Since the early part of 2016 I’ve had a theory about this year’s IPCPR Convention & Trade Show, one that was developed without any concerns about the impact of FDA regulation on the event.
This year’s trade show is going to be a moment of reckoning.
Over the last five years there have been three interesting trends developing in the cigar industry that all seem to point to an economic time bomb, or in more common financial terms: a bubble.
While there’s no concrete data on any of these things specifically, none of these trends are things that I hear many people disputing, and I think most people in the business would acknowledge the following to be true:
1. The Consumption of Cigars in the U.S. Isn’t Substantially Increasing
That is, the overall amount of cigars purchased by consumers from retailers hasn’t increased more than a couple of percentage points annually since 2011.
While it might look like the cigar boom1 in terms of the amount of new product, it’s certainly not the boom when it comes to consumption, i.e. consumer level purchasing and in particular, the amount of new cigar consumers.
2. The Amount of New Cigars Coming Out Each Year Has Doubled, If Not Tripled Since 2011
The problem isn’t simply new cigar brands, rather it’s a much larger symptom of the current market state of what’s new?
The amount of new product is probably at its highest point since the early 20th century when there were hundreds of cigar factories in the U.S. There are new cigar brands, but more importantly, there are new cigar companies and established ones that five years ago released one new regular production line per year that are now adding a new line each quarter.
Outside of companies that have gone out of business, I cannot think of one company that is introducing less new product today than they were in 2011 and certainly none of them that are doing it at any consistent rate.
It’s a vicious monster, almost an addiction to new product. And yet, there aren’t that many companies that seem to actually want to put out new product.
Rather, most companies feel introducing new products is necessary to stay relevant with consumers and retailers, something that’s probably true. This likely stems from the thought that introducing new products is seen as the cheapest and most effective way to market to consumers.
Coinciding with this is another problem: the amount of products that are discontinued each year hasn’t kept up with the pace of the new products being introduced. With little exception, nearly every manufacturers’ sales sheet of available product grows each year. And even when a company goes through a massive portfolio reduction, it’s quickly followed up by more new cigars. There certainly doesn’t need to be an add one, take one away philosophy, but it cannot be add 15, take one away.
3. One Plus Two = Inventory Problems
For the last few years, simple economic data at a typical cigar shop probably looks something like this:
- Revenue Is Up
- Profit Is Roughly the Same
- Margins on Cigars Are Up
- However, the amount of cigars purchased by the retailer has stayed the same or more likely increased; yet, the amount of cigars sold at the register is probably slightly down, or at the very least, flat.
That leads to a massive inventory problem.
It hasn’t been a noticeable issue because of price. In 2011, the only companies successfully marketing $15+ cigars were Davidoff, Fuente and Padrón. Now, there are new companies entering the market with cigars that retail for $15—something that would have been laughable in 2010.
Sure, there are price increases, generally 1-5 percent. But that doesn’t tell much of the story. New products are entering the market at an average price much higher than five years ago, meaning, in effect, consumers have been funding their own craze with new cigars. While introducing new products and the free press that is associated with it is probably cheaper than spending $250,000 in ads to promote an existing line, it’s still expensive. New packaging, promotional items and even ads have to be created to sell the cigars—all of this comes at a price, one consumers have been unknowingly paying for the last few years.
Increased prices have allowed retailers to buy more cigars than they are selling without the inventory issues becoming an immediate issue because their revenue and profits have remained roughly in check.
But eventually, the amount of inventory a retailer has in dead stock will come to bite them and we saw evidence of that at top brick and mortar retailers earlier this year.
In Q1, numerous companies and their sales representatives indicated they started seeing noticeable cutbacks from certain retailers, and I really think that’s just the start. Combine this with cutbacks at catalogs over the last 24 months, oftentimes blamed directly on inventory reduction, and what we are seeing is evidence that the i-word is becoming a problem.
The rate at which a single product is purchased, sold and then repurchased by a retailer—known as a turn—in the cigar business is horrific compared to many other retail industries. In a grocery store, items are perishable and as such product must move quickly, sometimes months, oftentimes weeks. In large department stores, items can have as little as one month before a retailer will begin marking them down in an effort to move them out of the store.
In the cigar industry? I probably could walk into half the stores in the U.S. and find product from 2011—and not in a vintage room.
Cigar retailers are somewhat unique because almost all of their product has to be sold in a specific room (humidors) or specific cabinets, yet the items aren’t particularly perishable. So when a retailer designs the floorpan for their store, they have to create a specific amount of space for their products to be sold and this space isn’t particularly flexible, in other words, you have to plan to grow.
Yet an empty humidor isn’t a good look and it’s also a bit of a double-edged sword in term of profit. Most retailers generate the vast majority of their sales from cigars—not accessories or bottles of soda—and as such the space in which they make the bulk of their money is confined into whatever size humidor they have. The less products that are in the humidor, the less potential revenue. So retailers fill the humidors, even new ones, to make it look full and develop an unhealthy relationship with old product. The thought is: it’s not going bad, I already paid for it and eventually someone will buy it, right?
This—and other factors—have led to a fairly inadequate approach to closing out products, something that becomes really problematic when you are buying more cigars than you are selling. The practice of closing out products at most retailers never really caught up to the post-2011 cigar world.
Previously new cigar brands would have lifespans of years. It would take multiple turns at the manufacturing/distribution level to figure out whether or not a new product would be successful. Now with the flood of new products, some cigars don’t even make it through a full turn at the upper levels within a year.2 Cigar brands today have an incredibly low lifespan and yet most retailers aren’t considering putting six-month-old product in a discount bin. Even if they were, they probably wouldn’t have the space, because there would be dozens of boxes that would need to go into the closeout section.
As such retailers are sitting on more inventory than likely ever before, even when the amount of customers isn’t at, or even close to, an all-time high.
AND NOW WE TALK ABOUT FDA
None of these problems are caused by FDA’s upcoming regulations of premium cigars, but as the theme of this article goes—FDA is going to compound them.
THERE’S GOING TO BE MORE NEW PRODUCT AT THIS YEAR’S TRADE SHOW
As is discussed in more detail here, manufacturers are taking a variety of approaches to introducing new products before the Aug. 8, 2016 deadline that will require any cigar introduced after Aug. 8 to receive FDA pre-approval before entering the market.
How much more new product is something that I’ll be able to much better address a week from now, but it’s clear that there is going to be at least 150 percent of the new product that was introduced at last year’s trade show, and it could be much more. It’s not going to be 400 percent, but it could very well be double.3
Because of the Feb. 15, 2007 grandfather date, there’s also going to be an odd sighting of products that seemed to have disappeared from the market a couple years ago, only now to reappear. While I certainly don’t think many of these products would meet the letter of the law established by FDA, that certainly isn’t going to stop some companies, at least now in the early stages of regulation.
SOME CIGARS IN THE HUMIDOR MIGHT BE ILLEGAL IN THREE YEARS THANKS TO FDA
If a manufacturer isn’t able to get grandfather status or doesn’t apply for substantial equivalence or a substantial equivalence exemption, they will have to remove the product from the market by Aug. 8, 2019.
It’s not entirely clear how this will work in practice because FDA has never had to deal with thousands of SKUs that are suddenly not in compliance, but it’s a looming issue.4 In theory, FDA will eventually issue stop sale orders, legal directives that would bar retailers from selling non-compliant product.
The major catalog retailers have already realized this and have begun telling manufacturers that they will no longer be purchasing, or at the very least substantially cutting back on products unless the retailer believes the product will be in compliance after the various deadlines.
This will certainly spill over to the brick and mortar retailers and I expect many cigar companies to market cigars at the trade show as products that the brand will definitely apply for substantial equivalence for, or products that meet the grandfather requirements.
While three years is certainly a long time, many retailers—particularly the catalogs—are beginning to or will realize that they already have lots of inventory that could be subject to a stop sale order in three years, which is a relatively short period of time when limited editions from 2009 are still on your shelves. Moving that potentially non-complaint product will begin to take an increasing priority as we get closer to 2019, because it’s one thing if the inventory is not moving, it’s a much different scenario when it’s illegal to sell the product.
And there’s no real recourse for these retailers. Once FDA issues a stop sale order, the manufacturers would also be prohibited from selling these products in the U.S., so there’s no incentive for a manufacturer to accept returns on these products even at a discounted rate. Furthermore, if a manufacturer hasn’t already submitted for substantial equivalence by Aug. 8, 2019, it seems highly unlikely they will suddenly have a change of heart. Even then, the manufacturer would have to wait until FDA approves their applications before they could resume selling the products.
(Note: As long as a manufacturer has submitted an application for substantial equivalence by March 10, 2018, they can continue selling the product until FDA rejects the application.)
THERE’S UNCERTAINTY ABOUT FDA
Those specific problems ignored, there’s a general uncertainty about FDA and this is going to spillover to buying at the trade show.
Everyone in the cigar business has concerns about FDA. And they should.
While there are some (yours truly) who have argued this isn’t the doomsday scenario that gets talked about on Facebook on a daily basis, this is a serious problem, one that is going to have dire consequences for some. It certainly will be disproportionally costly to newer and smaller manufacturers, but FDA will affect everyone in the cigar business. Up until Aug. 8, the industry has been essentially unregulated at most levels and as such, everyone has enjoyed almost unlimited freedom. That will change, but we don’t know how much, and likely won’t until the rules begin to go into effect.
Even the retailers who haven’t fully thought this through will likely be hesitant with their wallets, less willing to take chances on some brands and less committal to going deep on others.
What this long narrative equates to is a lot of evidence that buying at this year’s trade show will be down.
It’s not something that is exclusive to the trade show floor, this is an issue that is going to play out for months—if not years—to come.
I suspect trade show attendance will be up from last year, but it’s not going to be enough to offset any of the reasons above or the simple fact that there won’t be anymore money available at this year’s trade show than in prior years, despite a lot more new products.
The amount of money retailers have to spend isn’t dramatically increasing and every year we’ve seen that proverbial pie just divided up more and more. But this year—for the first time in a while—I think the pie of money is going to be smaller as retailers begin to cut back due to the realization of inventory issues and uncertainty related to FDA. This, combined with the increased new products, means profits for the manufacturers are likely going to take a hit.
Complaining about the trade show seems to be a sport that just about every manufacturer likes to play and this year, for reasons that are really no singular person or group’s fault, it’s going to be much more popular.
Speaking of complaining, manufacturers and retailers have complained, even publicly, about the amount of new product that is being introduced to the market. But they do it right after sending a newsletter to their customers about the new product that just arrived. The cycle continues without any real commitments to anyone taking a stand against it. And why would they when up until now such a stand is probably bad for business.
On the afternoon of July 28, the trade show will begin to pack up, with manufacturers, sales representatives, retailers and media heading home or to their next event. But the problems described above will continue. The market correction that I think is probably necessary will take years—something that won’t be solved by FDA. At this point, the problem isn’t even math-related. It runs deeper than numbers; much of it—the most challenging part to solve—will be behavior.
Many people—this website included—have profited off the what’s new? marketplace. It is easier to make a new cigar than a good cigar. But over time, a focus on quality cigars over shiny new objects will be the only way I see the industry overcoming this in any sort of non-catastrophic manner.
It is a matter of fighting inherent consumer behavior. People generally like new things, even if they may not be better than what already exists. Most people like to try new restaurants rather than simply going to established favorites. And even when we have less than optimal experiences with new restaurants or cigars, we generally are still willing to try another new one, and another new one, and another new one.
Without addressing this behavior at every level, the industry will likely be shackled to this cycle of what’s new until the vicious monster begins to spit out things, i.e. people’s business, as the market adapts to a more appropriate level of new products compared to consumption.