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What CVS Caremark's Decision to Drop Tobacco Means for E-Cigarettes

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CVS Caremark's (NYSE: CVS  ) recent decision to stop selling tobacco products in its drugstores could be a huge gift to e-cigarette manufacturers. Although it is not yet known what CVS will do, Lorillard (NYSE: LO.DL  ) is hopeful that the company will carry e-cigarettes as a smoking-cessation device. Altria Group (NYSE: MO  ) and Reynolds American (NYSE: RAI  ) trail Lorillard in the e-cigarette market but could ultimately benefit if CVS decides to carry the tobacco-free devices.

Good for CVS, great for e-cigarettes, no effect on tobacco
CVS' decision to stop selling tobacco products is centered around its focus on providing health-care services to its customers. Several of its stores feature mini-clinics that provide basic care and vaccines. CVS CEO Larry Merlo explained:

We have about 26,000 pharmacists and nurse practitioners helping patients manage chronic problems like high cholesterol, high blood pressure[,] and heart disease, all of which are linked to smoking... We came to the decision that cigarettes and providing health care just don't go together in the same setting.

As the first major retailer to eliminate tobacco sales since Target did in 1996, CVS is earning tremendous positive press for its move. Every major U.S. newspaper is covering the story, giving the company free press for its rebranding effort. Moreover, the $2 billion that CVS estimates it will lose in tobacco sales, and sales of items that smokers would have bought had they come into the store to buy tobacco products, is only slightly more than 1.5% of the company's annual revenue. This is a small price to pay for an important rebranding effort.

The three largest tobacco companies in the U.S. -- Altria, Reynolds American, and Lorillard -- have a lot to gain from CVS' decision as well. The drugstore channel represents only a small fraction -- less than 4% -- of cigarette sales. Even if Walgreen and other drugstores were to follow CVS' lead, cigarette distribution would hardly be affected.

E-cigarettes, on the other hand, could receive a big boost. CVS does not currently sell e-cigarettes and has not said that it will carry the tobacco-free devices, but the prospect is not out of the question. Many experts believe that e-cigarettes are significantly less harmful than traditional cigarettes, which could make the devices a healthier option for smokers.

A spokesperson for CVS said the company "is continuing to monitor what the FDA decides in regard to [e-cigarettes]." The Food and Drug Administration, or FDA, has spent more than two years formulating rules on e-cigarettes but has yet to take formal action. The federal agency missed its original deadline, October, and it is not known when formal rules will be proposed.

If the FDA indicates that e-cigarettes can be marketed as smoking-cessation devices, CVS may carry them in its stores. The company already carries nicotine replacement therapy products for its new smoking-cessation program. Like nicotine replacement therapy products, e-cigarettes neither contain tobacco nor produce smoke. If CVS and other pharmacies were to sell e-cigarettes, the product category would gain much-needed shelf space.

Big tobacco positioned for e-cigarette gains
Altria, Reynolds American, and Lorillard -- the three biggest U.S. tobacco companies -- are moving into position to capture a large share of the growing e-cigarette market. Lorillard maintains the biggest market share, accounting for nearly half of the market in its fiscal third quarter. Meanwhile, Reynolds American is rolling out its Vuse e-cigarette nationwide starting in July. Altria, which recently purchased a premium e-cigarette manufacturer to bolster its offering, has not yet announced a national rollout date.

Wells Fargo analyst Bonnie Herzog believes the three major tobacco companies will eventually split the e-cigarette market evenly with a 25% share each. As a result, all three would benefit if CVS decides to carry the product.

Foolish takeaway
CVS' decision benefits all parties involved. It benefits its own brand by making a small sacrifice in sales in exchange for a huge boost in the credibility of its health- care products and services. Tobacco sales will not be affected, as CVS represents only a tiny portion of overall sales and customers will simply go elsewhere to buy tobacco. Moreover, Altria, Reynolds American, and Lorillard are set to reap enormous gains in the e-cigarette market if CVS and other drugstores carry the new product. As a result, shareholders of all companies should cheer CVS' decision.

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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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