says.
Thus far, Odeh says, ITG hasn’t defined itself satisfactorily. “We’ve talked with their leadership and presented our 2016 set, but we’ve not mutually agreed on the merchandising fixture platform. When tobacco partners don’t give us clear direction, that’s a big concern,” he says.
Johnson expects that more than 70% of c-stores are going to participate in Altria’s and Reynolds’ programs, which doesn’t leave space for ITG on the rack: “If you’re not on the rack and don’t have signage, it doesn’t really matter what the price is if no one can see it.”
Scheeler, however, sees a silver lining for ITG in the OTP category.
“ITG can now use the power of their entire portfolio to help promote their signature OTP brands,” says Scheeler, citing Backwoods and Dutch Masters. “And perhaps that will force Altria and/or Reynolds to acquire or develop direct competing products.”
Looking Ahead
At the end of the day, it comes down to the numbers—regardless of top dogs and contracts. Luckily for retailers, cigarettes enjoyed relatively robust sales in 2015, thanks to lower gas prices, improved consumer confidence, a healthier economy and retailers lowering inventories of e-cigarettes. In 2016, however, Modi predicts that category decline rates will retreat to the 3% to 4% annual decline seen in the past decade.
“The moderation is really driven by a rolloff of the benefits that helped the category in 2015. As the year-over-year benefits lap, cigarette declines should go back to about 3%,” he says. “Premiumization will also continue, with the highest-priced brands continuing to display the best performance.”
While cigarette sales may continue their slightly downward slide, tobacco still needs to be given priority in convenience retailing.
Altria spokesman Brian May notes that tobacco still represents approximately 34% of in-store convenience sales.
Odeh agrees to the role premium cigarettes play, but cites the importance of a strong subpremium line, noting his 2016 set includes 305’s, Premier and Liggett, which address a non-EDLP market.
“It’s still our No. 1 category, and you have to pay attention to it,” he says. “I tell our category managers throughout our stores: Put [the brands] in and let the consumer decide. May the best quality win.”
Poll Position
When surveyed about the RAI/Lorillard/ITG deal, tobacco retailers revealed plenty:
- 46% expect a negative impact on the cigarette competitive environment post-merger, 26% expect a positive impact and 28% expect no impact.*
- More than 50% believe ITG will lose cigarette share,* and 48% see a competitive disadvantage for ITG Brands.**
- About 25% of EDLP participants recently signed up for the program, and nearly 60% believe EDLP participation will grow with the addition of Newport.**
- 90% see Altria’s new Retailer Leader program as a win for Altria.**
- 45% anticipate increasing shelf space allocations for Reynolds.**
- Almost 80% don’t plan on changing current shelf space allocations for Philip Morris USA (whose parent company is Altria).**
- Retailers have become more bullish on Newport’s potential post-merger: They expect the brand to gain nearly 1% additional market share in 2016 (up from a 0.76% prediction in December).***
- 61% of retailers describe the relative price gap between premium and deep-discount cigarettes as remaining “flat,” while 29% say it has widened and 10% say it has narrowed.***
*Wells Fargo Securities Tobacco Talk Retailer Survey, October 2015
**Wells Fargo Securities Tobacco Talk Retailer Survey, December 2015
***Wells Fargo Securities Tobacco Talk Retailer Survey, January 2016
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