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Allocable-share legislation and price promotions are driving consumers back to premium- priced cigarette brands

ALSO INSIDE A Matter of Time What will the breakup of mean for the tobacco business?

Playing the OTP Game Is OTP’s growth sustainable? The debate continues.

PAGE 1 of 11 CSPDigital editions are published by CSP Information Group, Inc. Contents Other CSPDigital editions Include: • Outlook Leadership 3 Reshuffling the Deck ADVERTISERS • Convenience Retailing Conference A drastic reduction in the relative price gap between • Convenience Insights: Beverages To view an advertiser’s page, first- and fourth-tier cigarette brands has gone a • Convenience Insights: Snacks & Candy click any of the company long way toward creating a more level playing field. • Convenience Insights: Foodservice names below: Consumers seem to be responding. • CSPDigital: Technology

6 A Matter of Time BIC USA To download previous CSPDigitals, visit: Page 5 http://www.cspdigitals.com With Altria’s spin-off of Philip Morris expected in the not-too-distant future, what changes loom for the For information on CSP Information Group, United States Smokeless Tobacco Co. tobacco industry? call 630-574-5075 Page 7 8 Playing the OTP Game For technical support with CSP Information Group, Inc. CSPDigital editions, call: Without question, the “other tobacco products” seg- 212-647-0396 ext. 5 ment is growing, led by moist smokeless tobacco and Page 10 flavored cigars, but whether its growth rate is sustain- To advertise in CSPDigital editions, contact able remains a subject of debate. For more information about Jim Bursch at: 630-574-5075 ext. 224 our advertisers, visit our Email: [email protected] Advertisers Index - Page 10

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PAGE 2 of 11 A drastic reduction of players and resulted in a shrinking shows consumer preference for value. in the relative price absolute and relative gap.” So they’ve stepped up the promotions gap between first over the past few years to give fewer According to data provided by Smith reasons for consumers to trade down, and fourth tier cigarette Barney, the relative gap, which stood and that has lessened the gap.” brands has gone a long at 73 percent in Q3 2001, has shrunk to 48 percent in Q2 2005. According to Parameswar, at the way toward creating a time of the MSA, the total promotional more level playing field. Because of the narrowing of the spend by the major cigarette manu- price gap between national brands facturers in the U.S. was about $6.5 facturers, more recently, state-level and fourth-tier brands, convenience billion. Today, it’s close to $11 billion. allocable-share legislation has led retailers are seeing a move away from “It’s not unusual to go into a store and more fourth-tier manufacturers to incur the deep discount segment and back see marked down $6.50 or the cost of compliance. to the majors. $7.00 a carton,” she adds. “Because of their promotional spending, the majors Because the states’ MSA revenue is “Consumers are coming back to pegged to sales of companies compli- more premium brands,” says Mike Average Price per Brand in ant with the MSA, many states have Zielinksi, president and CEO of Hills- Convenience Stores initiated allocable-share legislation dale, Ill.-based Royal Buying Group. Current Current Amount aimed at capturing funds from com- “I think consumers, given their choice, Retail Price of Buy Down panies that heretofore had been non- would rather have a branded product per Pack per Pack compliant with the MSA. over a private label product.” Marlboro $3.68 $0.67 Newport $3.99 $0.70 “The larger fourth-tier manufacturers While allocable share legislation has have become SPMs [Subsequently increased prices in the deep discount Camel $3.62 $0.76 Participating Manufacturers],” explains sector, simultaneously, aggressive Kool $3.49 $0.89 Dan Elrod, director of sales with price promotions by the major manu- $3.28 $0.89 —By Bob Phillips grocery distributor McLane Co., Inc. facturers have brought down prices Doral $3.20 $0.81 fter years of seeing consumers “The resulting exposure to payments among premium brands. USA Gold $3.01 $0.75 transitioning from premium- has driven up prices for the majority Apriced cigarettes to discount “The majors realized that the 96- Source: Smith Barney Tobacco Trade Survey fourth-tier brands, a change is under- percent share of the market they once have been able to keep the effective way that may be halting the trend. “The larger fourth-tier enjoyed had shrunk to 84 percent,” price gap in a manageable range.” Several factors have contributed to adds Bhavani Parameswar, vice presi- a shrinking of the price gap between manufacturers have dent and CFO of Paramus, N.J.-based Excessive state and local taxes (i.e. first- and fourth-tier cigarette brands King Maker Marketing Inc., which vol- “sin taxes”) have also put a damper on in recent months. While most obvi- become SPMs.” untarily complies with the MSA. “Obvi- cigarette sales. This can be particu- ous is voluntary compliance with the — Dan Elrod ously, this is because there have been larly devastating to convenience retail- Master Settlement Agreement (MSA) McLane Co., Inc. many price-value alternatives that ers, who, according to the NACS 2005 by previously non-compliant manu- have gained significant share, which State of the Industry report, count on

PAGE 3 of 11 “ People have not changed their con- Parameswar, meanwhile, thinks Bridging the Gap that making a direct correlation $4.00 between declining volume and sumption patterns; they have changed $3.50 their buying patterns.” actual consumption is naive, with smokers leaving the mainstream $3.00 retail channels in droves for the — Bhavani Parameswar Internet (until the recent credit card $2.50 King Maker Marketing crackdown on Internet cigarette $2.00 sales) and the growing black market. $1.50

cigarettes for 34.7 percent of their total According to Herzog, 17 states “People have not changed their $1.00 48% 48% 51% 69% sales. have excise tax legislation pending consumption patterns,” she insists. this year, while six states (Kentucky, “They’ve changed their buying pat- $0.50 “The current weighted average state Massachusetts, New Hampshire, terns.” $0.00 excise tax on a pack of cigarettes is Minnesota, Ohio and Washington) Q2 2005 Q2 2004 Q2 2003 Q2 2002 about 87 cents [or $8.70 per carton],” have already passed measures. The While the landscape in the The relative price gap between says Bonnie Herzog, tobacco industry tax increases range from 3 cents per volatile cigarette category is in a Average Premium Brand analyst for Smith Barney. “That’s up pack ($3.00 per carton) in Kentucky, constant state of flux, it can still first- and fourth-tier cigarette brands has shrunk by 21 percent from 82 cents at the end of ’04 – or to a proposed $2.50 per pack increase be very profitable if managed Average Deep Discount between Q2 2002 and Q2 2005 about a 6-percent increase. We’re still in Maryland, which would raise the tax properly. Because of a franchise’s Brand (Fourth Tier) estimating a 7- to 9-percent increase on a carton of cigarettes by $25.00. contract provisions with the c-store Source: Smith Barney Tobacco Trade Survey by the end of the year.” Meanwhile, 27 states have imple- chains and oil companies, however, mented cigarette tax surcharges since it almost seems to require the agility of But be forewarned: Retailers depen- 2003. a world-class juggler at times. dent on promotional paydays from the manufacturers to turn a profit are not “Consumers, Between the health risks and “It’s a category that’s become much positioned well for future profitability. given their increasing taxes, Herzog estimates more complex because of the contract The writing is already on the wall, with that cigarette consumption is declin- requirements, and it takes a great deal Philip Morris effectively raising prices choice, would ing between 1 percent and 2 percent of effort to do it right,” Zielinski says. this year by reducing retail buy downs. rather have a per year. But that doesn’t lessen the “You obviously want to be at the high- category’s importance. est level you can be with the cigarette “Retailers have to realize that they branded companies, because that’s where you can’t be dependent on promotional product.” “When you put it in terms of sales get the price breaks and can become payments for profitability,” cautions per square foot – there’s no way more competitive with your pricing. Zielinski. “That means, depending on cigarettes take up 34 to 36 percent But at the same time, some of those the amount of inventory they have to in square footage of the average c- higher levels require signage or other handle, the amount of liability associ- store,” Zielinski says, referring to the pieces in the store that may conflict ated with it, and competition, they’re category’s average contribution to with other contracts you’ve signed going to have to adjust prices so that  Mike Zielinski, Royal Buying Group store profits. “So it remains a pretty as a franchise for an oil company or they can realize as much business as profitable category in those terms.” c-store chain. It can be difficult.” possible.” 

PAGE 4 of 11 PAGE 5 of 11 Barney, that leaves just two ways to category by smaller manufacturers A Matter of Time grow the cigarette business: would be prohibitive. Philip Morris USA likely will soon be spun off from  Increase volume. This, however, Word on the street is that Philip Mor- is difficult to achieve in an industry ris is happy thus far with the test of the Altria Group and become its own company. What where volume is declining by 1 per- its so-called “low-risk” product (called does that bode for the tobacco industry? cent to 2 percent per year. Marlboro Ultra Smooth). Currently  Expand margins. This can be being tested in Atlanta, Tampa and n November 2004, Altria Group, fraud by claiming its “light” products done by reducing promotion dollars Salt Lake City, three separate prod- Inc. CEO Louis Camilleri an- (i.e., low tar) were less dangerous, and/or increasing list price. ucts with different taste profiles have Inounced at the company’s annual when, in fact, they may have been been introduced. Smith Barney focus investors’ conference that plans were more dangerous. Since both strategies are heavily groups have given positive feedback ongoing to break the company up into reliant on factors beyond the com- on the products’ taste and draw. Un- two or three distinct businesses. When Most industry analysts expect both pany’s direct control, many industry like the former “low-tar” offerings, the restructuring was done, Kraft and a favorable verdict and Philip Morris experts expect the company to broad- Marlboro Ultra Smooth features a spe- Philip Morris USA (PM USA) would be USA to become a standalone compa- en its focus beyond traditional ciga- cially designed carbon chamber that autonomous companies unto them- ny within a year. But what exactly will rettes. is said to filter out most of the carcino- selves. that mean for the tobacco industry and gens associated with smoking. the c-store trade? Retailers are taking “In the U.S. market, they’re continu- a “wait-and-see” approach. ing to test the low-risk products,” ex- “If there is a product on the market plains David Bishop, director of Willard that is truly safer – or reduced risk “It won’t have any direct, immediate Bishop Consulting. “The benefit of that – that could be a huge opportunity for effect,” says Mike Zielinski, president initiative will be highly dependent on everyone, quite frankly,” Herzog says. and CEO of Royal Buying Group. FDA oversight.” “However, once they provide long-term Expect the “new” Philip Morris to direction from a split, I’ll need to as- Indeed, Philip Morris is supportive look at other areas within the overall sess it.” of all aspects of the cigarette indus- tobacco category to grow business. try coming under FDA regulation. In Although the company currently terms of “low-risk,” the FDA would be “From a growth perspective in the owns about a 47-percent market share in charge of labeling and claims, which U.S. market, it’s logical for them to Before look at OTP as an extension in the Philip Morris “It’s logical for them to look at OTP as a tobacco category,” Bishop says. USA can be spun off, however, litigation pending against growth extension.” And OTP is the most logical place to the company in Illinois must be re- grow business. But will they acquire an solved. In what has become known as — David Bishop, Willard Bishop Consulting existing company to enter the market the Price case, a $10.1 billion verdict – or create a product on their own? “I was handed down against PM USA of the cigarette category, the U.S. mar- would limit the company’s future li- think they will enter on their own,” pre- in March 2003. The suit alleges that ket is a mature one, in early stages of ability. In addition, in order to become dicts Herzog. “They’ve been working Philip Morris engaged in consumer permanent decline. According to Smith FDA-compliant, cost of entry into the on it. Think Marlboro in a can.” 

PAGE 6 of 11 PAGE 7 of 11 “We keep growing our share [vis-à- over the past four or five quarters “In particular, MST doesn’t show any vis smoke shops]. We are a desti- – ranging between 5 percent and 7 immediate signs of slowing down. nation stop for tobacco.” percent. However, the investment firm Contrary to Smith Barney’s assess- Playing the is not sure that rate of growth is sus- ment, I think it is quite sustainable for One logical strategy tainable. the next few years. for retailers to employ: OTP Game Increase overall tobacco “I think it will continue to grow, but “It’s interesting that OTP – and moist sales by promoting the it will return to the historical levels of smokeless in particular – has a per- MST continues to grow as a “other tobacco products” about 2 percent growth,” said Herzog. ceived ‘health benefit’ over smoking. source of tobacco revenue (OTP) segment – cigars, roll-your-own Consumers perceive that it’s ‘better tobacco and accessories, and, particu- Others disagree. for you’ than cigarettes. And in some for convenience retailers larly, moist smokeless tobacco (MST). cases, state attorneys general have “The OTP category is growing,” agreed and actually have taxed moist ven though cigarette volume “Bottom line… OTP represents an counters Nik Modi, tobacco analyst for smokeless products more favorably as continues to decline in the Unit- attractive opportunity for retailers to UBS. “This is being supported primar- a result.” Eed States at a rate of 1 percent make money,” said Bonnie Herzog, ily by flavor innovation in cigars, and to 2 percent per year, the importance tobacco industry analyst for Smith ongoing growth in the MST segment. Low-End Drives Growth of the tobacco category to the c-store Barney, at a recent CSPNetwork Cy- I expect the MST segment to continue Of course, growth is a relative term. retailer’s bottom line remains clear berConference entitled Tobacco 2005: its growth at an estimated rate of 4 One factor cannot be argued: It’s the and constant. From Evaluation to Opportunity. “This percent to 5 percent over the next low-end of the MST market that’s driv- could be a way to diversify your to- three years.” ing all of today’s growth. “Because tobacco con- bacco business. Do you allocate a tinues to be the largest little more shelf-space to smokeless? David Bishop, director of Barrington, United States Smokeless Tobacco dollar volume sales cat- Roll your own? Cigars are also grow- Ill.-based Willard Bishop Consulting, Company (USST) remains the cat- egory other than motor ing. Together, they may be a way to agrees with UBS’ short-term assess- egory leader with over 70 percent of fuel, it continues to be the increase your margin.” ment. the MST market, including the No. 1 biggest driver of conve- and 2 premium brands, nience store sales and Which Way Is Up? “We’re seeing retailers budgeting and Skoal. When rivals Conwood and profits,” says Mike Zielin- Smith Barney reports that the MST for between 5-percent and 12-percent Swedish Match entered the market ski, president and CEO segment has enjoyed healthy growth growth in the OTP category,” he notes. with several discount brands designed of Hillsdale, Ill.-based to challenge USST’s position, USST Royal Buying Group, a introduced its own value brand, Husky, national organization Retail Price Gap Trend and threw a great deal of its marketing that selects, negotiates, (Premium vs. Deep Discount) Source: Smith Barney Tobacco Trade Survey muscle behind the low-end brand. As implements, and tracks Period Average Premium Deep Discount Absolute Relative a result, most new MST consumers vendor programs on Brand1 (4th Tier)2 Gap Gap are entering the category via the dis- 1 Copenhagen behalf of its members, Q2 ‘05 $4.88 $1.73 $3.15 181.7% count doorway. Skoal representing over 3,700 Q1 ‘05 $4.46 $1.72 $2.74 159.7% Kodiak convenience store loca- Q4 ‘04 $4.44 $1.68 $2.76 164.4% 2 Grizzly According to Smith Barney’s most tions. Q3 ‘04 $4.37 $1.85 $2.51 135.7% Husky recent quarterly tobacco survey, which Q2 ‘04 $4.52 $1.94 $2.58 133.2%

PAGE 8 of 11 change gears and switch to low-price “USST has tactically reduced prices Crystal Ball Gazing brands. in low-income areas, where the dis- count competition is gaining most trac- While overall cigarette consumption is expected to decline in the U.S. through 2009, “Clearly, there are a number of fun- tion,” says UBS’ Modi. “However, my look for cigar consumption to rebound, and other tobacco products, such as roll- damental changes occurring in moist sources suggest discount brands are your-own tobacco, to enjoy solid growth. smokeless today, similar to cigarettes, starting to gain more traction in higher- with the deep-discount value items income areas as well.” OTP Consumption coming in and affecting the premium Source: Euromonitor International 2005 business very much like fourth tier Many in the industry think that has done with premium cigarettes,” USST’s strategy to dominate the top 2004-2009 explains Bishop. “USST is definitely and bottom tiers is an effort to discour- Segment 2004 2009 CAGR % Change the market leader with three-quarters age new companies and brands from Cigars (million units) 6,262.8 6,944.2 +2.1% +10.9% of the business. They introduced their entering the MST marketplace. Smoking/Rolling Tobacco (tons) 7,259.1 7,553.6 +0.8% +4.1% own deep-discount product [Husky] Cigarettes (million sticks) 360,400.0 298,781.9 -3.7% -17.1% in response to Swedish Match, which “I don’t think that USST is going for had previously reduced the price of its share or trying to block new entrants, Cigarette dollars are projected to grow in the single digits in the brands.” because they have already been hit U.S. marketplace through 2009, while cigars and RYO tobacco are with antitrust litigation,” continues expected to enjoy double-digit growth. The biggest difference between the Modi. “They focus on category growth, cigarette market and MST markets which is the responsibility of the cat- OTP Sales (Millions) would be that the major companies egory leader.”  Source: Euromonitor International 2005 play in all four price segments – giv- Click Here to download an audio-visual recording of the ing them more control over the relative 2004-2009 recent CSPNetwork CyberConference, “Tobacco 2005: and absolute price gaps. According From Evaluation to Opportunity.” Segment 2004 2009 CAGR % Change to Smith Barney research, the relative Cigarettes $72,146.9 $78,552.2 +1.7% +8.9% and absolute gaps between premium “[OTP] will Cigars $2,287.5 $2,644.6 +2.9% +15.6% and fourth-tier brands were 181.7 per- continue to grow, Smoking/Rolling Tobacco $406.2 $550.0 +6.2% +35.4% cent and $3.15 for Q2 ’05. That statis- but it will return Total Tobacco Category $74,840.6 $81,746.8 +1.8% +9.2% tic goes a long way toward explaining to historic the dramatic, explosive growth on the levels of about low end of the category. polls tobacco retailers and wholesal- of retailers have seen the low-end 2 percent ers, more smokers are entering the brands (Grizzly, Longhorn and Husky) Indeed, USST offers a twofold ap- per year” MST category, but are doing so in the encroach on share from Copenhagen proach to the MST category: promote low-price segment. Ninety-four percent and Skoal. the profitability of the premium seg- of retailers have seen more smok- ment via retailer buy downs (averag- ers enter the category compared to USST research, meanwhile, indi- ing 80 cents per unit, according to last year, but the majority believe this cates that most new MST consumers Smith Barney), all the while growing growth is being driven by lower-priced are entering the category at the high the overall category by driving the  Bonnie Herzog, Smith Barney MST brands. Sixty-seven percent end, which would indicate they quickly fourth tier.

PAGE 9 of 11 Advertisers Index

BIC Consumer Products, USA U. S. Smokeless Tobacco Co. Joanne Witkin 100 West Putnam Avenue 500 BIC Drive Greenwich, CT 06830 Milford, CT 06460 Phone: 203-661-1100 Phone: 800-546-1111 ext 2460 Fax: 203-661-0298

The BIC tradition spans more than half USSTC, a distinctly different tobacco a century. Marcel Bich bought a factory company, is the leading producer and in France and introduced his first “BIC” marketer of the only growing segment of ballpoint pen in 1950. After establishing his the U.S. tobacco industry, moist smoke- company as the world’s largest ballpoint less tobacco. The company’s leading pen maker, Bich went on to capture the brands, Copenhagen and Skoal, each lighter market. Today’s BIC® Lighter con- represent more than $1 billion at retail. tinues to be the top-selling lighter in conve- Other brands include Red Seal, Husky nience stores across the USA. and Rooster.

Play an audio message from BIC

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