Put This Tobacco Company in Your Pipe and Smoke It

blu ecig Premium Starter Pack. Source: blucigs.com. 

While the anti-tobacco lobby debates how best to address the advent of electronic cigarettes, or e-cigs, the popularity of this smoking alternative has exploded and is expected to become a gargantuan industry in its own right -- hitting $1.7 billion in sales this year, with Reynolds American (NYSE: RAI  ) believing it could grow up to $3 billion over the next few years.

That's still a mere ash on the $80 billion stogie that the tobacco industry represents as a whole, but Wells Fargo thinks Reynolds is too timid. It says e-cigs could be a $10 billion industry by 2017 because it's a dramatically safer alternative to smoking and leads to smoking cessation or at least a reduction in the amount smoked.

Reynolds, for example, says e-cigs are a contributor to the 4% to 5% decline in tobacco volumes the industry is experiencing (along with moist snuff and snus). Meanwhile, e-cig leader Lorillard (NYSE: LO  ) , with a better than 40% share of the market, said its blu eCig brand contributed $57 million in sales in the second quarter, providing gross margins of 31% that are comparable to the 37% margins it realizes from its tobacco products unit. Although late to the game, even Altria (NYSE: MO  ) sees the potential of the niche's growth and introduced its MarkTen brand in August.

Unregulated because they use ingredients already approved by the Food and Drug Administration, and untaxed at the federal level (only one state -- Minnesota -- taxes them at the state level), electronic cigarettes are the Wild West of the tobacco industry. But the regulatory agency intends to shamble into town, pin on a badge, and slap on some leather in an attempt to tame this lawless region, as a good sheriff should for our own good.

The FDA is now proposing rules to cover e-cigs and bring the industry back under its authoritarian boot, including a potential ban on TV advertising; according to a Citibank report, e-cig commercial spending grew an estimated 18% last year. No doubt taxes like those imposed on tobacco products will soon follow.

Yet if the goal of the anti-tobacco lobby is to have people cut down on smoking, it should embrace this latest development. Instead, it is erecting smoke screens that suggest e-cigs are a "gateway" to real tobacco use.

The Centers for Disease Control and Prevention released a report stating that the percentage of kids using e-cigs more than doubled to 10% from 2011 to 2012. But the American Council on Science and Health says the survey is "intentionally misleading" as it fails to report on what the ACSH says is a key detail, daily use of e-cigs (as opposed to experimentation), "presumably because daily use is so rare that it would not support [the CDC's] findings that smoke-free nicotine products are equally addicting and just as harmful as smoking."

Like a smoker going through nicotine withdrawal, the government's regulatory apparatus is getting shaky from not having a hand in this growing business. If tobacco companies try to market e-cigs as a smoking cessation aid -- something you'd think people would want -- the FDA could regulate them as a drug or drug-delivery device because they're being used for "therapeutic purposes." Which is why you have the ridiculous disclaimer on the blu eCig site stating that the electronic cigarettes "are not a smoking cessation product." You certainly don't want people to know the benefits!

Yet despite the threat new rules would have on its business -- Lorillard says they could materially impact growth -- the company is still moving ahead, recently announcing its second acquisition of a device manufacturer in as many years.

Additionally, traditional tobacco supplier Universal (NYSE: UVV  ) , the largest leaf tobacco supplier to the industry, has directed a portion of its efforts to creating the liquid nicotine used by electronic cigarettes. As well it might. Revenues at Universal last quarter fell 6% as carryover shipments of tobacco were substantially lower, resulting in a drop in adjusted net income of $18 million. Yet Universal is so new to the e-cig side of the industry there's no knowing how its entry will play out.

I see no reason to think Lorillard won't continue to lead the way in the e-cig market, with its blu brand in more than 110,000 locations and growing steadily. Regulation, even draconian new rules, will take years before they have an effect, and in the meantime, we'll see the industry and Lorillard continue to catch fire. By then, the beneficial effects of e-cigs may be apparent to all and the gains the industry has made won't go up in smoke.

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