E-cigarettes are about to Change the "Tobacco" Market beyond Recognition (Part I)

Source from:  Tobacco Reporter  08/12/2013

The revolution is coming. What was once considered a fad is edging out its chunk of tobacco's $90 billion-plus U.S. retail sales. Experts say it won't take long for e-cigarette consumption to overtake sales of traditional cigarettes in the United States. In fact, if what's being predicted is true, e-cigarettes could change everything we thought we knew about using tobacco.

Bonnie Herzog, senior analyst and managing director of tobacco, beverage and consumer research at Wells Fargo Securities, recently predicted that e-cigarettes would impact sales of traditional cigarettes faster than any product in the history of tobacco. "Consumption of e-cigs could surpass consumption of traditional cigs in the next decade," says Herzog.

Five years ago, experts would have laughed at such speculation. But, today, when a leading analyst predicts that e-cigarettes will overtake their tobacco cousins within 10 years, you have to listen. Even more compelling, other industry analysts and company heads think Herzog may not be giving e-cigarettes their due. Craig Weiss, president and CEO of NJOY, a leading, trademarked e-cigarette company in the U.S., thinks Herzog is "very conservative" with her predictions about the category. Weiss doesn't believe it's going to take 10 years

Kevin Frija, CEO of Vapor Corp., a leading distributor and marketer of e-cigarettes, said that, originally, the big-gest misperception about e-cigarettes was that they wouldn't last. And it's not hard to imagine why many people in the tobacco industry would have thought so. Tobacco cigarettes are comparatively cheap, easy to produce and fun to smoke, while the first e-cigarettes were clunky, expensive and unreliable.

The early e-cigarette "was about the size of a large ballpoint pen, and it was hard to the mouth and didn't work very well. So it seemed like a gadget or a fad," says Frija. The technology has come a long way, however, and Frija believes e-cigarettes are here to stay.

Proponents say e-cigarettes eliminate the negative aspects of cigarettes, while still allowing users to "feel" as if they are smoking. E-cigarettes give smokers the social experience they are used to, and love. To top it off, e-cigarettes are already much less expensive than traditional cigarettes and are  getting cheaper.

With the e-cigarette market growing from $20 million in 2008 to a projected $1 billion in 2013, traditional cigarette producers have no choice but to take notice.

The e-cigarette evolution

While sales of e-cigarettes have taken off only recently, their concept has been around for some time. Herbert Gilbert developed "a smokeless nontobacco cigarette" in 1963. His patent describes a method of "replacing burning tobacco and paper with heated, moist, flavored air." With no nicotine, smokers of Gilbert's device pretty much smoked flavored steam. The product quickly fell into obscurity. However, it deserves a mention because, due to the length of time that has passed, Gilbert's patent is no longer protected by the U.S. Patent and Trademark Office. This could have an impact on litigation relating to the design of e-cigarettes.

The modern-day e-cigarette was invented in 2003 in China by pharmacist Hon Lik. The following year, Hon was the first person to manufacture and sell such a product, first in the Chinese market and then internationally. E-cigarettes started showing up in the U.S. in 2007. The company Hon  co-founded, China-based Ruyan (now also known as Dragonite), has since registered patents in the U.S. and more than 50 additionalcountries. Currently in the U.S., there are dozens of brands of e-cigarettes as the category is still new, quickly growing and highly fragmented.

An e-cigarette, in its basic form, comprises a cigarette replacement, delivering nicotine in a water-based vapor, containing a lithium battery, microchip, atomizer and ingre-dient cartridge. Some companies also offer flavors, such as clove, peach and strawberry, which are banned for regular  cigarettes, according to the Tobacco Vapor Electronic Cigarette Association (TVECA).

The most common ingredients in e-cigarette vapor include:

plant-based nicotine
water
flavoring, including tobacco, menthol and/or fruit
propylene glycol, which creates the smoke-like vapor and suspends flavoring
vegetable-based glycerol/glycerin, a sweetener and  preservative, also used to create vapor
cotinine, ethanol, acetylpyrazine, guaiacol, myosmine, citric acid and vanillin have been found in some products

Both propylene glycol and vegetable-based glycerol/ glycerin carry a "generally regarded as safe" (GRAS)  status with the FDA for use in food, but they have not been  evaluated for smoking. The FDA initially indicated concerns about these substances being smoked, which is the reason behind most of the controversy surrounding the devices. These ingredients are commonly used because they are good solvents as well as emulsifiers, according to the TVECA. They also have low vaporization temperatures and therefore enable "e-juice" to turn into gas at lower temperatures. Propylene glycol has been added to various pipe tobaccos for some time, although pipe smokers don't typically inhale. This fact could influence the direction the FDA takes towards regulating smoked/heated propylene glycol.

The e-cigarette has improved greatly with advancements in design, materials and technology since its introduction. Today's products are nearly one-third of the size and weight of those first ballpoint-pen-type products. Another challenge for e-cigarette developers was the firmness of the tip. Users often complained about the hard feeling while "puffing" on the product. The mouthpieces are typically made of a hard metal or plastic tube. There were also issues with battery life,  as well as some reports concerning fires that started while the device was charging. One user reportedly had an e-cigarette explode in his mouth.

Many manufacturers have addressed the firmness issue. Vapor Corp. has filed a patent for a soft, padded filter, according to Frija. Battery life and size have improved with each ensuing generation, allowing for the product to become safer and more life-like. Also, Swisher International recently released a soft-tip e-cigarette with the look and feel of a  traditional cigarette. If the e-cigarette continues to mimic the traditional cigarette ever more closely—while still delivering nicotine in a way that provides the sensation of smoking— the product's future could be even brighter than experts  currently expect.

Jumping onboard

As of January 2013, there were 2.5 million e-cigarette users in the U.S. Sales amounted to $500 million in 2012, according to the TVECA. While those figures pale against those of the U.S. tobacco industry—45 million smokers and $90 billion-plus in sales—the e-cigarette category has been growing  exponentially. "If we only gain 10 percent of [tobacco's]  $90 billion business, that's a $9 billion industry over the next 10 years," says Frija.

Vapor Corp.'s revenue alone grew from $800,000 in the year before going public to $16 billion last year. "Our gross profit margins are in line with most of the big tobacco  companies, at around [a] 40 percent gross profit margin," says Frija. "We believe we'll be able to sustain that going forward."

Perhaps the biggest proof of e-cigarettes' staying power is the interest shown by the traditional tobacco industry: Nearly every tobacco company is moving into or plans to move into the market. In 2011, British American Tobacco set up its Nicoventures subsidiary to develop alternative, nontobacco products, but it has not confirmed if it's currently working on e-cigarettes. Lorillard purchased blu eCigs for $135 million in 2012, and market leader Altria recently announced plans to roll out its own e-cigarette in the second half of 2013. "There is no denying that adult tobacco consumers have shown some interest in [e-cigarettes]," said Altria CEO Marty Barrington.

With their extensive distribution networks and substantial resources, the tobacco companies could potentially become a lot bigger than the current players in the e-cigarette segment. However, it's unclear whether the big companies will allow e-cigarettes to overtake their principal product: tobacco.

Andrew Kieley of Deutsche Bank says that while  e-cigarettes are too small to threaten tobacco sales now, their growth raises important questions for Big Tobacco.

"While the segment is too small to pose a near-term risk to tobacco or significantly change our estimates, it already has 2–3 million users, and it is not unreasonable that $300–$400 million could grow to [more than] $1 billion over time," he says.

Kieley also reminded investors that the larger tobacco  companies are not historically averse to buying into new  product categories instead of developing their own. Depending on how long they wait, it could be easier to purchase a leading  e-cigarette player at not-too-onerous a price.

"And since the real key to success is a superior product, [merger and acquisition] seems more likely if there is an inde-pendent company with advanced design, a proven sales foot-hold and strong [intellectual property] protection," he says. "[Reynolds American] has expressed confidence here, and we note that [Altria] has previously rejected acquisitions in a belief that internal development will yield superior products."

Frija believes Lorillard is on the right track and says that any company unwilling to board the e-cigarette train will be left at the station. "When they're looking to purchase a  company like Lorillard did, they're not only buying the brand, but they're buying the team—a dedicated team, to continue the core business of the electronic cigarette, that can focus  on the day-to-day, stay ahead of the curve of all the competi-tion," he says. "And, ultimately, if they don't do that, I think they're going to go the way of companies like Kodak in the camera business."

Kieley thinks the risks to entering the e-cigarette segment are minor. The strategy is relatively low-cost, he says, and should not carry anywhere near the litigation risk of the  traditional cigarette business. "The main risk is that the  category stalls, that significant health/safety issues emerge,  or FDA regulation becomes very disruptive," he says. "We also don't want to get starry-eyed about the commercial opportunity. There is reason to believe e-cigarettes will gain traction, but there is also a long history of 'breakthrough' tobacco flops." Herzog says that she believes e-cigarettes will eventually become bigger than tobacco, "especially given the rapid pace of innovation and consumers' demand for reduced-harm products."

FDA's game-changing card E-cigarettes are widely believed be less harmful than traditional cigarettes because they don't involve combustion. The chemi-cals commonly used to make e-juices—propylene glycol and plant glycerin—have been tested by the FDA and found to be safe for human consumption. Furthermore, the chemicals are used in many other products used by human beings, including medicine, cosmetics, cleaning products, creams and lotions. The two substances are easily broken down by the body into harmless compounds, according to the FDA. Although they carry the GRAS status, the quantifier here is these products have not been tested for smoking or inhaling, although they have been used in some pipe tobaccos for decades. The out-come of such studies could determine the path the FDA takes toward future regulation. Enditem