Price Increases in the World of FDA Regulation

Cigar prices are going up.

Over the last few days, we’ve published stories about what user fees will look like in 2017; another about one of the largest companies in the industry raising prices and that same company citing the regulatory environment as a reason for its most recognizable face departing. All of these are related to the U.S. Food & Drug Administration’s (FDA) new regulations on premium cigars.

In the last 90 days, two of the largest companies in the industry—Davidoff of Geneva USA and General Cigar Co.—announced a second set of price increases, following ones done earlier in the year, due to increased regulatory costs. If a cigar manufacturer hasn’t considered raising prices, reading this headline certainly has to make them start to think about it.

And my hope is they do think about it, but I also hope more thought goes into it than a knee jerk reaction of Davidoff, General and Padrón did it, so I should too.

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Price increases need to happen, but a responsible course of action is more than just updating the cost of cigars. Rather, it should be a complete evaluation of running a cigar company under FDA. Based on conversations I’ve had in the last couple of weeks, I’m led to believe those evaluations (sadly) aren’t taking place with every company in the industry. In fact, there are some that are still unsure about whether they will need to even do anything in order to comply with FDA.

That has to stop, and quickly.

I’m not a cigar manufacturer. Like many consumers, my blending experience is limited to a few trips to Drew Estate’s Cigar Safari and the like. But nearly every day, I have conversations with manufacturers, retailers and others about FDA regulations. I’m just a person who writes about cigars and perhaps more importantly for this conversation: someone who read the 499-page deeming regulations—and a couple thousand pages of other documents—something that sadly puts me in the extreme minority for those employed in this industry.

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This is food for thought.

Despite the newfound regulations, the beauty of the country we live in is that people are (generally) able to choose how to run their own business. In full disclosure, halfwheel has a massive price increase on advertising for 2017, something not because of FDA, rather a reduction in inventory and an increase in readership.

But, given that just about every company will raise prices to deal with very real regulatory costs—I think it’s important that every part of the cigar ecosystem—consumer, retailers and manufacturers—at least has some understanding of why and how prices will increase.

PART I: THE COSTS

Presumably, you have to start with the potential costs.

As was outlined in halfwheel.com/fda, there are four main added costs associated with FDA regulation:

1. Testing
2. Administrative Costs
3. User Fees
4. Warning Labels/Packaging Changes

For whatever it’s worth, FDA estimated the cost for a full substantial equivalence report, what it believes the most expensive pathway to approval for cigars, to be $22,787.

This is based off 300 hours worth of work divided between legal, testing and administrative costs. Depending on how various parts of the rule are interpreted by FDA and cigar companies, costs could be as low as $1,400[ref]For products that do not require testing.[/ref]—according to FDA estimates—and around $6,800 per cigar for something called bundled substantial equivalence, a strategy where a cigar company goes through full testing and reports for some products, but is only required to submit additional paperwork for others—like if the same cigar is sold in multiple packaging formats.

How accurate these estimates are—I don’t know; but they seem to be generally disregarded by most in the cigar industry. That could be because many simply didn’t read the economic analysis, a separate document from the main 499-page document most are familiar with, but probably didn’t read.

TESTING

As part of the new FDA regulations, products introduced to the market after Feb. 15, 2007 will require testing to gain FDA approval. Because FDA has never regulated cigars before, it remains to be seen just how thorough the testing required will be.

In the past week, I’ve had conversations with two larger manufacturers who sought bids from multiple labs. I’m not sure which or how many labs were contacted, but the costs ranged from $1,500-40,000 per SKU, i.e. an individual vitola from a single line.

These are companies who sought bids, not people that saw a number in a Facebook comment and decided to repeat it. Some of the variance is due to the thoroughness of the tests—if FDA requires a fewer number of things to be tested, the cost will be lower; more testing parameters, higher costs—but even then the ranges each company gave me individually are staggering: $1,500-20,000 and $20,000-40,000 per cigar.

Many fear that testing will be the largest cost associated with the regulations—and if it’s in the neighborhood of $20,000 per cigar that’s likely to be the case, at least in initial costs[ref]See below about user fees.[/ref]—but the fact that two educated endeavors to estimating price returned a range that varies over 25 times shows just how little is known about testing.

ADMINISTRATIVE COSTS

You might have read about shipments being held in customs, deadlines to register products and advertising and warning plans—these are all things that will require cigar companies to invest hundreds of hours of time they previously were not required to do.

For many companies, this investment is already in full swing. Manpower costs money and for some, particularly the larger companies, the meter is already running. Companies are having to hire attorneys to help guide them through the regulatory process, something that will certainly add a very real cost to the regulations.

How much this will cost is dependent on a variety of factors, including how efficient each company is in dealing with these things, but part of the reason why cigars will get more expensive is because it’s going to take a lot more time for companies to make sure they are legally able to sell said cigars.

USER FEES

As explained in much more detail here, user fees are fees paid by cigar companies to FDA to help fund the regulatory process. Cigars, pipe tobacco, cigarettes, roll your own tobacco, chewing tobacco and snuff all contribute user fees to FDA’s Center for Tobacco Products (CTP).

In total, these industries will send $635 million to FDA next year to fund CTP and will pay that same amount, plus an additional $35-40 million to CTP each year after.[ref]After 2019, Congress and the Department of Health and Human Services will determine how much money is sent from 2020 onwards.[/ref]

For 2017, cigar companies—premiums, mass market, etc.—will contribute $61.5 million to CTP with each company contributing a proportional amount based on how much money they pay in federal excise taxes, i.e. SCHIP.

In short—companies should likely pay no more than 4.3 cents per cigar imported to the U.S. next year.

Unlike testing and legal fees, which likely will be a one-time investment for each type of cigar a company sells, user fees will be an ongoing cost, though it seems unlikely they will exceed 5-6 cents before 2020.

WARNING LABELS

Companies will be required to place warning labels on all boxes by Aug. 8, 2018. Two warning labels, covering at least 30 percent of two primary panels—presumably the top and front of the boxes—will be required. This will take added time to apply the warning labels, which costs money, as well as the price for printing the warning labels.

Because most companies use a variety of different sizes boxes across the products they sell, companies will likely need to have the warning labels in multiple sizes for different boxes sizes, increasing the costs associated with warning labels.

Furthermore, cigar companies must randomly distribute five different warning labels across each SKU and give FDA a written explanation of how they intend to do so. In short, if you make 500 boxes of a particular cigar, 100 boxes will need to have warning label a, 100 boxes will need warning label b, etc. This will add more time, which of course means higher costs.

One potential cost that is unknown is what happens to boxes on shelves as of Aug. 8, 2018. It remains to be seen whether FDA expects cigar companies to make sure all of the product on shelves have warning labels, or simply just those shipped after Aug. 8, 2018.

If FDA requires all boxes on shelves to have warning labels as of Aug. 8, 2018, a very expensive process of retroactively applying warning labels—likely meaning the company’s representatives will need to be applying the labels when they visit cigar stores—would become another factor.[ref]As with much of the regulation, there really is no precedent for this and it’s particularly unclear how FDA would expect cigar companies to adhere to the warning label submission plans if previously shipped product is required to have warning labels by Aug. 8, 2018.[/ref]

LEGAL AND LOBBYING FEES

For many companies, there will be a fifth cost: money spent fighting regulations.

A lot of companies are already spending money to help fund organizations like the Cigar Association of America (CAA), Cigar Rights of America (CRA) and the International Premium Cigar & Pipe Retailer’s Association (IPCPR). But, these costs are only likely to increase not just for the lawsuits associated with the current regulations, but also lawsuits and lobbying for potential future regulations.

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With the exception of user fees, which are fairly easy to calculate, you’ll notice that there aren’t very many hard numbers associated with the costs. That’s because the industry is waiting on a plethora of clarifications and guidance from FDA about how the new rules will be enforced. While many have hired attorneys, it seems like few companies have received any bills from their attorneys for work that’s already been started.

The simple fact is it’s going to cost money, money that very few companies were forced to spend prior to 2016, but like most things with FDA, it’s still quite unknown.

PART II: EVALUATION

After assessing the upcoming costs, the next part of the process—assuming you haven’t already curled up in a ball and prayed this was all a bad dream—becomes determining how to help mitigate the costs—and it’s here where I think cigar companies need to think long and hard about their strategies.

As most readers of this site find out every January, the price of cigars continues to rise. There’s certainly a lot of truth to increased material and labor costs over the last five years, but there’s also another factor in play.

I write this as a co-owner of a business which sells advertising to cigar companies: the cost of selling and marketing cigars has quietly gotten a lot more expensive.

As discussed here, the amount of cigars consumed annually hasn’t increased much in the last five years. However, the amount of new cigars and new cigar companies has drastically increased, creating more competition. At the same time, consumers and retailers are demanding more: more new cigars, more intricate packaging, more events, etc. And this has led to shorter attention spans and much greater barriers to capturing consumers—all costing a lot more money.

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You can very much add regulatory costs due to FDA to the laundry list of factors that has made it more expensive to sell cigars, combined with the fact that many manufacturers are seeking to grow their business while spending more and selling less individual cigars. Whether or not cigar companies realize it, they have been raising prices—and introducing new products at higher and higher price points—not just because of the rising cost of producing a cigar.

Thanks to FDA, many companies will be faced with the largest increase to the cost of selling cigars (at the very least since SCHIP), one that also happens to be time-sensitive as they will need to be in compliance with new rules beginning next year. Now is the time, before price increases due to regulation come, that evaluations of portfolios needs to happen.

For cigars that were on the market as of Feb. 15, 2007, the decision will be pretty simple. The labor and costs associated with registering, warning labels and user fees will likely be very minimal. My somewhat educated guess says that 5-10 cents per cigar will likely cover the costs associated with grandfathered cigars.

But for everything introduced after Feb. 15, 2007, the story is much different. The real cost that companies fear is the  likely tens of thousands of dollars in a one-time investment associated with lab testing, legal fees and other administrative work. And for thousands of cigars on the marketplace, basic logic says these products simply cannot be justified by the costs.

DEFYING MATH

NOTE: THIS NEXT PART IS ALL HYPOTHETICAL AND USED JUST TO ILLUSTRATE AN EXAMPLE. THESE COSTS ARE ESTIMATED.

As noted in 1,000+ words above, the costs are still very much unknown. However, if they are say, as an example, $40,000 per cigar for the one-time legal, testing and administrative fees, it’s challenging to see how a company could justify spending that kind of money for a cigar they sell than 10,000 units of annually.

Even if the company had the financial flexibility to spread all of these regulatory costs over two years worth of sales, the numbers are staggering. Because cigars are generally sold on a keystone margin, i.e. the customer pays double the wholesale price of cigars, consumers would end up paying over $4 more per cigar in a state with no cigar tax.

If you take the median state cigar tax—15 percent—a cigar with a $9.50 MSRP at the moment, plus the $40,000 regulatory costs spread over two years and the user fees—jumps from retailing for $10.93 at the counter with state taxes to $15.76. Add in a relatively low sales tax of 6 percent, like in the state of Maryland, and a consumer will walk away with that same cigar for $16.70 assuming manufacturers keep their margins the same.

Or to put in cigar terms: an Undercrown sold in the future would be as expensive as a Liga Privada is now.

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For larger and established companies who likely have a fair bit of grandfathered product, higher sales volumes, access to lower legal and testing per cigar costs (due to volume) and the financial flexibility to spread these high one-time costs out, the impact may not be as much. But, for smaller and newer companies—particularly those that have a lot of different cigars within their portfolio—the effects could be extremely devastating.

While there is very much a communal feeling in the sense that every company has to tackle the FDA regulations, cigar companies are still in competition for consumer’s money. It seems unfathomable for companies to be raising prices on cigars $1.50+ in a world where many established products—like much of what Arturo Fuente and Padrón sell—will be grandfathered and only see minimal price increases. It’s tough to imagine a cigar originally competing with a Padrón 2000 priced the same as a Padrón 1964 Aniversario—but that’s the reality if companies try to keep everything in their portfolio with complete disregard for how much it will cost.

DEFYING LOGIC

Companies might also choose to apply price increases evenly across all their products without factoring in how much volume they do per SKU. What this means is that popular products would end up having to subsidize less popular products, something that could lead to mutiny amongst retailers.

Using General Cigar Co. as an example: if General did an across the board percentage increase, Macanduo Café—a very popular and grandfathered product—would see a more substantial price increase (than an increase based on sales) to help pay for other SKUs in the General portfolio that aren’t as popular, like say CAO OSA Sol, a product that’s not grandfathered. The per cigar cost of making sure Macanudo Café is compliant with FDA regulations is almost certainly lower than CAO OSA Sol. Yet, an across the board increase means they both get penalized evenly.

For retailers, this has to be the less preferred option because it means that retailers will have more substantial price increases on products they actually sell, to help pay for the regulatory fees on products they do not have in their humidor.

In the utopia where every single retailer carried the same product and every cigar on the market faced the same regulatory costs, the effects would be an ideal solution—but this sentence started with “in the utopia” and as such, this arbitrary method of price increases does not make sense for consumers and retailers.

PART III: IN CONCLUSION

And so my argument is this: companies need to be thinking beyond just how much they will raise prices, but also considering what products are simply no longer viable after FDA.

The good news, at least in the short term, is that if companies want to continue to sell products, they have two more years to do so, even if they have no intention of going through the regulatory process for a particular cigar. They can continue to sell these products with relatively little work and costs until Aug. 8, 2018—at which point they would need to be compliant with the warning label restrictions—or Aug. 8, 2019—at which point any product that has not applied for approval via grandfather, substantial equivalence or exemption must be removed from the market.

In 2014, when FDA released the draft of its deeming regulations, it estimated between 10-50 percent of the cigars on the market would not apply for approval and thus be removed from the market. Since then, FDA had decided to not update its estimations because it admitted it didn’t have a good grasp of how many cigars were actually being sold. Whatever the case, a lot of cigars—not just limited editions—will go away.

I think some companies need to use this to their advantage. A responsible company in my eyes is one that looks at the situation, decides to raise prices on products it believes are financially viable given the costs, while keeping prices the same on products it plans on phasing out—and then actively communicate these decisions with retailers and consumers.

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As someone who was purchasing cigars when SCHIP went into effect, I feel confident that consumers are going to be wary of price increases due to regulation. It’s not that people—or at least most people—don’t believe there will be costs associated with FDA regulation, it’s that for too long they’ve heard the (cigar) world is coming to an end. When people see or hear about outlandish numbers—like $400,000 in testing per cigar—it sets the stage for certain expectations. And then, when it turns out that number was off base and uninformed, the trust that consumers like me have is eradicated.

Trust is an important part of any company’s relationship with its consumers and times like this make it even more important. Whether it’s in conversations with retailers or with consumers in store or online, it’s imperative that cigar companies show they are beyond just outraged at FDA regulation.

Actions speak louder than words, even louder than the 3,187* above.