E-Cigs, Vapor Expected to Ramp Up Competition in Tobacco Industry

Source from:  Winston-Salem Journal 05/27/2014

The biggest outcome of a consumer shift from combustible cigarettes to electronic and vapor brands could be increased competition among the Big 3 U.S. tobacco manufacturers, a leading analyst says.

Philip Morris USA, maker of top-selling brand Marlboro, could see its overall industry market share drop from about 47 percent now to 32 percent by 2023, according to Wells Fargo Securities analyst Bonnie Herzog. The outlook combines all tobacco product sales.

Meanwhile, Reynolds American's market share is expected to be little changed from the current 25 percent, while Lorillard Inc. could jump from 14 percent to 25 percent, mostly because of the reach of its leading blu eCigs brand.

That scenario is based on a premise that Reynolds does not buy Lorillard, a potential $18 billion to $29 billion blockbuster deal that has been speculated by analysts for several months. It also is based on a premise that Philip Morris won't buy a smaller e-cig competitor, which analysts say it certainly has the money and motivation to do.

"We envision Philip Morris having 'the most to lose' and Lorillard 'the most to gain,' given our thesis that consumption of vapor products will surpass consumption of combustible cigarettes within the next decade," Herzog said.

Herzog estimated overall e-cig revenue reached $2 billion in 2013. She projects it will increase up to $10 billion by 2017.

She predicts Reynolds will have $4 billion in revenue from e-cigs in 2021, compared with $3.9 billion from conventional cigarettes. That's compared with barely any e-cig revenue and $6.4 billion in conventional cigarette revenue for 2013.

Susan Cameron, Reynolds' chief executive and president, offers a more optimistic view of Reynolds' prospects in the e-cig environment.

She spoke Friday of the "game-changing" potential of the e-cig Vuse as she announced the company's commitment to hiring at least 200 full-time employees over four years at its mammoth Tobaccoville plant.

Reynolds subsidiary R.J. Reynolds Vapor Co. plans to expand distribution nationally this summer from just Colorado and Utah, where it says it has top market share in the category.

Cameron is confident that not only will Reynolds gain significant e-cig market share with Vuse, but that it will lead to greater overall industry market share, along with its top-selling moist snuff brand, Grizzly, increasing consumer demand for its Natural American Spirit cigarette brand, and having the No. 3 and 4 traditional cigarette brands of Camel and Pall Mall.

Stephen Pope, managing partner of Spotlight Ideas in London, said the U.S. and global tobacco manufacturers have realized that e-cigs and vapors have gone beyond a trend to becoming a mainstream product.

"They realize they can no longer ignore this new element in the tobacco retailer's armory," Pope said.

"E-cigs started out as an almost unregulated back water of the industry.

"However, as the saying goes, 'there is no smoke without fire,' and on a global scale health authorities are undertaking rigorous tests into the smokeless cigarette product."

Cameron said Reynolds is studying the feasibility of selling Vuse globally, or at least in Europe, but it wants to get the U.S. distribution of Vuse in hand first.

Pope said Herzog's premise has merit given how long it has taken Philip Morris to launch its e-cig brand, MarkTen.

"The result is that Philip Morris can only see the dust that the rest of the field have kicked up into its face as they have sped off into the distance," Pope said. "So far, no sales data has been released for Indiana and one has to suspect that if Altria is finding it hard going in a sophisticated and developed market such as the U.S., Philip Morris International will find the going overseas full of tough terrain."

That said, Pope stressed to not underestimate the financial advantage that Philip Morris has over its competitors.

Frank Armstrong, owner of Blue Ridge Tobacco in Winston-Salem, said that although e-cigs remain very popular with customers, he said the vapor products, with far more nicotine liquid flavor choices, are gaining momentum.

"Vapors are growing by leaps and bounds, particularly since some offer liquids with zero nicotine up to 24 milligrams of nicotine," Armstrong said. "The advantage with the vapor products is that while a open-fill cartridge can cost between $30 and $70, the juice costs about $6.99 - the equivalent for most smokers of five packs of cigarettes."

Armstrong and analysts recognize vapor marketers may have a narrow window of opportunity as the Food and Drug Administration has begun its formal review of all products in the category.

The FDA released April 24 an initial range of potential regulations that come across as an attempt at finding common ground among public health, scientific and economic standpoints, according to analysts and advocates.

Among the main FDA recommendations are a ban on e-cig sales to underage youths, requiring health warning labels, FDA review of existing and future products and no more free samples.

However, the FDA did not call for an outright ban of e-cigs, as some anti-tobacco advocates had pushed for. It did not curtail Internet sales or current marketing efforts that include television and social media. It also is not recommending curtailing flavorings, such as candy and fruits, that anti-tobacco advocates say make e-cigs appealing to youths.

The agency could propose more regulations once approved standards are in place. Analysts warned it could take several years to get initial standards in place.

Some analysts believe the FDA will opt to limit, if not ban, open-fill vapor cartridges for public health reasons. Reynolds' Vuse nicotine liquid is in a closed setting, designed so that only its battery can be used in one of its cartridges.

"I can't speak for all of the nicotine juice makers, some of which probably do make the juice in their backyard," Armstrong said. "The ones we contract with, the ones who are in this for the long term, they are preparing for enhanced FDA regulation."

A comparison can be made that the current e-cig category resembles the traditional cigarette marketplace shortly after the large U.S. manufacturers reached their precedent-setting Master Settlement Agreement with 46 state attorneys general in 1998.

For a short number of years, discount manufacturers surfaced and flourished because they could sell their cigarettes at a lower price because they didn't have add on the MSA payment costs.

After the large manufacturers complained about the competitive discrepancy, most states responded by requiring smaller manufacturers to put potential payment money into an escrow account, cutting out much of their pricing advantage.

Herzog said traditional cigarette smokers should prepare for waves of price increases as the Big 3 manufacturers seek additional resources to expand e-cig and vapor production. "Accelerated pricing will position the major tobacco manufacturers to capture expanded profits from consumers who refuse to switch to vapor products." Herzog said.

Armstrong said that as FDA regulations are unveiled, there will be a compliance cost the smaller manufacturers will have to pass on to consumers.

That likely will take away some of the pricing difference between e-cigs, vapors and combustible cigarettes.

Herzog said investors "aren't fully appreciating" the volume adjustment component of the MSA payments, which decrease as traditional cigarette volumes decline.

"It creates an incentive for tobacco manufacturers to encourage their consumers to switch to vapor products," Herzog said.

"The MSA payments tied to combustible cigs will never be part of the vapor cost structure" since the payments were created in 1998 to help states pay for health-related expenses related to smoking.

Even if the Big 3 hold 82 percent of the projected tobacco market share in 2023, Herzog said there is "plenty ofroom" forsmaller competitors, such as NJOY, Mistic, Fin and Logic.

"We view the Big 3 as a triple threat - treasure troves of cash, distribution power at retail and superior brand building capabilities," Herzog said.

"We are particularly impressed with Mistic and NJOY's recent announcements to bring vapor products to broad national distribution at retail, which could give both companies a competitive advantage."