Tobacco’s Two Tiers

Patrick Carroll is unabashed about going where big tobacco companies can’t. The CEO of fledgling Freedom Tobacco International launched Legal cigarettes last spring by sending a corps of models and actresses into New York City bars to chat up friendly guys. Their main prop: A pack of Legals perched on the bar. Their goal: Get men to bum a smoke (read: request a sample) without telling the guys they work for Legal.

Big tobacco marketers swore off such guerilla marketing — and a lot more — five years ago when they signed the Master Settlement Agreement (MSA) crafted by the attorneys general of 46 states. Carroll, who once worked in brand management at British American Tobacco and Brown & Williamson, says it was a mistake. “The big guys gave away a lot of First Amendment rights,” he says. “But the big companies lied for 40 or 50 years, and the settlement payments are damages for those lies. We didn’t cause those damages, so we won’t pay for them.”

Tobacco marketing has gotten more contentious since the MSA, and two tiers of marketers have emerged on either side. Companies that abide by the MSA — especially original signers Philip Morris USA, RJ Reynolds Tobacco Co., Brown & Williamson Tobacco Corp. and Lorillard Tobacco Co. — say that non-participating companies flout the MSA’s marketing restrictions and annual payments to states. They say that gives non-participants more leeway in marketing, especially pricing.

Smaller players’ market share has quintupled to about 10% of the $6.3 billion U.S. tobacco market; their total share was about 2% in 1998.

The playing field shifts again this year when RJR merges with B&W’s U.S. business to form Reynolds American with an estimated $10 billion in U.S. sales and 33% market share. That’ll give now No. 2 RJR and No. 3 B&W more muscle against PM, whose 50% market share gives it the most clout at retail. The merger is expected to close mid-2004, pending Federal Trade Commission approval. Reynolds American, to be based in Winston-Salem, NC, will comply with the MSA.

Meanwhile, the U.S. Department of Justice continues its case under RICO laws, first filed in 1999, against nine tobacco companies. The case is set to go to trial in September 2004 to collect $289 billion from tobacco companies for allegedly deceptive marketing and could impose more marketing restrictions, including an end to trade promotions and slotting fees (see sidebar).

This year could see heavy legal and legislative efforts to even the playing field for all marketers — and retailers. Marketers’ battle over pricing inequality will affect trade promotion programs: If more small companies pay into MSA escrow accounts, retailers could see fewer discounts from big marketers eager to shore up their own margins.

The situation already has prompted organizational changes. Weeks before announcing its merger, RJR began 2,600 layoffs and cut marketing for most brands, pressured in part by increased competition from low-priced brands. RJR will lay off 40% of its worldwide staff by 2005 and shifts support to top brands Camel and Salem. Layoffs among the sales force begin this month as RJR outsources some execution and administrative tasks (see RJR sidebar).

Flawed filter

Since non-participants aren’t bound by MSA marketing restrictions, none of the top anti-tobacco watchdog groups — think American Legacy Foundation and Campaign for Tobacco-Free Kids — tracks non-participant activities. Government oversight is up in the air, with Congress debating whether to put the Food & Drug Administration in charge of regulating tobacco. Meanwhile, the Federal Trade Commission and state attorneys general carry the ball — and AGs have got their hands full pressuring non-participants to set up escrow accounts to cover costs if states sue non-participating companies in the future. (Non-MSA participants are also open to class-action suits; MSA signers aren’t.)

A lot of money is at stake: MSA participants have already paid $29 billion to states and will pay about $200 billion by 2025. Escrow accounts could garner another $20 billion or more by 2025.

Marketers not paying escrow put that money towards discounts, pressuring big brands to compete on price. That’s why the big tobacco companies encourage states to enforce MSA terms with everyone. Individual states have filed at least 431 suits against tobacco companies doing business in the U.S. (many of them from overseas) to force the companies to either join the MSA or set up escrow accounts. (Many of the suits overlap as several states sue the same companies.)

The National Association of Attorneys General encourages states to create a directory listing all tobacco marketers who abide by the MSA or have appropriate escrow accounts; any brand not in the directory isn’t released for sale. Last year, 35 states passed such “complementary legislation” that’s enforced through distributors. Eighteen states passed “allocable share” laws to base escrow payments on actual sales in each state, replacing a 1998 formula that let marketers short some states.

New York City-based Freedom Tobacco has 46 escrow accounts, one for each MSA state. Per-carton payments vary by state and are comparable to MSA payments — but escrow balances are refunded in 25 years. That’s why it was “not a tough decision” for Carroll to forego signing on. “The MSA outlaws things that I don’t have a problem with,” like branded premiums and unlimited sponsorships, he says. “As a free-market society, why not allow 100 sponsorships [instead of just one], as long as they’re in venues and activities geared to adults?”

Pricing is the biggest issue, but there are a few consumer marketing infractions. In November, AGs settled with a handful of marketers to eliminate ads from Time, Newsweek and U.S. News & World Report issues distributed in schools. “A handful of eighth graders in Vermont brought that to our attention,” says Vermont AG Bill Sorrell, also chairman of NAAG’s tobacco committee. RJR is appealing a 2002 verdict in California that would fine RJR for ads in magazines with high youth readership.

Some AGs met with film producers and directors last month to cut smoking in films. “Maybe glamorized smoking should trigger an R rating, or theaters should be required to show an anti-smoking message before screening the film,” Sorrell says.

Big marketers also are pushing states to enforce tax laws with 400-plus Web sites, arguing that sites rarely collect local and state taxes, undercutting retail sales (and states’ tax revenue). Some sites tell consumers to pay tax in their own states.

At least two bills to govern online and mail-order sales are now before Congress. The House Judiciary Committee is considering the Internet Tobacco Sales Enforcement Act (HR 2824), while the Senate’s PACT (Prevent All Cigarette Trafficking) Act (S.1177) passed its Judiciary Committee in July and comes up for a full Senate vote in 2004.

NAAG last year signed agreements with Wal-Mart, Walgreens, ExxonMobile and BP Products to curb tobacco sales to minors in about 40,000 retail outlets. The agreements ban self-serve displays and sampling and require retailers to check ID for customers who look under age 27. Retailers also agreed to hire an independent firm to check compliance.

Fighting at the top

Don’t think “Big Tobacco” has banded together, despite efforts to quell non-MSA marketing. They’re competitors, after all, wrestling over more than $400 billion in business. Two issues divide them further: Retail merchandising contracts, and possible FDA jurisdiction over tobacco.

Seven companies, led by B&W, are pushing state-level legislation, dubbed Retailer Rights, to combat Philip Morris’ Retail Leaders merchandising program. Competitors say PM unfairly uses its market power to control shelf space. They say its program restricts competition by forcing retailers to aggressively merchandise PM brands in order to qualify for promotional pricing.

No state bills have passed yet. The push for legislation comes after RJR, B&W and Lorillard lost a 1998 anti-trust suit to shut down Retail Leaders. The court ruled in PM’s favor in May 2002; the ruling was upheld in June 2003.

PM has signed about 175,000 retailers to Retail Leaders since its 1998 launch. (PM sells to another 100,000 stores that aren’t signed to Retail Leaders.) Retailers choose from five levels of participation; the more prime shelf space they give to PM brands, the more promotional dollars they get — primarily to fund discounts. Retailers also earn PM merchandising money through youth-prevention activities.

Competitors and a number of retailers say skimpy promotional funding on the lower tiers force retailers to sign on at the highest levels, committing 75% to 100% of prime shelf-space and signage to PM brands. That shuts out all but No. 2 RJR, competitors argue; No. 4 Lorillard claims it lost at least 4,000 promotional contracts in part due to Retail Leaders.

“Our program is in no way anti-competitive,” says a PM spokesperson. “It doesn’t restrict what retailers are doing, but rewards them for taking steps towards responsible marketing.”

About 400,000 retail outlets carry cigarettes; as many as 16,000 retailers signed petitions supporting Retailer Rights legislation.

Retailers likely will benefit once RJR and B&W merge, and challenge PM for shelf space based on market share.

Consumer promotion has changed little since tightening drastically in 1998. Brands focus on events in adult-only venues and direct mail (via tightly vetted databases). Freedom continues its bar program via Interference, Inc., New York City. RJR and B&W carry on as competitors until they merge; B&W recently wrapped up a 10-city Kool DJ Tour that sent the winner and runner-up of its 13-city Kool Mixx DJ competition to play bars and clubs. 141 Worldwide, New York City, handles. Brand reps sign smokers up for future offers. PM also hosts Marlboro Bar Night programs, and continues data-based rewards programs such as premiums catalogs. But most of its marketing budget funds retail promos, primarily discounts; since the MSA, PM has cut its ad budget in half and shifted funds to retail activities.

Wither anti-tobacco efforts?

Meanwhile, the divisive issue of FDA jurisdiction remains in limbo. Plans for a Senate bill were scrapped in September after negotiations between Senate Democrats and Republicans failed. Sen. Mike DeWine (R, OH), Sen. Judd Gregg (R, NH) and Sen. Ted Kennedy (D, MA) collaborated, but in the end couldn’t agree on a draft that would limit ad placement, sponsorships and in-store signage and treat “light” and “mild” as health claims (not taste descriptions). Most tobacco marketers and healthcare advocates criticized the draft for not giving the FDA enough power to force product changes, including reduction of nicotine. (PM supported the draft.) A bill may be introduced this year.

The House’s Tobacco Livelihood Ecomonic Assistance for Our Farmers Act (HR 140) has been in subcommittee since February 2003.

FDA jurisdiction has been up in the air since the Supreme Court shut down its youth-prevention measures in 1999, saying the FDA overstepped its authority. That made it clear that only Congress can grant FDA jurisdiction — and marketers and healthcare advocates have been scrapping over it since then.

The FDA backed away in September when it declined to regulate Star Tobacco Co.’s Ariva lozenges (with 60% tobacco powder), calling it a traditional tobacco product outside FDA jurisdiction. Campaign for Tobacco-Free Kids argues that Ariva is a smoking cessation drug, so fair game for the FDA. The FDA does regulate nicotine water, lollipops and lip balm.

Meanwhile, the American Legacy Foundation stops getting MSA funding this year. The Washington, DC-based non-profit was founded as part of the MSA and got $300 million annually from tobacco marketers’ payments for five years (through 2003). Now ALF is seeking corporate partners to continue its “truth” campaign via Crispin, Porter + Bogusky, Miami (ads) and Arnold, Boston (tour). Avon Products ties its college-targeted Mark brand to “truth,” training Avon on-campus reps to give anti-smoking messages.

ALF also ratchets up cessation programs this year, testing quit-smoking ads targeting 18- to 24-year-olds in New York and Washington, DC, this quarter. “Teens have been asking us for information to quit, but cessation is a tricky thing,” says ALF COO Lyndon Haviland. “How can we reframe ‘quitting’ and make it a good thing?”

The struggle — on many levels — could intensify this year.

MSA Terms

The 1998 Master Settlement Agreement between 46 states and six tobacco companies set marketing restrictions and annual payments to states, based on tobacco firms’ market share. In all, tobacco companies will pay about $206 billion by 2025. Another 40 tobacco marketers have signed on to the MSA since 1998. About 50 or more companies have not. “They’re very hard to keep track of,” says Vermont Attorney General Bill Sorrell. “Some are very small; many are international companies that are here today, gone tomorrow, replaced by another firm.”

Florida, Minnesota, Mississippi and Texas settled independently with marketers and get separate annual payments.

Racketeering Gets August Hearing

The U.S. Department of Justice is set to go to trial in Sept. 2004 to collect $289 billion from nine tobacco companies charged with racketeering. That could bankrupt the industry.

DOJ first filed suit in 1999; that action lay fallow until it was reinvigorated in March 2003.

Judge Gladys Kessler threw out most counts in 2000, but let the RICO charge stand.

DOJ wants to impose more marketing restrictions, including:

• Abolish trade promotions and slotting fees

• Allow only b&w print ads, half with “graphic” health warnings

• Require health warnings to cover half of each pack

• Require a list of ingredients, manufacturing methods and market research

• Forbid “light,” “low-tar” and “mild” descriptors

• Require health leaflets in packs

• Ban vending machines

Tobacco companies argue that MSA restrictions are enough, and will fight the suit.

RJR’s Revamp

RJR and B&W will reevaluate marketing for their combined portfolio once they merge. In the meantime, RJR is dramatically shifting its promotion strategy. It has cut sampling, expanded direct mail and tailored retail discounts by region and by brand. Camel and Salem get more event marketing, “but not in the same fashion as before,” which was primarily bar promos, says spokesperson Carole Crosslin. (RJR discontinued its estimated $75 million field marketing and on-premise bar program in spring 2003.) Slow-growth brands Winston and Doral get regional support — primarily discounts — to squeeze profit with less spending. Consumer promotion spending has been approximately $200 million to $300 million. Trade promotion strategy shifts, too, as RJR tests different discounts to find the best price point for each brand. Last year, RJR stopped supplying merchandising fixtures for retailers, tightened its return-goods policy and revamped trade promotion programs. Going forward, RJR will focus on price, availability and in-store branding.