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E-Cigarettes: Questions Remain for Lorillard, Altria, and Reynolds

Bloomberg estimates e-cigarette sales at companies like Lorillard (NYSE: LO.DL  ) , Altria (NYSE: MO  ) , and Reynolds (NYSE: RAI  ) could top $1.5 billion this year, but the market could be substantially bigger given how much bigger the cigarette market is. Perceptions of e-cigarettes as a healthier nicotine source have Bloomberg forecasting that sales of e-cigarettes could surpass traditional tobacco in 30 years.

However, hitting that heady forecast won't be easy. The industry faces significant hurdles as it matures. New competitors, new regulation, and increasing scrutiny by anti-smoking groups could all derail efforts by these companies to dominate the e-cigarette market.

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The big three get busy
E-cigarettes began capturing attention about 10 years ago, but the industry has really taken off in the past two years thanks to cheaper, smaller, and longer lasting batteries that have helped make e-cigarettes mass-market friendly. Of the three big tobacco companies, Lorillard has been the most aggressive in embracing the new e-cigarette category. Lorillard bought the e-cigarette brand Blu for $135 million in 2009, and Blu's market share among e-cigarette makers stands at just shy of 50%. In the first quarter, Lorillard's e-cigarette sales totaled roughly $50 million.

A lot of Lorillard's success stems from launching flavors like Peach Schnapps and Java Jolt. Flavors are top sellers, but they're also putting Lorillard under the microscope given their potential appeal to younger consumers.

Regardless, Blu has caught Altria's and Reynolds' attention. In February, Altria announced it would spend $110 million to buy e-cigarette maker Green Smoke to complement its existing MarkTen brand, and Reynolds has launched Vuse, its own e-cigarette brand. Those brands will compete for a share of up to $10 billion in industry sales by 2017.

How safe are they?
First, let's take a look at three reasons advocates support e-cigarettes:

  • The e-cigarette industry was built on the premise that e-cigarettes are a cessation tool similar to nicotine patches. That's one reason that manufacturers offer e-cigarettes in varying nicotine strength. However, whether e-cigarettes actually help people quit smoking is debatable -- there just isn't a lot of data on that yet. A lot of users -- particularly younger consumers -- have never smoked cigarettes before -- and some studies suggest quit rates, without counseling, are around as low as they are for patches.
  • Some evidence suggests that nicotine could improve brain function. This leads some to claim that nicotine delivery devices, like e-cigarettes, could conceivably help delay cognitive disease like Alzheimer's. Since nicotine can act as an appetite suppressor, some also argue e-cigarettes could theoretically have a place in treating obesity and diabetes. However, those assertions are hotly debated.
  • Since e-cigarettes use liquid nicotine rather than tobacco leaves, users are exposed to fewer cancer-causing chemicals than cigarette smokers. Of course, this suggestion comes with some caveats, which I'll get to shortly.
Now, let's take a look at some of the concerns surrounding e-cigarettes.
  • The FDA is attempting to regulate e-cigarettes by proposing a slate of changes, including FDA approval of new products to better control ingredients, strict marketing rules, and age restrictions. Some cities, like New York, have already gone one step further than the FDA by including e-cigarettes in public smoking bans based on worries about secondhand vapor.
  • Those concerns are backed up by a review of studies conducted by the University of California at San Francisco's Center for Tobacco Control Research and Education. That review concluded that e-cig vapor may not be as harmless as makers say.
  • While the industry has maintained that e-cigarettes' main ingredients, including glycerine, are pretty benign, and research has indicated that e-cigarettes may have lower carcinogen levels than traditional cigarettes, many wonder if any carcinogen level is acceptable. According to UC San Francisco's review, vapor can contain trace amounts of chemicals like formaldehyde, a carcinogen, and acetaldehyde, a possible carcinogen.

An emerging threat
So far, research shows that the levels of carcinogens appear to climb with the amount of vapor. That's concerning because the use of vaporizing tanks, which produce more vapor, is growing more quickly than e-cigarettes. Vaporizers use bigger batteries, offer more customization in terms of flavors, provide more nicotine and, in some cases, are cheaper than e-cigarettes -- advantages that are allowing them to win market share.

During Lorillard's first-quarter earnings conference call, the company reported that vaporizers were one reason behind its quarter-over-quarter e-cigarette sales growth slowing to about 10%. That's got Lorillard ramping R&D to make its e-cigarettes more powerful. "The challenge for e-cigs, which we believe is the preferred consumer format, is to put -- close the performance gap relative to vaporizers," said Lorillard CEO Murray Kessler.

Kessler went on to note that:

Blu will be making a series of technical advances in the next 6 months that improve battery strength, vapor production, consumer value and satisfaction. We believe these types of changes will accelerate the acceptance and/or minimize the defection from traditional e-cigs, but we will be watching the vaporizer category carefully.

Fool-worthy final thoughts
The FDA, Centers for Medicare and Medicaid Services, and Department of Health and Human Services have invested billions of taxpayer dollars during the past five decades in the war on smoking.

Since the mid 1960s, the Surgeon General has published its annual report warning of the health risks and costs associated with smoking. In its 2014 report, the Surgeon General reported that more than 20 million Americans have died early due to smoking during the past 50 years, and that the cost of medical care for smokers is as high as $130 billion annually.

Those efforts to educate consumers on potential risks and costs have helped reduce smoking, but the FDA and anti-smoking groups are increasingly concerned that e-cigarettes may morph from cessation products to gateway products, encouraging younger people to migrate to other nicotine products like cigarettes. As a result, Lorillard, Altria, and Reynolds appear to have their hands full managing e-cigarettes' rapid growth and growing scrutiny.

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Todd Campbell

Todd has been helping buy side portfolio managers as an independent researcher for over a decade. In 2003, Todd founded E.B. Capital Markets, LLC, a research firm providing action oriented ideas to professional investors. Todd has provided insight to a variety of publications, including SmartMoney, Barron's, and CNN/fn.

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6/12/2015 4:05 PM
LO.DL $0.00 Down +0.00 +0.00%
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MO $53.59 Down +0.00 +0.00%
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RAI $42.21 Down +0.00 +0.00%
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