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Tobacco companies pay generous dividends to shareholders because they rarely have investment opportunities to grow in the industry. However, the rise of smokeless products may change that.
Smokeless products could be the paradigm shift that Altria Group (NYSE: MO ) , Lorillard (UNKNOWN: LO.DL ) , and Reynolds American (NYSE: RAI ) need to shake free of the declining traditional cigarette market.
Tapping into the fast-growing e-cigarette market
Altria has a 55% share of the smokeless market in the U.S. but derives only 7% of its revenue from the segment. Smokeless products make up less than 1% of Lorillard's total sales and barely eke out a profit. Reynolds American generates just 8% of total revenue from smokeless products. That may be about to change.
Electronic cigarettes, or e-cigarettes, represent a huge market opportunity for the tobacco companies. E-cigarettes are battery-operated devices that deliver nicotine to users in aerosol form. The innovative devices do not contain most of the harmful chemicals found in traditional cigarettes and do not produce smoke, leading some observers to conclude that they are safer than traditional cigarettes.
Lorillard's Blu is the best-selling e-cigarette in the United States, with a 30% share of the domestic market. Reynolds American's leading e-cigarette, Vuse, captures just 2% of the market. Altria's MarkTen e-cigarette does not yet have meaningful market share.
Bonnie Herzog, an accomplished tobacco analyst at Wells Fargo, believes U.S. e-cigarette sales will quintuple to $10 billion in 2017 with Altria, Lorillard, and Reynolds American each claiming a 25% share. The $2.5 billion in annual sales projected for each company by 2017 represents 14%, 30%, and 38% of Altria's, Lorillard's, and Reynolds American's 2012 sales, respectively. This is the biggest growth opportunity that any of the three has come across in years.
However, cannibalization and promotional pricing will limit manufacturers' profits in the early growth stage. Forbes quotes Altria veteran and e-cigarette executive Miguel Martin as saying that retail margins for e-cigarettes are double those of traditional cigarettes. In other words, Lorillard and other manufacturers are making concessions to get the products into retail channels. However, as e-cigarettes become more popular, Altria, Lorillard, and Reynolds American will operate in an oligopoly that can force retail partners to pay higher wholesale prices similar to those of traditional cigarettes. If this turns out to be the case, then e-cigarettes are a game changer for big tobacco.
Altria and Reynolds American to grow smokeless segments
In addition to e-cigarettes, Altria and Reynolds American have a growth opportunity in other smokeless products like snuff and snus. Altria's dominant share of the smokeless market is due to its two dominant brands -- Copenhagen and Skoal -- which combine for a 50.6% share of the market.
Both Altria's and Reynolds American's smokeless-tobacco segments are growing faster and have a much higher profit margin than their traditional tobacco segments. Altria's smokeless revenue grew 4% in 2012 and posted a 55% operating margin, while its smokeables revenue grew just 1% and earned a 28% operating margin. Reynolds American's smokeless revenue grew 5% in 2012 and it turned 55% of it into profit, while its smokeables division shrank 5% and only 25% fell to the bottom line.
Altria's and Reynolds American's 2012 companywide operating margins were 29% and 27%, respectively. Although the revenue growth is small compared to most businesses, Altria and Reynolds American can enhance companywide operating profits if they can cross-sell to current smokers or convince them to switch to smokeless products altogether. The more revenue that gets shifted to the higher-margin smokeless business, the faster earnings will grow.
Big tobacco is not dead yet. Although the traditional cigarette market is under fire from all directions, a massive growth opportunity exists in the form of smokeless products. Over the next few years, top-line growth can be fueled by e-cigarettes while bottom-line growth can be enhanced by snuff, snus, and similar smokeless alternatives to traditional cigarettes.
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