E-Cigarette Expansion Coming Just in Time for Reynolds American

Source: Reynolds American.

Following a successful unveiling in Colorado and Utah test markets, tobacco giant Reynolds American (NYSE: RAI  ) is gearing up for a national rollout, and it seems it couldn't come at a better time. Cigarette sales are falling faster than the industry as a whole, so Reynolds will be looking for its Vuse brand of vapor cigarettes to take up some of the slack.

The e-cigarette market has quickly become a bandwagon the tobacco industry jumped onto, but it's already growing and expanding beyond just a smoking alternative, with so-called "vaping" turning into a lifestyle choice all its own. Analysts suspect sales will hit $10 billion by 2017, a relatively small percentage of the overall $100 billion tobacco industry, but with triple-digit growth rates still in its future, e-cigs have the potential to eventually surpass tobacco sales.

Reynolds American entered the space last year with a test run in Colorado that saw it immediately capture the leading share of the market, followed by a similarly strong performance in Utah when it was unveiled there, giving the cigarette maker the confidence to roll it out nationally. After Wisconsin and Indiana are tapped in early June, Reynolds anticipates 15,000 convenience stores across the country will be stocking its Vuse brand later that month, where it hopes to continue expanding the market.

It can't come soon enough, though. Industrywide cigarette shipments fell 2.7% in the first quarter, but the R.J. Reynolds division reported volume declines of 3.8%. However, after wholesale inventory adjustments, the cigarette maker estimates volumes were down 5.2% compared to a 4.4% drop by the industry.

Source: Reynolds American SEC filings.

It's clear that Reynolds American's tobacco cigarettes are doing worse than the industry as a whole, and Vuse remains key to staunching the bleeding; yet in committing the funds necessary to support its rollout, the cigarette maker will be ceding margin, as expenses associated with the campaign increase significantly.

This past quarter, for example, Reynolds reported earnings of $0.72 per share, and though it gained from its stock buyback program, the results were only in line with last year's effort because of the sales and marketing effort needed to bring Vuse to market. Operating margin also fell 2.2%, to 34.4% because of Vuse spending. That's going to continue throughout the rest of the year, as well, and its reaffirmation of guidance for full-year earnings of $3.30 to $3.45 per share takes into account the support Vuse will receive.

There's no guarantee a national presence for Vuse will result in the same sort of market leadership it achieved in Colorado and Utah, but the fact that the size of the total e-cig category grew with Vuse's introduction in both states, along with higher sales of replacement cartridges, strongly suggests there's a good probability consumers are trying and adopting its brand, and that it will achieve similar results nationally.

Reynolds American can only hope the e-cigarettes maintain their current trajectory because, as it falls behind in traditional cigarette sales, it can then command the leadership mantle in e-cigs.

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