US: Tobacco Industry Looks to Ecigarettes for Growth

Source from:  Financial Times 06/18/2013

Demand for electronic cigarettes is booming – and big tobacco companies are hoping to get a piece of the fast growing $1bn market.

In the US, the three largest manufacturers, which control 85 per cent of the domestic cigarette market, will all be selling ecigarettes by the end of the year.

"They don't want [ecigarettes] to be their Kodak moment," says Deborah Arnott, chief executive of Action on Smoking & Health, a health group. Corporate history is piled with the corpses of giant companies, such as the US camera film company, brought down by consumers' sudden adoption of new technology – and the companies behind Marlboro and Camel do not want to be added to the heap.

Altria and Reynolds, the biggest and second-biggest tobacco groups in the US by sales, this month announced their plans to launch ecigarettes – rechargeable tubes that let users inhale vapour, rather than smoke, for a nicotine hit. In the UK, British American Tobacco bought an ecigarette start up at the end of 2012, while Imperial Tobacco, which owns the Golden Virginia brand, announced its own foray into the market earlier this year.

Tobacco executives say they have been studying demand and have decided to test the waters. "The category is in its early stages and time will tell how it will evolve," Marty Barrington, Altria chief executive, told investors in New York last week.

"It's like Betamax and VHS," says David Hayes, a tobacco analyst at Nomura. "We don't know what the preferred standard will be."

Previous attempts to get nicotine addicts to shift from traditional tobacco have been mixed. Snus – a small bag of nicotine, ingested by stuffing it under your top lip – is popular with Scandinavians but few others.

In the 1990s Reynolds introduced Eclipse, a cigarette that produced heat, but did not burn. "The knock on effect was that it tasted horrible – one of these details that's hard to get over," points out Erik Bloomquist, an analyst at Berenberg bank. Eclipse was eventually scrapped.

Ecigarettes have, so far, been an exception. US retail sales of ecigarettes could pass $1bn this year from $600m in 2012, according to Bonnie Herzog, an analyst at Wells Fargo. In the UK, there are already 1.3m users, according to ASH.

The devices are "revolutionising the tobacco industry", says Ms Herzog, who estimates that "consumption of ecigs could surpass consumption of conventional cigs within the next decade".

Not all in the industry agree. "[Ecigarettes] will be smaller than our combustible business," says David O'Reilly, who heads BAT's research arm and sits on its management board. "It will be a big category, as long as we're able to innovate," he added.

Whether or not ecigarettes will overtake traditional tobacco is a secondary concern. For tobacco executives, the fact that they provide growth in an industry where volumes have fallen steadily since 2009 is enough to pique their interest.

Reynolds' chief executive Dan Delen says ecigarettes are a category where the company expected "expanding growth to mitigate some of the volumetric decline" in traditional smoking.

Altria and Reynolds both say ecigarettes will eventually command better profit margins than their tobacco counterparts, although they would not give specific estimates. Wells Fargo estimates that margins could reach the mid-40 per cent range in another five years, compared with conventional cigarette margins of about 40 per cent.

Not all tobacco companies are as gung-ho about ecigarettes.

Philip Morris International, the world's largest tobacco group by sales, is the most high-profile ecigarette refusenik, and is instead focusing on developing a cigarette that heats rather than burns tobacco, producing less tar and smoke.

While BAT invested about £40m in its ecigarette subsidiary CN Creative, it spent £2bn on a share buyback a few months later. Imperial Tobacco, the £22bn tobacco company based in Bristol in the southwest of the UK, will not have an electronic product out until at least 2014.

The lack of enthusiasm has left some analysts perplexed, especially given Imperial's reliance on developed markets in western Europe – an area where cigarette volumes have slumped more sharply than in the rest of the world.

Time, however, is not necessarily a pressing issue. The embryonic ecigarette manufacturing sector is ripe for consolidation, with 250 operators in the UK alone. Global tobacco companies have the financial firepower to buy in to the sector once the market has settled, rather than running the risk of heading down a research cul-de-sac.

Craig Weiss, chief executive of NJOY, the US leader in ecigarettes by market share, compares the devices to the introduction of filtered cigarettes in the 1950s. "They were perceived initially to be fake and artificial," says the 39-year-old. "There was foam between you and your tobacco."

But from an initial 2 per cent of sales, filtered cigarettes came to dominate the market within a decade. He's betting ecigarettes will follow the same path, and has won over celebrity investors including Sean Parker, the Napster founder, and Bruno Mars, the pop star.

Mr Weiss argues that the big companies' entrance into the market is positive for NJOY since it drives customers into stores in search of electronic devices and raises awareness through advertising. Ecigarettes, unlike regular cigarettes, can be advertised on television in the US. "I'm not in this business to steal market share from [rival ecigarette company] Blu," he says. "I'm in this business to steal market share from Marlboro." Enditem