Investors Must Be Careful in the Hot New E-Cig Market

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High taxes and the negative health risks associated with traditional tobacco products have pushed investors away from tobacco companies and their stocks during the past decade. However, over the past few years, a revolutionary technology has become mainstream and now investors are jumping over one another to get a piece of the action.

Of course, the technology I'm talking about is electronic cigarettes, or e-cigs, which are widely considered to be one of the most disruptive new technologies to hit the market during the past few years.

The U.S. e-cig market is expected to be worth around $1 billion at the end of this year, and many companies are scrambling to get a piece of the action. That said, with so many products now under development, the market is at risk of becoming overcrowded.

In particular, traditional tobacco has many different styles and flavors; each flavor, cut, and blend comes from a different producer, region or factory, all giving the end user a different "experience" and allowing for the thousands of different types of tobacco in use today. In comparison, e-cigs are essentially similar in all factors apart from flavor, which can easily be replicated if you know the recipe.

Growing competition
Currently, Lorillard (UNKNOWN: LO.DL  ) , Reynolds American (NYSE: RAI  ) , Imperial Tobacco,  British American Tobacco, and Altria all have e-cig brands in development. In addition, Vapor  (NASDAQOTH: VPCO  )  (the only fully reporting publicly traded electronic-cigarette company within the U.S.) and privately held NJOY are the largest pure-plays in the sector.

With so many competitors in such a relatively small but rapidly growing market, it is highly likely that price wars will soon start to ripple across the market. Rising competition means smaller margins, which will inevitably push some smaller competitors out of the market.

First mover
Lorillard acquired Blu eCigs last year for $135 million, and so far growth has been explosive; the brand is already in 80,000 stores.

Lorillard and Blu have the "first mover" advantage. Blu already has a 40% share of the e-cig market within the U.S., and sales during the second quarter alone totaled $57 million. For the first half, the gross margin stood at 33% although the net margin was only 8%. However, this did include the cost of rolling out the product across the country; margins should expand into the third quarter and second half of the year.

Unfortunately, in comparison, Vapor is hardly able to compete. Vapor's sales for the first six months of the year totaled $12.5 million and the gross margin was 40%. Nonetheless, the company's tiny size means that it is not able to achieve the economies of scale that Lorillard can, and the net margin was only 0.5% for the first half of the year. That said, performance in the second quarter was poor and the company lost $54,600 while the gross margin contracted to 39%.

When we compare Lorillard's performance to that of Vapor, we can easily see how hard it is for smaller companies to break into this industry. On the other hand, it also shows how easy it is for larger, existing tobacco companies to enter the industry. Moreover, as Lorillard already controls nearly half of the market, it's going to be even harder for more competitors to enter the market.

All of these factors point to one conclusion: Big tobacco has the ability to lock out smaller competitors. The CEO of yet another small e-cig producer, Logic Technology, states: "We're hoping they don't tell their customers, 'If you want to carry our cigarettes, make sure you have our e-cigs.' " 

However, with such a huge amount of choice hitting the market, underhanded tactics like this may start to take hold.

Faster growth
In the past two months alone, Altria and Reynolds American have started the roll-out of e-cig brands: Altria with the MarkTen e-cigs and Reynolds with Vuse -- both on the back foot of Lorillard.

But it's not just e-cigs. Sales of existing smokeless products notched high single- to double-digit growth as Americans puffed on fewer cigarettes and other traditional smoking-tobacco products.

Reynolds American leads the U.S. smokeless-tobacco market when it comes to snuff, so the company is well placed to break into other smokeless markets. Indeed, Reynolds' adjusted operating income from cigarettes sank 2.2% in 2012 while earnings from snus advanced 10%.

The company's key brand is Camel snuff, which accounts for 81% of the $175 million United States snus market. The closest competitors are Altria's Marlboro and Skoal brands. What's more, according to leading tobacco company Swedish Match, the U.S. snus market has grown at a rate of 5% annually for the past five years and this is expected to continue -- cigarette consumption is expected to continue declining, however.

Foolish summary
All in all, e-cigs may be one of the fastest-growing and most disruptive technologies to hit the market this year. With so much competition now hitting the market, however, it could be wise to stand back and only back the winners -- when they emerge.

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Read/Post Comments (6) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 14, 2013, at 11:18 PM, idiotIM wrote:

    I found this Yahoo finance page called Victory Electronic Cigarettes Featured on Bloomberg, FOX, ABC and Howard Stern Show, I searched and found ABC WZZM13 on page www wzzm13 com

    and a news article pumped by "Alex Shabad" showing the owner of ECIG talking about his company, the stock price is up %900 it's

    in the low $20's now look at the video and the stats is this company worth low $20 per share or zero.

    They have segment on wzzm13 called "Made In Michigan", I zoomed in on ECIG's inventory room and one of the boxes you can clearly see labeled "Made in China". I also have found GLLA listed as a e-cigarette company on some pages yet it as listed as gold mineral company as it's profile and others like that. Let the Buyer beware I would trust LO, MO, VPCO for the biggest and safest bang for your buck.

  • Report this Comment On October 18, 2013, at 9:14 AM, MRFool113 wrote:

    Before making comparisons between any company that sells e-cigarettes should only be done after researching the actual products. Lately, the trend known as "vaping" has been making a big jump around the public places I have been. The 4-5" long, 1/2" diameter cylendars with a clear reservoir to hold liquid that is "atomized" into a vapor that is then inhaled. There are also stores popping up that will mix any flavor you want, with any level of nicotine you want, they have over 100 flavors to sample right there.

    In the past week, after noticing a co-worker with one and asking about it, I have met 3 people who have quit smoking and 1 who has quit chewing tobacco using VPCO techology. Start out with a nicotine content relative to what they were smoking, and reduce over time; the physical habit of mouth to lips and inhaling is maintained and thus they only break part of the habit at a time. Of course, I had to see if any of this were available from a public company! :) I read in another article that 78% of smokers want to quit - THAT, my foolish friends, is a market just waiting to be filled. I personally have met 4 people in the past week alone who have quit smoking through this technology, and 1 quit dipping.

    Only one company mentioned here (that I was able to find) makes this technology - VPCO. The others all make solid cartridge e-cigarettes that look like cigarettes (so you get the nicotine and flavor that the company wants you to get, not what you want). VPCO builds the equipment that many smaller outlets buy, rebrand, and package while selling their flavor of juice to put in them.

    For the record, though I have few posts to these boards, I am not a VPCO shill. I am, however, buying a position because I am getting the same feeling I got after eating at Buffalo Wild Wings, and Chipotle before Hidden Gems recommended either of them.

  • Report this Comment On October 18, 2013, at 9:16 AM, MRFool113 wrote:

    Sorry about the bad edit. 3 quit smoking and 1 quit dipping - I had added those numbers the first time and didn't get the original line out when I edited. Either way, I haven't met 3 people who have quit smoking successfully over the period of a year, never mind 3 days.

  • Report this Comment On November 27, 2013, at 1:27 PM, jonsandy wrote:

    Gilla Inc (GLLA) is another very newly public electronic cigarette company. They did a reverse merger a ways back and that is why in some places they show up as a mining company which is what they used to be. I don't know about the fundamentals of the company, just thought it was worth mentioning that there is now another pure play electronic cigarette company out there to trade.

  • Report this Comment On May 21, 2014, at 5:13 AM, bptr wrote:

    I find it really annoying when PROFIT MARGINS are called "margins", Is it THAT hard to make sense by saying or typing the actual term?

  • Report this Comment On July 15, 2014, at 5:21 PM, SpartanWaves wrote:

    I'm sorry but this author really has no idea what he's talking about. Bonnie Herzog from Wells Fargo has this industry nailed. Blu is your fathers ecig!

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