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Trouble is Brewing in the Electronic Cigarette Sector

Competition in the e-cig market is heating up. Both Altria (NYSE: MO  ) and Reynolds American (NYSE: RAI  )  are set to join the electronic cigarette, or e-cig, market later this year or early next year. Lorillard (UNKNOWN: LO.DL  )  already has its own brand of e-cig called blu, and the company has used its first mover advantage to snap up a 49% share of the retail electronic cigarettes market.

What's more, the domestic e-cig market as a whole is expected to be worth a total of $1.7 billion this year. This is double what it was worth in 2012. Indeed, if growth like this is set to continue then there might be room for all companies to have their own share.

However, the Food and Drug Administration will decide this month if it will lump e-cigs in with conventional cigarettes when it comes to regulation and taxes. Obviously, this would slow growth within the market, but there would still be plenty of room for expansion .

The rapidly growing e-cig market is already showing some signs of maturing. According to this Forbes article, while there are over 300 e-cig companies, the top three have 85% of the market. This is set to change as the big fish like Altria, Reynolds and UK-based British American Tobacco enter the fray, which is set to happen during the next few months.

Early mover
Still, Lorillard's early movement into the market has helped the company surge forward. As I have already mentioned, the company's blu e-cig brand has captured a large share of the domestic market and produced income of $9 million, or $0.02 per share, for the company during the first nine months of the year. However, it would appear that after this performance growth from Lorillard's e-cig division is going to slow down over the next few years.

Running into trouble
In particular, Lorillard's venture into the e-cig market is already showing some strain. For example, looking through the respective earnings reports, we can see that Lorillard's e-cig gross margin has declined from 37%,  reported during the first quarter of this year, to 32 % during the second quarter, and finally 24%  during the third quarter.

What's more, Lorillard's operating income and margin from its e-cig segment have declined from $7 million and 12%, respectively, in the first quarter of this year to 0 during the third quarter. That's right, Lorillard made no profit from its e-cig sales in the third quarter.

The reason for this? Well, the company rolled out a new, cheaper e-cig product and expanded its offering into an additional 127,000 stores, which damaged the gross margin. In addition, the company's marketing spend increased as it tried to beat competitors. 

Far from being a short term effect, it seems as if higher marketing spending is going to become the norm as more competitors enter the e-cig market.

Here comes the cavalry
That said, Lorillard is only trying to compete with smaller peers. The impending entry of tobacco industry behemoth Altria into the e-cig market could change all of that. Indeed, this comment from Wells Fargo Securities researcher Bonnie Herzog sums up Altria's entry into the market. "Altria has the ability to leverage its war chest of cash, its sizable infrastructure, its deep understanding of the tobacco consumer, and its entrenched position at retail."

Elsewhere, Reynolds is also claiming that its new electronic cigarette, Vuse, will be a "game changer." 

There has also been some concern among smaller e-cig companies that the entrance of big tobacco could spur big tobacco to use aggressive marketing tactics. This could include telling suppliers that they cannot stock the respective brand's cigarettes unless they carry its e-cigs. .

Foolish summary
Over the next few quarters a number of new e-cig products are going to come to the market. With more products hitting the market, price-wars are likely to take hold. This will hit margins and force companies to spend more on promotion.

Unfortunately, in this situation a big tobacco company such as Altria is likely to come out on top as it uses its deep pockets and experience in the sector to grab customers' attention.

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Read/Post Comments (3) | Recommend This Article (3)

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 29, 2013, at 12:27 PM, orthokneepa wrote:

    Discussion of the sector should also include VPCO. Although a small player it has many upcoming catalysts that could make the share price increase significantly.

  • Report this Comment On October 29, 2013, at 1:28 PM, GregoTX wrote:

    Meanwhile, Chinese companies that aren't focused on cig-a-likes are raking it in. Innokin, Joyetech, Smoktech, et al. are where the real spending is with serious vapers. I don't see American vapers moving from these larger capacity devices back to the smaller cigarette-sized units that Altria, Reynolds, Lorillard, et al. will be selling.

  • Report this Comment On January 06, 2014, at 11:36 AM, ridefixer123 wrote:

    I agree with GregoTX. These new canister type e-cigs are unbelievably popular. I sat outside a store in FTWayne IN. and watched, never less than 15 people at a time in the store at the same time. I know 8 heavy smokers in my family all quit in 1 month and went to VAPING instead. they all said the same thing "I like it better than smoking and it cost less" after the initial setup.

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