<strong>China Set to Lose Some E-cigarette Production</strong>

Source from:  Nikkei Inc. (jp)  07/29/2014

These should be good times for makers of electronic cigarettes. Global sales have surged from almost nothing in 2008 to around $2.2 billion today, and are expected to keep growing at double-digit rates for years to come. Some forecasters, such as Bloomberg Industries, even expect "e-cigarettes" to overtake traditional cigarettes within a decade.

The importance of e-cigarettes was further underscored when R.J. Reynolds Tobacco merged with Lorillard Tobacco in July and in the process, sold several of its brands to Britain's Imperial Tobacco Group for $7.1 billion. It is widely believed that Imperial Tobacco would not have agreed to deal unless it included Blu, Lorillard's bestselling e-cigarette brand that commands around 45% of the US e-cigarette market.

The e-cigarette was invented in China around a decade ago and the vast majority of manufacturers are still located there. Shenzhen alone produces around 95% of global supply, thanks to scores of small and midsize manufacturers.

Yet the future of Chinese e-cigarette production has recently been called into question. Quality concerns and the prospect of tougher regulation in the U.S. and Europe have enticed some companies to shift production to developed countries, especially the U.S.

These moves come a time when several big companies, including U.S. giants Apple and Whirlpool, have taken similar steps to "re-shore" manufacturing -- moving it back to the country of origin -- as the gap between U.S. and Chinese production costs narrows.

In April, the U.S. Food and Drug Administration proposed regulations that would require companies marketing e-cigarettes in the U.S. to undergo a "premarket review." Such reviews are designed to ensure that companies closely monitor how their e-cigarettes are manufactured.

"A lot of U.S. (e-cigarette) companies would just order products from China and didn't necessarily know what they were getting, and weren't necessarily monitoring quality," said Bryan Haynes, a Washington, D.C.-based attorney at Troutman Sanders who represents e-cigarette firms with the FDA. "In an FDA-regulated environment, you absolutely have to know what you're getting, and you absolutely have to be on top of basic quality and efficacy."

Regulation is one reason a few e-cigarette companies have already moved production to the U.S., and several more in the industry are talking about doing likewise, said Haynes. Onshore manufacturing helps to speed the premarket review, in part because companies can more reliably control the amount of nicotine in each e-cigarette.

Quality also plays a role. A recent survey conducted by Bonnie Herzog, an analyst at Wells Fargo Securities in New York, found that American consumers prefer e-cigarettes manufactured in the U.S., which are considered better and safer than those made in China.

Two American e-cigarette makers, Mistic Electronic Cigarettes and White Cloud Electronic Cigarettes, announced in April that they would move production to the U.S. Adding to the shift are big tobacco companies such as Reynolds, Philip Morris International and others, which prefer to make e-cigarettes for the American market in the U.S.. As these companies gain market share, the proportion of e-cigarettes made in the U.S. will edge up.

However, others are skeptical that re-shoring will take off.

"It's just not going to happen," said Rick Sharpe, a distribution consultant with Beijing Greenworld Technologies, one of the few Chinese e-cigarette producers that also retails in the U.S., where it uses the brand name Red. He said that while some companies might establish small final assembly plants in the U.S., or move manufacturing to Mexico, full production in the U.S. was not feasible for most players in the market.

"They're not coming to the U.S. because it doesn't make financial sense," said Sharpe. "You can't do it. You can't compete against the Chinese on this."

Rather than full-scale re-shoring, analysts say a more likely upshot of regulation will be consolidation, both among Chinese manufacturers and e-cigarette brands. Only big companies have the capacity to undergo expensive and time-consuming premarket reviews, or to comply with strict manufacturing rules.

The industry has already seen a recent flurry of takeovers, even before Imperial Tobacco acquired Blu. Lorillard, Blu's seller, bought Skycig, another e-cigarette brand, in October 2013. In June, Philip Morris bought one of the U.K.'s biggest e-cigarette brands, Nicocigs, and Japan Tobacco acquired Zandera, the British maker of the E-Lites brand, both for undisclosed amounts. Earlier in the year Altria Group, which makes Marlboro cigarettes, acquired Florida-based Green Smoke for $110 million.

On the production side, Shenzhen is filled with small, fly-by-night e-cigarette manufacturers, but few in the industry think that will last. Rumors suggest that large China-based manufacturers, especially Taiwan's Foxconn Technology Group, will soon move into e-cigarette production with an eye towards cutting costs and consolidating the market. Foxconn could not be reached for comment.

"People coming in (to Shenzhen) to hand-assemble e-cigarettes with a bunch of employees -- that's coming to an end," said Erik Bloomquist, a tobacco industry analyst at Berenberg in London.

Manufacturing is also likely to stay in China because the country's consumers could provide juicy opportunities down the road, said Bloomquist. China has around 320 million smokers; even if only 1% to 2% of those "convert" to e-cigarettes, the market would be enormous.

Data on how many e-cigarettes are sold in China is patchy, but they have started popping up at upscale venues in big cities. Parlor, a chic bar in Beijing's Sanlitun district, is one of a handful of places that have been hosting e-cigarette "tasting" parties. Its recent event drew around 30 people.

"It's getting more and more popular," said Jeff Li, the bar's owner. "Young people think it's fashionable."

However, Shane MacGuill, a tobacco industry analyst at Euromonitor International, said e-cigarettes were unlikely to expand much outside China's yuppie circles for at least another 5-10 years.

In the U.S. and Europe, the popularity of e-cigarettes has surged in part because they are price-competitive with traditional cigarettes and can be smoked in public places, such as bars and restaurants, where the regular variety is banned. Government-funded health campaigns to publicize the dangers of cigarettes have also pushed smokers towards less unhealthy alternatives such as e-cigarettes.

None of these conditions apply in China. Traditional cigarettes are cheap and can be smoked in most public places. Moreover, the state has a monopoly on the domestic tobacco market, which in a typical year contributes between 6% and 7% of government revenues. This conflict of interest goes some way towards explaining why few public health campaigns either combat smoking or encourage e-cigarettes.

Until regulators decide to change course, analysts say that e-cigarettes are unlikely to gain much traction.

"In order for electronic cigarettes to really start growing in China, it would need significant input from the Chinese government," said MacGuill. "And there's no evidence that that sort of buy-in is likely to happen in the near future." Enditem