Will E-Cigarettes Destroy Big Tobacco?

When I first read about electronic cigarettes, I was a non-believer. Cigarettes have been around forever, how could they be replaced by e-cigarettes? While it may not happen overnight, e-cigarettes could change the way people smoke and the way big tobacco makes money.

What's an e-cigarette?
The way an e-cigarette works may differ (according to brand), but basically, it is a device made to heat and vaporize a mixture known as e-liquid with nicotine inside a cartridge using a rechargeable battery. It has no ash, smell or the usual combustion that happens after you light up a conventional cigarette. This makes an e-cigarette 99% healthier than the alternative. 

Source: Blu Cigs Wiki

Why are e-cigarettes going to change the industry?
E-cigs may deliver a similar user experience, and according to most online reviews, offer a fairly authentic smoking experience. More importantly, people smoking traditional cigarettes are using e-cigs as a way of quitting.

Finally, e-cigs are a better bargain as they are not regulated. A 2 pack smoker could spend $10 and up on traditional cigarettes. After changing to PrimeVapor Electronic Cigarettes, he spent $5.10 (assuming two PrimeVapor Flavor Cartridges at $2.50 per cart plus $0.10 for the battery). That $4.90 per day in savings equals $147 per month. Cheaper, healthier and similar to a conventional cigarette, e-cigs are better for those who smoke. 

Goldman Sachs has estimated that e-cigs could reach $10 billion in retail sales over the next several years, accounting for more than 10% of the whole tobacco industry volume and 15% of profit. This is not a fantasy. It's a projection based on current growth rates and the low penetration of the product.

Source: Goldman Sachs Investment Research (Taken from Stocktwits)

E-cigs have doubled the past two years and are on their way to reaching over $1 billion in sales by 2013. And there's plenty of room for growth, because according to Gallup, as much as 74% of smokers want to quit. And e-cigs make it easier to do just that.

How is Big Tobacco reacting?

Lorillard (NYSE: LO  ) is the second best performing tobacco stock over the past year. It has exposure to e-cigs because it bought Blu Cigs for $135 million last year.

Blu Cigs performance was sequentially flat, but this should change in the next two or three quarters. It is now available at 110,000 retail locations and is reducing the price of its starter kit. The new kit doesn't sell for a profit according to Morningstar. But, this razor blade strategy could work in the long run.

The focus is to promote the migration of traditional smokers to e-cigs, and a cheaper starter kit should help. According to MarketWatch, the company's second-quarter profit grew 10%, and its bottom line is being bolstered by higher prices and rising demand for e-cigs.

Altria  (NYSE: MO  ) , the owner of Marlboro, chose not to acquire a company but to use a subsidiary to join the e-cig market. It announced in June that its Nu Mark subsidiary would launch e-cigarettes under the brand-name MarkTen. Notice the similarity of the box design to Marlboro's usual color combination.

Source: MarkTen website

Altria has a clear competitive advantage because it already owns the most-used tobacco product in the world: Marlboro. Altria should be able to get some Marlboro smokers to shift to its e-cig brand.

Regardless of the outcome, the company offers plenty of value. In its latest quarter, revenue fell by about 3%. However, it was still able to increase operating profits by 6.6%. That was due to strong pricing and cost-cutting initiatives, which helped EPS advance by 5.1%.

Reynolds American (NYSE: RAI  ) , the maker of Camel cigarettes, is also trying to catch up. It is about to expand the testing of its Vuse e-cigs to retail outlets in Colorado. It's Solo package, which will retail for $10, comes with an original or menthol cartridge.

Since a cartridge is equivalent to about a pack of cigarettes, there won't be a difference in price between Vuse and traditional tobacco alternatives. And because it is a late mover, I don't believe the Vuse brand will add value to the firm's 2013 financial results. Still, the company has been able to successfully introduce new product concepts, like Camel Snus, a moist powder tobacco product.

Foolish final thoughts
E-cigs won't destroy big tobacco companies; they may enhance them. Ultimately, this is an opportunity to increase the welfare of smokers. According to Goldman Sachs, for every pack of cigarettes sold in the U.S. about $3.16 goes to government agencies. E-cigs are not yet regulated and could be sold cheaper than conventional cigarettes.

While most tobacco companies are already in the game, Lorillard's Blu Cigs and Altria's MarkTen look promising. Particularly, Lorillard's strategy to reduce the price of the starter kit and decision to make it available in 110,000 retail locations should drive sales and profits.

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