Is Tobacco Dead? CVS Thinks So

Tobacco was once a cash crop, but with all of its known health effects many people have stopped buying it over the years. Still, discount retailers like Dollar General and Family Dollar rely on tobacco products to make their earnings targets.

Feb 9, 2014 at 3:46PM

Phillip Morris (NYSE:PM) has been in operation since 1847. Marlboro, the company's leading product line, is the number-one cigarette in all 50 states. According to the company, its retail market share was 43.7% in 2013, larger than the next 11 brands combined. That said, the U.S. cigarette industry is not what it was 50 years ago -- industry volume was down 4% in 2013 alone.

It is a little known fact that Marlboro cigarettes were originally marketed toward women -- that failed. So, in 1950 the company began marketing the cigarette to men by featuring the picture of the infamous Marlboro man -- according to a recent article by CNN, at least four of the Marlboro men have died of smoking-related diseases.

The article goes on to say that one-third of cancer deaths are caused by tobacco yet 44 million people still smoke, which means there's still a large demand for tobacco products. Gas stations and grocery stores continue to sell tobacco products because they help to increase customer traffic. Even pharmacies sell tobacco products, which seems like a contradiction in practice--but then again, nicotine is a drug.

CVS says no to tobacco
On Feb. 5, CVS Caremark (NYSE:CVS) stunned the world and announced that it was going to stop selling tobacco products, a move public health experts applaud and hope to be precedent-setting. CVS is restructuring itself to be more about health care than retail and this is just one step in that process. In December, the company announced a 10-year agreement with pharmaceutical distributor Cardinal Heath Inc to form the largest generic-drug pharmacy in the U.S.

Both Dollar General (NYSE:DG) and Family Dollar (NYSE:FDO) continue to use tobacco as a means to increase customer traffic, specifically repeat traffic, even it if means selling more low-margin products. Dollar General had a record third quarter with a 4.4% increase in sales over 2012. The company attributes the growth to the introduction of tobacco products. On the last earnings call the CEO had this to say:

As I said earlier, the addition of tobacco products has had a significant impact on growth in our customer traffic, which I continue to believe is the most important metric with regard to evaluating the success of our tobacco initiative. We're very pleased with the progress we made in building our market share in tobacco. Going forward, we expect both traffic and transaction size to build as customer awareness of tobacco products in our stores continues to grow.

When asked by an analyst to quantify the lift created by tobacco products, the CEO provided the following detail which sums up how tobacco can increase average basket size:

When we started the tobacco journey, 1/3 of our cigarette sales were by themselves, 1/3 were what we would call a smoke and a coke, where they would grab a cigarette and maybe a soda or a chip. And then 1/3 is where the cigarettes were actually going into a basket that was beginning to grow. We're now at the stage of the game that back 1/3 where cigarettes are going into the actual basket is now at 44%. And cigarette purchases only are declining to 26%. So we're beginning to convert the cigarette customer into a shopper.

Family Dollar started selling tobacco products in 2012. On the fourth-quarter 2013 earnings call, Michael Bloom, who's no longer with the company, said, "Our introduction of tobacco continues to drive traffic and sales." He went on to say that, "We haven't seen an impact from the roll-out of our competitor," referring to Dollar General. Sadly, tobacco sales couldn't save the company from declines in traffic over the first quarter of 2014 --  Family Dollar announced a same-store sales decline of -3%.

The Foolish bottom line
It's hard to say what kind of ripple effect this will have on the tobacco industry, pharmacies, or even discount retailers. CVS should be applauded for its actions. The company is making a business decision to align itself with the more profitable growth segment -- pharmacy is outpacing retail by 5%. By doing so, CVS proves that it is possible to be a good corporate citizen and make sound business decisions at the same time. Dollar General, with more stores in the U.S. than Wal-Mart, will certainly benefit from CVS' decision -- tobacco sales are already the highest growing segment in consumables.

How do other retailers look today?
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

B Bryant has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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