Lorillard's Feeling blu

Now is not the best time to be a cigarette maker. Domestic consumption is down, health consciousness is up, and the American market is melting. So instead of melting, maybe it's time to vaporize; Lorillard's (NYSE: LO  ) latest acquisition is a shift toward new products that aren't the traditional paper-and-tobacco offerings of the sector. Will that strategy catch fire or go up in smoke?

Got a light? I mean, a charge?
Tucked into Lorillard's quarterly earnings release was the interesting news item that the company had bought, for $135 million, blu ecigs. What's novel about the acquisition is that blu is a line of electronic cigarettes. These work by vaporizing a liquid solution into a very thin, tobacco-flavored mist, which is inhaled by the user. For those who like a little banana or vanilla mixed with their 'bacco, accessory flavor cartridges are also available.

Unlike the many studies damning the health effects of traditional cigarette smoking, the jury's still out on e-cigarettes. Some research may indicate the electronic butts are nearly as damaging as the tobacco variety, while others figure the risk is more minimal. E-cig firms are careful how they market their goods -- they don't challenge findings that e-cigs might serve as a means for users to wean themselves off traditional cigarettes. Of course, the Lorillards of the world would rather have these users as regular, steady customers -- lifetime e-smokers, if you will.

Hoping to fire up some growth
So essentially, Lorillard is making a $135 million bet that e-cigarette consumption will at least gain some acceptance from American smokers. That'll take some good marketing -- although e-cigarettes somewhat replicate the analog experience, they're just not the same. And they're higher maintenance too; like a cellphone, an e-smoke requires sufficient charge in order to function properly.

So they could be a tough sell simply based on the extra maintenance required, but in order to grow on the domestic market tobacco companies have few better options. Regulatory scrutiny is high, laws are strict, and these days it's basically a stigma to smoke traditional cigarettes. Because of this, American consumption has dropped, from 24.4% to 20.1% of the adult population in only the five years from 2005 to 2010. Thanks to extremely inelastic demand (easy when your customers are essentially addicts) and modest input costs, cigarette manufacturing in America is still a lucrative business. It's just not one with a bright future.

That's the big problem faced by Lorillard, as well as its bigger rivals Altria (NYSE: MO  ) and Reynolds American (NYSE: RAI  ) . All three are heavily concentrated on the U.S. market, and have painted themselves into a corner as a result. Lorillard's just-announced 1Q results saw a 1% quarter-on-quarter dip in revenue and a sharper decline of 10% in net profit. Altria's net grew in its most recent quarter but this was largely because of cost-cutting measures; its revenue slid by 8% from the previous period. Reynolds also had a disappointing quarter, with top line sagging by $30 million or so to $1.93 billion.

Light 'em up abroad
At this early stage, no company except Lorillard seems to believe in the power of e-cigarettes to revive their flagging fortunes, and none yet has an e-brand. That's because the only cigarette strategy that's worked lately is to go overseas. Although foreign countries have made some moves to limit the classic method of smoking, by and large they're still more permissive than America. Generally speaking, the less "developed" the nation, the more lax its smoking restrictions and social stigma.

Philip Morris International (NYSE: PM  ) knows this very well. This past quarter, sales volumes increased for the company in three of the four regions it sells to. Asia was a particularly ripe market -- revenue there grew a fat 19.5% on a year-on-year basis. Although Phil saw a 5% quarter-on-quarter revenue decline in 1Q 2012, net saw an impressive 15% boost in the same time frame.

And there's more growth to be had. Smoking-friendly countries have lots of potential customers; overall cigarette sales to the troika of India, Bangladesh, and Vietnam totaled 274 billion units in 2011, but Philip Morris held less than 1% of the combined market share in those nations. With a little marketing push the company could sell many more packs of Marlboros to those eager to smoke.

Philip Morris doesn't sell to the U.S. at all (in fact, it used to be the foreign cigarette division of Altria, from which it was spun off in 2008). This is the polar opposite of a Lorillard or Reynolds. Both companies have non-existent or microscopic levels of exports, and neither has indicated that it will change that anytime soon.

Keep selling those classic smokes
Hence Lorillard's move into electronics. This will be an interesting development for the industry, although the smart money probably isn't placing bets on it to succeed. No matter how high-tech or funky or cool an e-cigarette may be it doesn't feel like a trend that will catch on. Rather, the winners in this game will likely be those that specialize in non-U.S. markets. At this stage, Philip Morris looks like the top in its class... even if it's as analog and traditional as a cigarette maker can be.

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Fool contributor Eric Volkman owns no stocks mentioned in the story above. Motley Fool newsletter services have recommended buying shares of Philip Morris International. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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