Are E-Cigarettes the Next Big American Success Story?

Altria Group, Reynolds American, and Lorillard could lead the resurgence in American manufacturing. Here's what it means for shareholders.

Jun 7, 2014 at 3:00PM

President Obama often speaks of a new age of American manufacturing. Touting a resurgence in manufacturing jobs in Asheville, North Carolina, last year, the president remarked that America is becoming more competitive as the cost of doing business in China increases. Obama was speaking about an auto manufacturer, but the resurgence in American manufacturing could just as easily be led by the e-cigarette industry.

As a result of quality concerns and regulatory restraints, Altria Group (NYSE:MO), Reynolds American (NYSE:RAI), and Lorillard (NYSE:LO) could soon boost American jobs by moving e-cigarette production to the U.S. This would be a rare win-win for big tobacco and the American public -- and it could be good news for investors as well.

Quality and price bring e-cig manufacturing home
Noted tobacco industry analyst Bonnie Herzog believes that e-vapor sales will surpass combustible cigarette sales within a decade if innovation persists. The closer that e-cigarettes can be made to look and feel like the real thing, the more smokers will view the products as legitimate substitutes.

Only high-quality e-cigarettes come close to mimicking the buzz smokers get from combustible cigarettes, which is why Altria, Reynolds American, and Lorillard are doing all they can to maximize quality. Altria acquired e-vapor company Green Smoke partly for its expertise in manufacturing high-quality e-cigarettes.

Moreover, all three major tobacco companies already manufacture e-liquid within the U.S. to ensure quality. In addition to e-liquid, Reynolds American also manufactures its e-cigarettes in a factory in Kansas. Altria and Lorillard produce e-liquid in U.S. factories and ship it to China, where it is assembled into a final product.

However, Altria and Lorillard may soon join Reynolds American in manufacturing the whole shebang in the U.S. China's booming economy has led to higher wages and a more valuable currency, thereby shrinking the cost advantage it used to enjoy over American manufacturing. As a result, Altria and Lorillard may find that eliminating international shipping costs by moving production home would more than compensate for modestly higher U.S. wage rates.

Moving e-cigarette manufacturing to the U.S. would allow Altria and Lorillard to manage quality and avoid the stigma attached to products that are made in China. As a result, the companies have a strong incentive to bring production home.

Regulators could demand move to U.S.
E-cigarette makers may have another reason to choose domestic manufacturing. Although proposed e-cigarette regulations remain relatively light, the U.S. Food and Drug Administration will likely increase its oversight as e-cigarettes evolve and further scientific studies are conducted. Already, the proposed rules require manufacturers to submit new e-cigarette designs for FDA approval before they hit the market. In the not-so-distant future, the agency may standardize e-cigarette manufacturing to ensure consistent quality and safety across all products. Complying with these standards -- and proving it to the FDA -- may be simpler and more affordable if the products are manufactured in the U.S. As a result, Altria and Lorillard have yet another reason to follow Reynolds American's lead.

E-cigarettes set to take off
If Altria, Reynolds American, and Lorillard can manufacture high-quality e-cigarettes at affordable prices, then the big three tobacco companies will likely dominate the market.

Lorillard, the third-largest U.S. tobacco company, owns the market-leading Blu e-cigarette. Blu has a 45% market share by dollar volume. With its lead firmly established in the U.S., Lorillard is now expanding Blu distribution to the U.K. Although e-cigarettes generate only 3% of Lorillard's overall revenue, e-cigarette growth could become a meaningful profit driver if the company continues to innovate.

Altria and Reynolds American are well behind Lorillard in e-cigarette market share, but both should catch up soon as they begin distributing e-cigarettes nationwide. Altria began nationwide distribution for its MarkTen e-cigarettes earlier this month. Reynolds American is also rolling out its Vuse e-cigarettes this summer. If rumors of an impending merger with Lorillard are true, Reynolds will become the leading American e-cigarette company with a strong secondary brand (Vuse) to boot.

In any case, gobs of free cash flow and limited reinvestment opportunities position Altria, Reynolds American, and Lorillard to manufacture the highest-quality e-cigarettes at the lowest cost -- setting them up to dominate the booming market.

Foolish takeaway
President Obama probably was not thinking of the e-cigarette industry as a potential standard bearer of the resurgence in American manufacturing, but it could be among the first in a number of industries that moves manufacturing to the U.S. The move makes sense for consumers (who want quality), regulators (who want close oversight), and shareholders (who want low costs). Don't be surprised if e-cigarettes become the next big American success story.

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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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