Electronic cigarettes, or e-cigarettes, and other e-vapor devices are some of the hottest new consumer products on the market. Commentators are buzzing about the prospect of ending tobacco consumption once and for all by replacing combustible cigarettes with e-cigarettes, which may deliver nicotine in a less harmful way. This could be great news for the millions of daily smokers who cannot kick the smoking habit to save their health, but Altria Group (NYSE: MO ) , Vector Group (NYSE: VGR ) , and other tobacco companies can be excused for being less-than-elated about the new product class.
Between Altria and Vector, only one will prosper amid the industry's changing climate, while the other's tobacco operations could dwindle in coming years. Investors should know why one will sink while the other succeeds in order to be positioned for the coming upheaval.
E-cigarettes could wipe out discount cigarettes
E-cigarettes represent a huge threat to discount cigarettes. People who buy discount cigarettes are primarily concerned about price rather than brand. Vector derives all of its tobacco revenue from discount cigarettes, meaning its customers are likely to switch to a lower-priced substitute if one becomes available. E-cigarettes could be that substitute.
E-cigarettes are more cost-effective than combustible cigarettes. Several ex-smokers told The Anniston Star how much money they are saving now that they have switched from combustible cigarettes to e-cigarettes. According to those interviewed by the Star, the cost of an e-cigarette starter kit is the same as a carton of cigarettes. After that, weekly e-liquid refills might cost $30 to $75 less per week than equivalent packs of combustible cigarettes, depending on the quality of the e-liquid and how often the consumer used to smoke.
Clearly, price-conscious smokers should be attracted to the e-cigarette market. Brand-conscious smokers, those who pay for premium cigarette brands like Altria's Marlboro, may be wooed by e-cigarettes' novelty but probably will not switch in large numbers until e-cigarette technology progresses to mimic the feel of combustible cigarettes. As a result, Altria's market position is better-protected than Vector's.
Big tobacco to conquer e-cigarettes
The obvious antidote for tobacco companies' e-cigarette problem is to enter the market and dominate it. In fact, every significant tobacco company in the U.S. has its own e-cigarette brand. Altria's MarkTen e-cigarettes will be rolled out nationwide in June. Altria also recently completed the $110 million acquisition of Green Smoke, an online e-vapor business that has a superior supply chain and more expertise than Altria's existing e-vapor operations. By contrast, Vector invested only $1 million to start Zoom E-Cigs, its e-cigarette subsidiary that launched last year.
It doesn't take a genius to figure out which company will crush the other in the e-cigarette market. Altria generates more than $4 billion in free cash flow each year, while Vector generated less than $40 million in free cash flow in 2013. More regulations will likely be put into effect as the e-cigarette market grows, giving the upper hand to large companies that can spread compliance costs across a greater number of units. This favors Altria, which also has a distribution advantage.
Vector's only hope is that state governments decide to make up for lost cigarette revenue by taxing e-cigarettes, thus making the substitutes less attractive to smokers. However, a scenario in which states prop up cigarette manufacturers seems unlikely unless the largest cigarette manufacturers also become the largest e-cigarette manufacturers. Either way, Vector's tobacco prospects are grim.
Vector's way out
The writing is on the wall for Vector's tobacco business. If the e-cigarette market reaches its full potential, Vector's core customer may abandon the company. However, Vector is not necessarily doomed to bankruptcy. The company recently increased its stake in its real estate subsidiary, Douglas Elliman; it now owns 70.6% of the subsidiary, a stake valued on Vector's balance sheet at $85.7 million. Real estate operations accounted for nearly one-third of Vector's overall revenue in the first quarter of 2014, up from hardly any contribution in the same quarter last year. Real estate may be responsible for the majority of Vector's revenue within a few years. As a result, it is difficult to count this company out despite its vulnerable tobacco operations.
Vector may be able to survive -- and even thrive -- for years to come, but it probably won't be as a tobacco company. Discount cigarettes are threatened by cost-effective e-cigarettes, which could eventually topple Vector and its high dividend yield; Altria is better positioned to handle changing tobacco industry conditions. However, Vector's real estate prospects are good enough that the company could outperform if the transition to the new industry goes smoothly. As a result, it's too early to count Vector out as a great investment.
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