A Hedged Play on the Booming Electronic Cigarette Market

The electronic cigarette market is booming, with Lorillard taking the lead. However, the competition is intensifying, and Universal Corp is well positioned to benefit.

Jan 6, 2014 at 1:40PM

Once described as the most disruptive technology of the century (or at least the most disruptive to the tobacco industry), electronic cigarettes have proven to be one of the most successful products to hit the market in the past few years. Indeed, industry behemoths like Reynolds AmericanAltria (NYSE:MO) and Lorillard (NYSE:LO) have been falling all over themselves in attempts to get their own electronic cigarette products to market. While these tobacco industry giants fight it out, Universal Corp (NYSE:UVV), a major supplier of tobacco to the industry, has hedged its bets.

You see, Universal's subsidiary Virginia Tobacco Company has joined with Avoca, one of the world's premier botanical extraction companies, to form AmeriNic. AmeriNic's goal is to produce liquid nicotine for the electronic cigarette industry. The company is focusing on producing high quality, United States Pharmacopeia, or USP, grade liquid nicotine using fully traceable and compliant tobaccos.

This partnership is a really exciting endeavor for Universal. Expansion into electronic cigarettes opens up a huge new market for the company, which has traditionally been a standard tobacco supplier. Some might say that this diversification is essential for Universal to survive as the number of cigarettes consumed around the world declines.

However, as of yet Universal is not coming under pressure from the global decline in cigarette consumption, and this drive into the e-cig business should only boost the company's bottom line. Actually, Universal is spending to boost its tobacco output (which you can read more about here), as well as driving into the liquid nicotine space.

Showing signs of maturing
While Universal is hedging its bets and producing key ingredients for e-cigs, big tobacco companies are aggressively fighting it out for share of the e-cig market -- something Universal does not have to worry about.

In particular, Lorillard, one of the first domestic tobacco companies to move into the e-cig market, is already reporting almost no profits from its e-cig operations as marketing and selling costs rise.

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. Lorillard's marketing budget for its e-cig products was around $30 million last year, and this is set to rise for 2014. If Lorillard can drive sales then perhaps this will be money well spent, but the competition is about to get a whole lot more intense.

Here comes the cavalry
At present, Lorillard is only trying to compete with smaller peers. The impending entry of tobacco industry behemoth Altria into the e-cig market will 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."

There has also been some concern among smaller e-cig companies that the entrance of big tobacco, Altria in particular, could spur big tobacco to use aggressive marketing tactics. Altria subsidiary, Philip Morris USA owns, produces and sells the famous Marlboro brand within the United States. Altria and the Marlboro brand control around 50% of the United States' domestic cigarette market. Smaller e-cig companies are concerned that the company could use this position to leverage its dominance over the industry. For example, Altria could warn retailers that they cannot stock Marlboro cigarettes unless they carry its e-cigs .

While I'm not sure how realistic this threat actually is, it could threaten Lorillard's move into the industry as well.

Foolish summary
So all in all, the e-cig market is booming but the competition is intensifying. This is forcing market participants to increase their marketing spend, compressing margins. However, Universal is hedging its bets. As the company is producing the ingredients for e-cigs it is likely that its services will be in demand from the smaller firms that dominate the market. There is also scope for Universal to chase contracts from larger market players.

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Fool contributor Rupert Hargreaves owns shares of Altria Group and Universal. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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