Is the Young E-Cig Industry Already Running Out of Puff?

Electronic cigarettes, or e-cigs, have been one of the most disruptive technologies to hit the tobacco sector in recent years. The market for them has grown rapidly, and many smokers are now switching to the e-cig over traditional, more harmful cigarettes.

Unsurprisingly, this rise to fame within the smoking community has sent tobacco players such as Altria Group (NYSE: MO  ) , Reynolds American (NYSE: RAI  ) , and Lorillard (NYSE: LO.DL  ) into a sort of e-cig arms race.

However, as this arms race intensifies and the U.S. Food and Drug Administration takes aim at the rapidly growing, unregulated market, it would appear as if the market is running out of puff and profits are disappearing.

Aggressive marketing
At present, e-cigs are, for the most part, unregulated, allowing companies to aggressively market them and claim they are relatively safe. This approach can't be used with conventional cigarettes, and it's a strategy for growth Lorillard has been using heavily. 

Lorillard dominates the US juvenile e-cig market with its brand of Blu e-cigs. Indeed, during the fourth quarter of last year, Blu's share of the domestic e-cig market reached 50%. However, Lorillard has acquired this market dominance at the expense of profitability, as the tobacco company has spent millions on advertising the brand to increase awareness.

Nevertheless, during the past year or so, Lorillard has had a relatively easy time dominating the e-cig market, as it remains by far the largest company operating within the national market. The rest of the e-cig market remains highly fragmented, with 250 different brands trying to chase a relatively small domestic market of $1 billion to $2 billion. This makes it easy for Lorillard, with its multi-billion dollar marketing and development budget, to push smaller peers out of the way.

On the other hand, Reynolds American and Altria will soon roll out their e-cig offerings nationally, and this could stop Lorillard in its tracks.

Quietly building support
Lorillard has been chasing market share during the past year. Meanwhile, both Reynolds American and Altria have been testing their products in single states, identifying consumers' needs and wants before committing themselves to national roll outs. In particular, Reynolds has developed the Vuse digital-vapor cigarette, which it rolled out in Colorado; Vuse has quickly become consumers' e-cig product of choice.

This initial success should be extremely worrying for Lorillard. Vuse appears to have been very successful. And if it can replicate the success seen in Colorado when Reynolds rolls it out nationally later this year, Lorillard's first-mover advantage could be threatened.

What's more, the initial performance of Altria's e-cig offering, MarkTen, has exceeded expectations. Within just seven weeks, MarkTen achieved brand leadership by taking a market share of 48% within the trial market. Altria intends to leverage lessons learned from its initial roll out when it commences national distribution during the second quarter of this year.

Furthermore, Altria recently acquired Green Smoke, an e-vapor business, to boost its e-cig offering. Green Smoke has been manufacturing and marketing high-quality, premium products since 2009, so it knows the market well. The acquisition will bolster Altria's already-strong e-cig development and sales team; it will also expand Altria's product portfolio to address adult smokers' and vapor users' different product preferences.

Growing opposition
Still, while tobacco companies fight hard to drive sales and establish their brands in a competitive marketplace, the FDA has the industry in its crosshairs.

According to Reuters, the FDA is "pushing very hard" to get a proposed rule that would establish the administration's authority over e-cigs to be approved by the White House's Office of Management and Budget; this office reviews potential regulations to assess their economic impact.

Nevertheless, there is still an enormous amount of support for e-cigs, which could lead to the FDA's powers being restricted. Throughout November and December, more than 35 organizations, including public health advocates, lawyers, and physician groups, petitioned Washington, D.C.'s Office of Management and Budget to stop a rule which would bring e-cigs under control of the FDA (this rule was proposed by the FDA.)

If e-cigs were brought under the control of the FDA, the administration could potentially require companies to do the following: register and pay fees, list the ingredients in their products, obtain prior approval for new products, and restrict online sales and marketing to children.

The OMB has not stated when it intends to make a decision on the matter.

Foolish summary
E-cigs have been quoted as being the most disruptive product to emerge in recent years. But with so many competitors chasing after such a small market, things are getting tough.

Moreover, the national rollout of Altria's and Reynolds' e-cig products later this year will only increase competition and decrease profits.

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Rupert Hargreaves

Rupert has been writing for the Motley Fool since December 2012. He primarily covers tobacco and resource companies with a passion for value-oriented investments. .

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