The Surprising Product That Will Drive Future Growth at Dollar Store Chains

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Cigarette displays only take up a small amount of wall space behind a register, but convenience stores and dollar store chains are finding they deliver big sales gains. Photo: tanakawho.

Depending on which rumor you believe, the Federal Trade Commission is either poised to approve the $27 billion merger of tobacco giantsLorillard and Reynolds American or its staff has recommended the agency sue to block the deal.

No matter which way the decision goes, there will be one winner in the deal: convenience stores. According to a recent article inConvenience Store News, the industry watchers at Management Science Associates say C-stores account for 62% of all tobacco sales volume even though they make up less than half (47%) of all the retail locations selling tobacco products.

Tobacco also accounts for a large portion of convenience store revenue, too, representing some 35.9% of all sales, though the category dropped to third in terms of profitability. There, tobacco accounts for 17.3% of profits, according to The Association for Convenience and FuelRetailing.

The decline in profitability was actually due to cigarette sales, which have a lower gross margin (13.5%) than those of other tobacco products (29.3%).

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Convenience stores like 7-Eleven have been a big beneficiary from the decision by CVS Health to stop selling cigarettes, but there may be a bigger competitor on the horizon. Photo: Mike Mozart.

Stubbing out growth
But convenience stores should be looking over their shoulder because their dominance might not last much longer. Ever since CVS Health announced it was prohibiting tobacco sales at all of its 7,800 drugstores, tobacco customers have been streaming away to buy their smokes at a new spot: dollar stores.

The pharmacy reported that because it stopped selling tobacco, its front-end comparable store sales tumbled 6% in the first quarter and would have been 800 basis points higher had it still sold cigarettes.

While tobacco retailers are generally gaining as a result of CVS' decision, deep discounters seem to be doing best. Management Science Associates said dollar stores only make up 5% of the retail store base selling tobacco, and just 1% of the volume, but their total volume jumped 42% year over year.In comparison, convenience stores volumes rose just about 1% last year.

Don't discount the opportunity
Part of the reason for the volume spike is that dollar stores only began stocking cigarettes and tobacco products in recent years. They're starting from a much smaller, almost negligible base. Leading dollar store chain Dollar General , for example, only started selling tobacco products in 2013, and not even at all of its stores, but the company is finding tobacco products are driving more frequent trips by existing customers and attracting new ones.

The introduction of tobacco was largely responsible for Dollar General's increase in sales and gross profit in 2014, even as it caused the gross margin rate to narrow. Revenue rose 8% last year to $18.9 billion while gross profit spiked by nearly 7%. Dollar General is looking forward to tobacco driving further increases in customer traffic that should lead to higher average tickets at checkout.

That's what Family Dollar also found after it began selling tobacco in 2012. While tobacco has helped to increase sales, the lower margins pressured the troubled retailer's profits. Still, as one of the first dollar store entrants into the market, it reported earlier this year that tobacco sales helped it grow its market share to 4%.

Tobacco giants will remain profitable regardless
Lorillard and Reynolds American have two of the most popular brands on the market in Newport and Camel, respectively. Whether they're joined together in a new powerhouse tobacco company or remain independent under their current owners, they'll continue to drive the gains of the cigarette companies and the outlets that sell them.

Newport is Lorillard's flagship brand; the tobacco giant reported last month the menthol cigarette increased its retail market share to a record 13.3% in the first quarter and had a 40.7% share of the menthol market. Reynolds reported Camel had a 10.1% share of the cigarette market and together with its sister brand Pall Mall, owns nearly a fifth of total retail share.

Altria's Marlboro brand remains the industry heavyweight, with a 44% share of the entire cigarette market.

Lorillard's blu eCig may be losing market share, but the electronic cigarette helped usher in a new era of nontobacco product growth. Photo: Lindsay Fox.

But tobacco products beyond cigarettes might be where dollar stores and even C-stores see the greatest growth.

Up in smoke
Family Dollar noted that adding other tobacco products, or OTPs, and new national brands to its stores produced the increase in comparable-store sales last quarter. While comps only rose 0.5% from the year-ago period, that was the biggest increase such sales enjoyed since the dollar store chain's fiscal third quarter in 2013. The consumables section they occupy enjoyed 4.6% growth in the quarter and represented 72.3% of total net sales compared to 71.1% a year ago.

The Association for Convenience and FuelRetailing saidthat unlike the declining cigarette market, other tobacco products are enjoying growth and broader profits. Comparable sales of OTPs were up 4.9% in 2014, with a 1.3% increase in margin percentages. Look for smokeless tobacco, cigars, and electronic cigarettes and personal vapor systems to maintain this momentum.

Convenience stores are smoking the competition when it comes to sales of tobacco and related products, but this is the new growth category for the dollar store chains regardless of what happens with the megatobacco merger.

The article The Surprising Product That Will Drive Future Growth at Dollar Store Chains originally appeared on Fool.com.

Rich Duprey has no position in any stocks mentioned. The Motley Fool recommends Apple and CVS Health. The Motley Fool owns shares of Apple. 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.