Should Investors Bet on E-Cigarettes?

Cigarette smoking in developed countries like the U.S. and Western Europe has been in decline. E-cigarettes have been identified by tobacco companies as a big opportunity for business growth. How much potential is really there? Should investors bet on this up-and-coming segment of the industry?

Image source: US Food and Drug Administration.

The evolution of nicotine consumption

Since 2005, the percentage of smokers in the U.S. has dropped from an estimated 25% of the population down to 19%. The trend has been similar in other developed markets. North America and Western Europe made up 20% of the global cigarette market in 2005, but that figure has dropped to 14%.

There are numerous reasons for this, including better education on the health risks of smoking and tighter governmental controls on marketing and consumption. The tobacco industry has continued growing nonetheless, offsetting fewer smokers in the developed world with higher product prices and an increase in smokers in developing markets like Asia, the Middle East, and Africa.

While cigarette use has started to shift away from the world's wealthiest nations, they still provide opportunities for tobacco companies. After its invention in China in 2003, the e-cigarette made its way into the U.S. and Europe, helping to offset the decline in cigarette consumption.

Why do people switch or start using e-cigs? Respondents to surveys cite numerous reasons, including the ability to smoke inside, fewer adverse health effects, quitting the use of traditional cigarettes, and the availability of different flavors.

Some of the reasons respondents gave -- like being able to smoke inside and a purported reduction adverse health effects -- may change with increasing government regulation and health studies. But vaporized nicotine products are nonetheless on the rise and have been picked up by the tobacco industry as a future driver of growth.

Current trends in the e-cig business

The e-cig industry is still small. Total sales in the U.S. were about $800 million in 2014. Compare that to the traditional tobacco market, which generates revenue in the tens of billions each year in the United States. Marlboro seller Altria (MO 2.20%) alone generated $22.7 billion from cigarette sales alone in 2015.

Though a small percentage of smokers regularly use e-cigs, the number is growing. An estimated 3.7% of adults in America regularly use e-cigs, with about 12% reporting that they've tried them at least once. While this is a small percentage of the population, it still translates into millions of customers just in the United States.

That figure makes a dramatic jump to 16% and 5.3% of high-schoolers and middle-schoolers, respectively, that reported regular use of vaporizers last year. Users of the products were virtually non-existent five years ago. This makes electronic smoking not only a fast-growing industry, but also by far the most popular nicotine consumption method among the youngest part of the population.

The industry also cites the high percentage of smokers who say they would like to quit as a reason to be excited about e-cigs. Survey data reveal that 58% of smokers say they would like to stop using cigarettes and view electronic smoking as an alternative.

An action plan for investors

Despite the hoopla surrounding e-cigs, there are limited opportunities available to invest in this segment of the industry. Outside of a few very small but unprofitable companies that do nothing but sell e-cig products, investors are left with the major tobacco companies to choose from.

E-cig sales barely show up on the revenue radar at this early stage, but Reynolds American (RAI) is in the driver's seat in the U.S. market with its Vuse brand claiming over a third of sales. Imperial Brands holds second place in the US with its blu brand. Philip Morris International (PM 2.57%), the world's largest independent tobacco company, recently unleashed its iQOS e-cig in Japan to test the international viability of non-combustible inhaled products.

For those bent on buying into the business, I would start with one of the big tobacco names. Quick to recognize a possible change in trends, all of the world's major tobacco companies have developed a vaporized product of some sort to mixed results. But is it really worth investing in?

While the growth of the e-cig business in its first decade of existence has been staggering, industry hopes for future growth have been tempered as an increasing focus on potential health and safety concerns and government regulation complicate the picture. Just as traditional cigarettes have drawn fire from the concerned non-smoking public, e-cigs are inevitably headed toward the same fate.

Also worth noting is that while the growth got off to a quick start, the industry is still minuscule when compared to the tobacco industry overall. The trend of increased tobacco use ended several decades ago, being supplanted by slowing international growth and shrinking sales volumes in developed markets. While e-cigs are on the up-and-up, they look to be a good way for tobacco companies to replace lost business rather than to boost top-line sales.

So should investors bet on the e-cig business? With few viable "pure-play" options available, I think the answer is no. Tobacco companies will certainly take advantage of the growing industry, but it will be to replace lost business and stagnating sales from declines in cigarette use.