A PACK OF TROUBLE

RICHARD TURCSIK

Supermarkets may soon have their sales of an important profit builder siphoned off by yet another category killer: cigarette stores.

Cigarette specialty stores are emerging in scattered major markets across the country. They sell mostly cigarettes and tobacco-related products, at rock-bottom prices. And they aggressively seek out manufacturer deals and allowances, often underpricing and outmerchandising supermarkets in the process.

"The growth and proliferation of these stores in the last year or two has really been dramatic," said Sam Hendrix, vice president of trade marketing at R.J. Reynolds Tobacco Co., Winston-Salem, N.C. "They have gone from 1% or less of industry volume three or four years ago to today, where they are approaching about 6% of volume."

The specialty stores are operating in markets including Detroit, New Orleans, Denver and St. Louis, and in Virginia and North Carolina, according to industry sources.

Though apparently a limited phenomenon so far, the specialty retail format has surfaced at a time when other retailers, such as supermarkets, may find their efforts to sell tobacco frustrated by the prospect of tax hikes and local government efforts to restrict traditional merchandising practices.

And where they do open, they sponge off sales from the local supermarket, sources said.

"If you get a real good operator in there with a good location, they have definitely drained some sales away from the traditional outlets, like supermarkets, drug and convenience stores," R.J. Reynolds' Hendrix said. He added that while most of the stores are under 2,500 square feet, there are some operators putting up huge tobacco warehouses, with 20,000 to 30,000 square feet of floor space.

An official at Philip Morris, based in New York, said the stores have been cropping up in strip centers near supermarkets.

"Basically, they do a high volume and they are growing at a good pace. In many cases these stores offer a more customer-friendly environment, something which many smokers do not perceive supermarkets as having at this point," the Philip Morris official said.

Bob Coughlin, vice president of sales at Eby-Brown Co. of Michigan, a cigarette, candy and grocery wholesaler based in Ypsilanti, Mich., said cigarette stores have been having a "dramatic impact" on supermarket carton sales in that state.

"Those that are carton customers and buying in supermarkets and mass merchandisers are now switching over to the cigarette stores. That's where we're finding most of the people are switching," he said. "Convenience stores are primarily more of a pack-motivated customer, and they are not losing the cigarette volume that the grocery stores and mass merchandisers are."

Coughlin noted that in Michigan the cigarette stores first appeared in inner-city Detroit, but are now popping up in the suburbs.

Grocery buyers at some of the 500 stores throughout Michigan supplied by Spartan Stores, Grand Rapids, Mich., are reporting that cigarette sales are down, said Mary Dechow, government and regulations spokeswoman at Spartan.

Dechow said Spartan and supermarket operators have been unable to determine how much of the losses are because of the cigarette stores and how much is because of a hefty hike in Michigan's cigarette tax, which took effect earlier this year. She agreed, however, that the cigarette stores seem to be appealing to the carton customer.

"Our tobacco distributor has told us they anticipate that there is a major growth in these stores and they have the potential for a major impact," Dechow said. "These stores are usually in strip malls and are located near regular supermarkets."

Dechow said that while the stores have not been a major problem for Spartan's customers yet, Spartan is expecting them to become more of a factor as they mushroom with new locations.

Specialty wholesalers also report impacts on their business. William Fenska, a tobacco buyer with Macomb Tobacco & Candy Co., an Eastpointe, Mich., wholesaler, said, "Our volume is definitely down a bit, some of which can be attributed to the rise of the cigarette stores."

Sources said the specialty operators stores derive anywhere from 50% of their revenue up to 80% or more higher from the sale of cigarettes.

"These stores drive the category. Unlike conventional outlets, where cigarettes are only a part of the mix, these people would not be in business were it not for the sale of cigarettes," said Hendrix of RJR. "They focus entirely on that category and carry any SKU available. They take any deal available and carry large quantities of promotional product and even mass displays."

One such operator, Richard Augustyn, president of Smokers Hub, a division of King Group, operates a chain of four cigarette stores in suburban Detroit, ranging from 900 to 1,500 square feet.

Augustyn opened his first store in September 1992. He told SN sales have taken off since a massive tax hike raised Michigan cigarette prices by $5 a carton earlier this year.

While Augustyn's stores do have a pop machine and a 3-foot candy counter, the vast majority of his sales are from cigarettes and smoking-related products like lighters, he said.

"We're cheaper than a supermarket, convenience store or drug store. But I think the variety is what really brings people back," he said.

"We carry the products that are kind of hard to get a hand on, like Philip Morris Commander, and products that most retailers wouldn't stock on a day-to-day basis, like Parliament. The other stores will order these products for the consumer, but not necessarily keep them on hand, seven days a week. We keep those brands available. And we have a nice clientele as a result," he said.

Smokers Hub makes money through high-volume turns. The high volumes, in turn, come from accepting lower margins than other classes of trade and underpricing those competitors. Smokers Hub also tries to take advantage of every trade promotion and premium program on the market.

"Our stores are self-service, with service orientations. We are very customer-oriented and service-conscious, yet we allow the customer to do their shopping. It becomes a fun experience for them because they can wander around the store and become familiar with various promotions and premiums that have been made available by the manufacturers," Augustyn said.

He said he is convinced that much of his business comes straight from drug chains, supermarkets and similar classes of trade.

"We have seen a definite move of customers to come to a location where consumers can find everything they want in one store, with drug stores and a number of supermarkets downplaying cigarettes. That has been a natural progression.

"Some of the supermarkets have limited their variety and priced it at a point where, if they sell it, that's fine; if they don't, that's OK, too. The supermarkets really don't merchandise the category," he said.

Industry observers said changing societal attitudes toward tobacco may keep the ground fertile for this retail format to continue to proliferate.

"Where chains make decisions to not carry a product because of social questions, then it opens up opportunities for other retailers, in the same way that restaurants that totally ban smoking run the risk of losing customers to other restaurants," said Marc Cohen, a securities analyst with Goldman, Sachs & Co., New York.

"These category-killer stores have the potential to be a very high-profit retail segment," said Burt Flickinger 3rd, an industry consultant at A.T. Kearney, New York. "If Nat Sherman can sell cigars in one of the most expensive pieces of real estate in North America, on Fifth Avenue in Manhattan, then a cigarette category-killer store makes a lot of sense."

Rob Huberman, vice president and general manager at Starkman Distributors, an Atlantic City, N.J.-based candy and cigarette wholesaler, said supermarkets themselves are liable to help fuel this competition.

"If supermarkets and drug stores eventually drop cigarettes, as has often been predicted, then there will be a tremendous opportunity to develop stores that only sell cigarettes," Huberman said.

Other observers, however, questioned whether this retail trend will have staying power, especially if the political and regulatory climates shift once again, this time in a more favorable direction for traditional cigarette merchandisers.

Gary Black, a securities analyst who follows the tobacco industry at Sanford C. Bernstein & Co., New York, said that while he was enthusiastic about cigarette specialty stores only a few months ago, his views changed after Election Day.

"I don't think these stores have the allure that they did six months ago, when we were talking about huge excise taxes to pay for the proposed health care bill," he said.

Still, Black said, the format's concept is solid from a merchandising standpoint. The stores can undercut supermarket prices by taking advantage of display, promotional and allowance money offered by the leading cigarette manufacturers -- resources that supermarkets don't have the room to fully use.