Why Cigarette Alternatives Are the Key to Your Investments in Philip Morris, Altria, and Lorillard

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Philip Morris International (NYSE: PM  ) , Altria Group (NYSE: MO  ) , Lorillard (NYSE: LO.DL  ) , and the rest of the tobacco industry sell products that kill hundreds of thousands of people each year. However, the industry is on the cusp of changing that.

Although traditional cigarettes remain the most important product for these companies at the moment, tobacco companies are developing new and healthier ways to deliver nicotine to addicts. Lorillard is the U.S. market leader in electronic cigarettes, or e-cigarettes, which are all the buzz in the smoking world right now. In addition, Philip Morris announced plans to spend $680 million building two plants in Italy to develop lower-risk alternatives to traditional cigarettes.

Shareholders may think that the shift away from traditional cigarettes is bad news for tobacco companies, but it could end up being a growth driver.

Alternatives are flooding the market
E-cigarettes are all the rage in the tobacco industry right now. A sell-side analyst recently gushed, "[E]lectronic cigarettes will prove to be the most significant development in the history of the organized tobacco industry."

The e-cigarette market is still tiny compared to the tobacco industry; worldwide, e-cigarette sales may have topped $3 billion in 2013, compared to $700 billion for tobacco products.

E-cigarettes are especially popular in the United States, where Wells Fargo analyst Bonnie Herzog estimates there were $2 billion in sales in 2013. Herzog also believes that e-cig sales will surpass traditional cigarette sales inside of 10 years. Lorillard estimates its blu e-cigarettes lead the category with a dominant 49% share. But Herzog believes the U.S. market will eventually be divided between Lorillard, Altria, and Reynolds American, with no single company maintaining a dominant share.

The profit potential from e-cigarettes is appealing. Lorillard generates a 34% gross margin on its nascent e-cigarette business, only slightly lower than the 36% gross margin generated by its traditional cigarette business. If Lorillard's e-cigarette margin holds up even after Altria and Reynolds American push their way into the market, then the transition from traditional cigarettes to e-cigarettes will end up being a major plus for the industry.

As the e-cigarette market grows, the traditional cigarette market shrinks. That is bad news for Altria, which currently enjoys a 50% share of the traditional cigarette market. However, the transition from traditional cigarettes to e-cigarettes may not happen as quickly as analysts project. As Philip Morris CFO Jacek Olczak told investors on the company's second-quarter conference call, "[An e-cigarette] is not a product which is very close to the conventional cigarette and I think consumers are looking for something which is at least similar." 

Philip Morris' new Italian factories will produce safer alternatives to traditional cigarettes that are closer to the real thing than e-cigarettes. The company's heat-not-burn products are similar to e-cigarettes except they heat up tobacco to manufacture the taste of a real cigarette. The new heated products will launch in 2015; if the gross margin matches that of e-cigarettes, Philip Morris will be the market leader in what could be the next big thing for the tobacco industry.

Philip Morris and Altria have combined forces by licensing alternative products to one another; Altria has the right to manufacture and distribute Philip Morris' heated products in the United States, and Philip Morris has the right to do the same with Altria's e-cigarettes everywhere outside the United States. The result is that both companies have a full slate of cigarette alternatives to offer to their respective markets.

Key to prosperity
They key to Altria, Philip Morris, and Lorillard ultimately dominating the market for cigarette alternatives is more regulation. At first, this may seem counter intuitive. Marketing restrictions essentially prevent traditional cigarettes from gaining market share, which makes it difficult to grow. However, an inability to market new products means the existing market leaders will remain market leaders due to insurmountable barriers to entry. This has enabled the biggest tobacco companies to earn high and steady profits for decades.

The market for cigarette alternatives is wide open compared to the heavy restrictions in the traditional market, but that may be changing. Chicago and New York recently passed laws to regulate e-cigarettes like tobacco products. A French court ruled in December that e-cigarettes qualify as tobacco products and must therefore abide by tobacco regulations.

This is good news for Altria, Philip Morris, and Lorillard. The three companies can use brand extensions to sell alternative products to their existing traditional cigarette user base. For instance, Altria and Philip Morris could roll out a line of Marlboro e-cigarettes, and Lorillard could do the same with its popular Newport line. These brands already have wide customer appeal and dominate retail shelf space, making it difficult for other brands to compete.

Bottom line
The tobacco industry will eventually shrink to a fraction of its current size, but that may not spell the end of tobacco companies. During the societal transition from smoking to near-total cessation, tobacco companies have an opportunity to sell less-harmful products to wean addicts off of cigarettes. This transition has given birth to a new market for cigarette alternatives -- a market that Altria, Lorillard, and Philip Morris are in the best position to dominate.

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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 January 22, 2014, at 11:36 PM, mansourg54 wrote:

    The author failed to address the fact that former smokers and new smokers who never smoked before might return to smoking if e-cigarettes and other non-burn cigarette types are proven to be safe.If any tobacco company might shrink it would be Lorilard and American Reynolds because Altria is big in alcohol such as wine and beer and can expand in both fields. In addition it has a highly profitable finance business. I never smoked but I am thinking seriously of smoking the e-cigarettes.

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Ted Cooper

Ted Cooper is a value investor based in Texas. He does not ride a horse to work.

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