Why the Late Mover Will Win in the E-Cigarettes Battle

Lorillard was the first among the Big Three tobacco giants to enter the e-cigarette market, and it is now the market leader. However, that doesn’t automatically make this company the best choice for investors who look to capitalize on the future potential of e-cigarettes.

Feb 23, 2014 at 12:45PM

While the awareness of e-cigarettes among smokers continued to increase from 89% in June 2012 to 92% in June 2013, the new market remains small relative to that for traditional cigarettes. It is estimated that in 2013, U.S. smokers spent about $75 billion on traditional cigarettes, but only $1 billion on e-cigarettes. However, the market potential of e-cigarettes can't be ignored. The Big Three tobacco companies--Lorillard (NYSE:LO), Altria (NYSE:MO), Reynolds American (NYSE:RAI)--are all getting into the thick of the action, albeit with different strategies and at different paces.

The early mover suffers
Although Lorillard is the third-largest cigarette manufacturer in the U.S. behind Altria and Reynolds American, it has leapfrogged its peers to become the market leader in e-cigarettes with close to 50% market share. Lorillard's success is largely attributable to the fact that it was the first of these to enter the e-cigarettes market with its acquisition of Blu eCigs in 2012.

However, it is important not to overemphasize Lorillard's current market leadership in the category. This is because market penetration is still very low and the de facto technologies and products in the category haven't appeared yet.

Given Lorillard's larger presence in the e-cigarettes space, related regulations will affect the company to a greater extent than its peers. While proposed regulations on e-cigarettes are still under way, regulators at the local state level are already moving ahead. As of end-January 2014, states like Utah, New Jersey, and North Dakota have disallowed the use of e-cigarettes in indoor public spaces. Philadelphia and Oregon could be following in their footsteps very soon. Minimum age requirements and taxation are also in the cards.

The late mover advantage
Altria, the largest U.S.tobacco company, has ironically been the slowest to move into the e-cigarettes category among the Big Three. However, this isn't necessarily a bad thing. In fact, it is better to be second considering the number of late movers in corporate history that have succeeded, including Google's AdWords and Apple's iPod. Given that consumers don't really know what they want (until they see it), it is rare that the first mover becomes the eventual market leader of the new market. Instead, the second mover learns from the mistakes of the early mover and goes on to introduce its own version of the winning product.

That seems to be the case with Altria. It launched its first MarkTen branded e-cigarette products in the test market of Indiana in August 2013. In December 2013, MarkTen e-cigarettes were introduced in Arizona as well. Based on the company's research on adult smokers, Altria's MarkTen e-cigarettes utilize its proprietary FourDraw technology, which it claims will more closely replicate the experience of traditional cigarettes. In early February this year, Altria announced the $110 million acquisition of Green Smoke, a seller of rechargeable and disposable e-vapor products, to further expand its e-cigarette product portfolio.

Differentiated products with customers' feedback in mind  
Reynolds American's VUSE digital vapor cigarettes have become game-changing products in the market, given that they have addressed the key concerns and complaints of early adopters of e-cigarettes.  Firstly, as with smartphones, some smokers have complained about the short battery life of e-cigarettes. Reynolds American claims that its Vuse Rechargeable Lithium Polymer battery can last a day before requiring charging. This is made possible by a Vuse VaporDelivery microprocessor which regulates power efficiency.

Secondly, most e-cigarettes tend to see their aerosol yield per puff falling in tandem with the number of puffs taken. The Vuse VaporDelivery microprocessor ensures that the aerosol yield per puff remains consistent throughout the puff duration by adjusting the amount of power delivered with every puff.

Since Reynolds American launched Vuse in Colorado in June 2013, it has been steadily gaining market share at the expense of its competitors. As at October 2013, it has an estimated 61.5% e-cigarette market share in Colorado, In contrast, Lorillard's Blu e-cigarettes have seen their Colorado market share decline from the mid-twenties to 17.8% in October 2013.

More importantly, Vuse isn't just taking market share from competing products; it actually significantly expanded the e-cigarette market in Colorado. In fact, e-cigarettes' market share of the total cigarette market increased from 0.7% in June 2013 to 2.3% in October 2013.  This speaks volumes about the appeal of Reynolds American's Vuse products. With a national roll-out planned for mid-2014, Reynolds American could give competitors a serious run for their money.

By committing significant investments to Vuse, Reynolds American also becomes another 'early mover' in its product category. However, there isn't a guarantee that an new innovative product will come onstream to disrupt Vuse in the near future. 

Foolish final thoughts
Of the three tobacco companies, my bet is with Altria, as I believe any advantages associated with being the first mover and releasing game-changing products are largely transient and can be easily imitated by competitors.  By proceeding cautiously and leveraging customer feedback in test markets, Altria is well-positioned to expand in a big way when consumer preferences and mainstream technologies are in place.

What's the Fool's favorite stock?
Altria is my top pick among tobacco stocks, but not necessarily the best choice in the U.S. stock universe. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple and Google. 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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