Why Altria Group Could Derail E-Cigarette Growth

One variable could have enormous consequences for the e-cigarette market. Find out what it is -- and what Altria Group, Reynolds American, and Lorillard can do about it.

Mar 17, 2014 at 11:04AM

E-cigarettes are the buzziest new product class to hit the tobacco industry in decades. Growth projections are through the roof for these products, with some analysts predicting that e-cigarette consumption will surpass that of traditional cigarettes within the decade. The outrageous potential of these products has led to a mad scramble by tobacco companies to enter the market. Lorillard (NYSE:LO) is the market leader, while Reynolds American (NYSE:RAI) and Altria Group (NYSE:MO) are just now introducing e-cigarettes nationwide.

If analysts' projections are borne out, the e-cigarette market could become a profitable growth market for big tobacco. Consumers, it seems, are crazy about the product. Regulators, however, remain skeptical. If the skeptics have their way, e-cigarette growth could be limited.

Anti-tobacco turns into anti-nicotine
Throughout the years, public policy has been designed to curb cigarette consumption primarily through taxation and restrictions on where one can smoke. The concerted effort by public health officials and anti-tobacco activists has led to a stunning decline in the smoking rate. In 1965, more than 42% of American adults smoked cigarettes. In 2012, only 18% smoked cigarettes.

The decline has spared millions from the debilitating effects of long-term smoking. President Obama's 2015 budget proposal aims to accelerate the decline through across-the-board tax hikes on tobacco products. Studies have shown that taxing cigarettes is an effective method of curbing consumption, making Obama's proposal a logical one for limiting cigarette consumption.

In addition to raising the price of cigarettes through taxation, providing a cheaper and safer alternative to cigarettes would further reduce the smoking rate. E-cigarettes have the potential to be that cheaper and safer alternative. Although conclusive scientific studies have yet to bring consensus on the issue, e-cigarettes are widely touted to contain far fewer toxins than are found in traditional cigarettes. Moreover, with no excise taxes on e-cigarettes in most U.S. markets, e-cigarettes are far more affordable than traditional cigarettes. As a result, e-cigarettes could potentially replace traditional cigarettes.

However, many observers are concerned that e-cigarettes will make smoking cool again. The product is designed to look and feel like the real thing; they could easily become a gateway to smoking traditional cigarettes. In an effort to limit this possibility, municipalities like New York City and Chicago are banning e-cigarette use wherever traditional cigarettes are also banned. The rule accomplishes a common-sense goal: Allow smokers to buy e-cigarettes and use them in private spaces, but do not flaunt a device that could hook a new generation on nicotine.

However, states are also proposing massive excise taxes on e-cigarettes that will make them less-appealing alternatives to cigarettes. The governor of New Jersey recently proposed an e-cigarette tax equal to that on traditional cigarettes. Bills in other states propose even more eye-popping e-cigarette taxes: 75% in New York state, 81.25% in Oregon, and 95% in Washington state.

At these rates, current smokers may be less inclined to switch to e-cigarettes. As a result, CSP magazine opines that e-cigarettes' enormous 30%-50% projected growth rate may turn out to be a more modest 10%-15% rate.

What can big tobacco do about it?
Given tobacco companies' history of misdeeds, Altria, Reynolds American, and Lorillard's participation in the e-cigarette market may be partly responsible for public officials' skepticism of the new product. Since the stigma attached to these companies will never go away, e-cigarettes may have a better chance to succeed from outside the big tobacco umbrella; e-cigarette company NJOY has more credibility arguing in favor of its product than does, say, Altria, which has deliberately deceived the public in the past. Tobacco companies recently settled a lawsuit brought by the U.S. Department of Justice and will admit, through a series of ads as well as "corrective statements" on cigarette packages, to lying about the dangers of smoking and the addictive nature of nicotine, among other breaches of the public's trust. The stain from the industry's unscrupulous past gives it a weak hand in pushing a new product onto the public.

There is speculation that Reynolds American will buy Lorillard's tobacco business -- which would leave Lorillard as a stand-alone e-cigarette business. Altria and Reynolds American could spin off their e-cigarette businesses in an effort to further separate the category from tobacco products.

However, Altria and Reynolds will likely retain their e-cigarette businesses. Smokeable tobacco products make up 85% of Altria's sales and 82% of Reynolds American's sales. As a direct substitute for cigarettes, e-cigarettes harm the companies' main products. In fact, the president of Lorillard's e-cigarette business told CSP magazine that 99% of its customers were existing smokers. Altria and Reynolds American can hedge the decline in cigarette consumption by owning e-cigarette businesses. If the e-cigarette business falters as a result of big tobacco's involvement, that's all the better for the cigarette business.

Foolish takeaway
E-cigarettes are thriving as a cheaper and possibly less harmful alternative to cigarettes. However, taxing e-cigarettes like traditional cigarettes could stunt the former's growth and ease the latter's decline. Either way, Altria, Reynolds American, and Lorillard are in position to profit. That's not such a bad position to be in.

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Ted Cooper has no position in any stocks mentioned. 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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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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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