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PRIC;E/VALUE CIGARETTES AN ANALYSIS OF SALES AND DEVELOPMENT Prepared By: R. J. Reynolds Tobacco Company USA, Inc. January, 1987

CONTENTS PAGE SECTION 1 I Overview of the Price/Value Segment 5 II Company Performance 6 III Sectors Within Price/Value 9 IV Pricing and Profitability 11 V Demographics of Price/Value Smokers 13 VI Food Store Development APPENDICES Appendix A Price/Value Market Shares Appendix B Price/Value Categories

I. OVERVIEW OF THE PRICE/VALUE SEGMENT " Although most consumers and many retailers were unaware of it, there have been discount labels in the market throughout the history of the cigarette industry. Examples include: Shop-Rite, which was a big seller in some New Jersey stores in the early 1960's; Vello, which Liggett sold for "5f less per pack, 50¢ less per carton" in the 1970's; and trrands from minor manufacturers, such as Larus Tobacco's Marvel and Domino brands in the 1950's. These labels, however, had low presence and only spotty availability in limited areas or stores with a heavy discount emphasis. The emergence of today's Price/Value segment really began in 1980, as Liggett began manufacturing black and white generics, which they later rolled national in 1981. • 1980-1982 In 1980, Ligqett began soliciting contracts for large supermarket chains and distributors to carry their non-menthol 85mm black and white generics. In June, 198]., Liggett introduced 3 new styles and began their national : expansion. Ety year end, Liggett claimed 70% distribution for their generics and consumer studies indicated that more than half of all smokers were aware of generics' availability. Market share for 1981 ~ reached .5%. In 1982, Ligqett introduced two ultra low "tar" styles, and exited the year with total sales of 17 billion units and a market share in excess bf .9%. • 1983 was a key year in the development of Price/Value for two reasons: 1. The Federal Excise Tax (FET) on cigarettes was doubled from 8¢ to 16¢ per pack„ pushing retail prices up sharply at a time when many consumers• were still feeling the effects of an economic recession. This FET increase, combined with sizeable tax increases in 14 states, caused retail cigarette prices to jump by about 20% from 1982 to 1983. Consumer price sensitivity cost the industry about 5% in total volume and spurred generics from 1% to nearly 3% of total industry sales. This share increase, however, was accompanied by the explosion of 140 new generic/Private Label styles into the market. 2. Brands without the "generic look" entered the Price/Value market, ringing the concept of direct manufacturer marketing to the segment, and creating a third major tier in cigarette prices. RJR's CENTURY 25's, introduced in July, 1983, was the first brand to break ground in this area, reaching a .4% SOM for the full year despite being available in only 33 states. RJR also took the initiative to work with the other 17 states to revamp tax laws to accomodate 25-packs. (Some laws would have taxed 25's at double the 20-pack rate.) It was not until 1985, however, that all tax laws were finally updated. 1

Richland 25's (B&W) were also introduced in late 1983,_but remained in limited areas and below a .1% SOM until the middle of 1985. As shown below, CENTURY's contribution, layered onto the FET-spurred growth on generics, yielded a total Price/Value market share of 3.3% for 1983. TOTAL PRICE-YR1E 'SFGM£M 6T. 80M AT OOrBI'ER LEVEL S. 4.~ 3.-~ 2." i. 0. • 1984 also held two key events. 1. B&W entered into the generic/private label business, offering Liggett serious competition from a major manufacturer for the first time. B&W's overall stronger position in the marketplace allowed them to make rapid inroads into Liggett's generic business, but did little to expand total sales of generics/private labels. In fact, total ' generic/Pl_ SOM growth slowed in 1984, signaling their eventual decline due to competition from new Branded Price/Value entries. 2. In April, 1984, RJR repositioned DORAL, a brand with years of "low tar" heritage, to be sold at a parity price with generics. DORAL was an immediate success, reaching a .8% SOM by the end of 1984, after only 8 months in market. ' Since DORAL's entry, generics/private labels have been at a serious disadvantage in the market. As industry analyst Jeffrey Weingarten said, A smoker can pull out his cigarettes 20 times a day, and he wants them to say something positive about him. A plain white package with stark lettering reading only "Cigarettes," as many generic packages do, does not say much about the smoker except that he is ,unwilling or unable to spend much money on smoking. 2

DORAL also upgraded merchandising for the entire segment, offering an attractive Saving Center program which gave identity to the segment at retail. - _ • 1985 Competition between B&W and Liggett for generic/private label business was intense in 1985, as they battled for market share using trade incentives and rebates, on-carton coupons and price-off stickers, and various lawsuits and counter suits. This competition culminated in B&W's takeover of Liggett's GPC label, marketed by Generic Products Co. (Fort Worth). Another Liggett effort in 1985 was the introduction of Stride Deluxe Blend, a"mid-priced" entry intended to sell for $1 less per carton and 10¢ less per pack. Stride followed in the footsteps of Bronson, a similarly priced private label introduced in 1984 for Quiktrip (Oklahoma). Both of these brands, as well as tiny Park Avenue Tobacco's mid-priced West, Delta, and Astor brands, held virtually no interest for consumers, who could get the same benefits at a lower price with DORAL. Both Stride and Bronson were ultimately reduced to the generic price level, but were too late to reap any significant sales benefit. In mid-1985, B&W converted Richland from a nine-pack to a ten-pack carton, still priced at parity to standard brand cartons, and rolled the brand out nationally. Backed by a large quantity of pack promotions (which had been rare within Price/Value), Richland 85's rose to a .5% share for the 1985 year. • 1986 Early 1986 was distinguished by Philip Morris' entry into the Price/Value arena. According to Business Week, "the decision to come out with low-priced brands represented a major setback for PM, which had hoped to stick exclusively with its high-margin name brands." PM's first entry was Players Lights 25's, a "spin-off" from their black-pack "upscale" brand. Players Lights 25's started as a mid-price proposition, with an 8-pack carton priced to sell for "$1.50 less" than standard brand cartons. Dampened by CENTURY's conversion to a ten-pack carton and continued promotions behind Richland, Players 25's share peaked early and slipped to a .4%. In an effort to be more competitive with CENTURY and Richland, Players 25's were converted to a ten-pack carton in September, 1986. In April, 1986, PM repositioned its Cambridge label to compete with DORAL and generics. This involved discontinuing three of the brand's "ultra low tar" styles, repricing the fourth, and adding 4 more "lights" styles. Since DORAL continued to grow at the rate of .8 share points per year, PM maintained constant promotions behind Cambridge to enable it to reach a .5% SOM for the 1986 year. Finally, in June, 1986, PM moved into the generic/private label business, by taking over Liggett's Best Buy label and making presentations to the trade on its black and white "All American Value" line. 3

_B&W continues to explore the branded Price/Value market, wiirh a rollout - of generic-priced Falcon into 179'% of the U.S. and test markets on Kim (a female-targeted Value 25) and g2-off pricing on Belair and Viceroy. This $2-off strategy is similar-to American Tobacco's handling of Lucky Strike, whose filter styles have been continuously discounted since 1984 but are not "officially" considered Price/Value styles. TOTAL PRICEIVALUE EST. SOM AT CONSUMER LEVEL 15 .'. ZA ... ~ 10 ~ ~ a 2 ~ 0 0 1981 1882 1983 1,984 1985 1886 Total Price/Value 19 1983 1984 ' 1985 1986 Share of Market .9% 3.3% 5.5% 7.3% 8.9% Number of Styles 8 160 190 230 280 Snare trends for Price/Value brands and sectors are summarized in Appendix A. 4

l.I. COMPANY PERFORMANCE - • RJR has become the leading company in Price/Value, with a 33% share of the segment's sales, which is comparable to the Company's total market share. This reflects continued strong growth on both DORAL and CENTURY. • Liggett, with two-thirds of its total business tied up in generics and private labels, has been hard-hit by the-growth of branded Price/Value entries and qeneric competition from B&W and PM. The company has slipped-- from a 73% share of Price/Value sales in 1984 to only 29% in 1986. • B&W continuedi to show growth versus the segment in 1986, primarily due to Richland (which was rolled out in 1985). Currently, however, both Richland and B&W generics are trending flatter than in previous years. Overall, B&W is about holding its share of Price/Value at 27%. • Philip Morris' nine branded and sixteen generic/private label styles accounted for 11% of total Price/Value sales in 1986. • American has no official Price/Value entry, although Lucky Strike is continuously discounted. ATC is also beginning test markets on Malibu, a new brand, at both generic and full price levels. • Lorillard has no entry in the segment and no apparent plans of making one. - Share of Price/Value Sales by Company Share Point Versus 1982 1983 1984 1985 1986 1986 Vs. 85 R. J. Reynolds - 11% 19% 26% 339'. + 7 Liggett 100 88 73 47 29 -18 Brown & Williamson - 1 8 24 27 + 3 Philip Morris - - - 2 11 + 9 American - - - - - - Lorillard - - - - - - 5

III. SEC-TORS WITHIN PRICE/VALUE Based on market observation since 1983, competition for Price/Value business tends to fall within two dist-inct-sectors, or clusters of Price/Value labels. These two sectors are: • The Generic-Priced Sector • Value 25's All efforts to create a third "Mid-priced 20's" sector have failed, although a few minor labels are still in the market. Generic-Priced Sector This sector is composed of two distinct parts -- a group of Generic-Priced Brands and the highly fragmented group of black and white generics and private labels. These groups have a very different character in that manufacturers have given their Generic-Priced Brands a level of distribution, packaging, point-of-sale, and promotional support quite comparable to standard cigarette brands. Also, for both DORAL and Cambridge, there is an element of "heritage" associated with a quality brand history. On the other hand, generic and private labels have very localized distribution and run somewhat counter to the smoker loyalty which has traditionally characterized the cigarette indust'ry. (For example: Smokers cannot be certain that the product in a black and white pack is the same.one they have been smoking.) In terms of market share, however, all generic-priced products have clearly been competing for the same base of smoker business. The Branded group is clearly the winner in this competition, providing smokers with a full range of brand benefits and quality perceptions and gradually driving generics from the market. Branded Generics have captured the growth trend which was seen on generics and private labels in the early 1980's, by drawing business from both existing generics and from brands outside Price/Value. mfxlc Ra® ScroR Esr. SOM AT aorsM LEVM 0 0 0 No -6-

Although the large number of generics and private labels make i.t difficult to obtain precise data across the total U.S., our best estimates indicate that most of the decline in generics/private labels is confined to the generics themselves, while private labels are holding share or showing very slight growth. Share Point Versus 1983 1984 1985 1986 1986 Vs. 85 TOTAL GENERIC-PRICED MARKET SHARE 2.9% 4.7% 5.9% 7.0% +1.1 Branded - .4 1.2 2.6 +1.3 Generic/PL 2.9 4.3 4.6 4.4 - .2 Generic NA NA 3.8 3.4 - .4 Private Label NA NA .9 1.0 + .1 NOTE: May not add due to rounding. Share of Total Generic-Priced Sector 1983 1984 1985 1986 TOTAL GENERIC/PL 100% 92% 79% 64% Liggett 100 85 56 37 Brown & Williamson - 8 23 26 Philip Morris - - - 1 BRANDED GENERICS - 8 21 38 ora - 8 21 30 Cambridge - - - 8 Falcon - , - - * *Less than .5%. NOTE: May not add due to rounding. Value 25's Value 25's have only recently merged into a uniform price and package structure. Today, all have 10 x 25-pack carton configurations and offer consumers about a 20% savings versus standard brands. In general, all of the value 25's brands are on slower growth trends than the Branded Generics. Overall, the Value 25's and Generic-Priced sector appear to appeal to different smoker groups and show little competitive interaction. 7

Although market share for Value 25's was slightly lower in late 1986 than earlier in the year, this primarily reflects differences in the level of promotions behind these brands. CENTURY's market share trend continues to outperform all other brands in the sector. 1984 1985 1986 TOTAL VALUE 25'S MARKET SHARE .5% 1.3% 1.9% CENTURY .7 .7 .9 Richland .1 .5 .6 Players Lights - .2 .4 NOTE: May not add due to rounding. 8