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Is This the Future of Big Tobacco?

Big tobacco companies like Philip Morris (NYSE: PM  ) , Reynolds American (NYSE: RAI  ) and British American Tobacco (NYSEMKT: BTI  ) are well known for their defensive nature and hefty dividend payouts. But with the volume of cigarettes sold in some markets around the world in almost continual decline, big tobacco is innovating in an attempt to entice customers back to its products. The development of e-cigs is one way in which these companies are innovating to drive growth, but they are also spending hundreds of millions of dollars on the development of 'reduced risk' products.

Research and development
Philip Morris has spent a grand total of $650 million during the past three years to develop reduced risk products. The company is ramping up spending to get these products to market within the next few years.

Designed around the thought that the products must look, taste, smell, and burn like regular cigarettes, Philip Morris is counting on its new innovative products to help boost sales.

Both Philip Morris and British American have decided the best way to meet these goals is by creating devices that burn tobacco at lower temperatures. Philip Morris' new device heats tobacco to around 400 degrees Fahrenheit instead of the 1,600 degrees of a conventional cigarette.

A lower burning temperature ensures that the user still receives the same amount of nicotine and the flavor of tobacco but fewer harmful chemicals, which are usually the result of burning. 

Not that new
These initiatives are not new. Reynolds has tried to develop these kinds of devices before, although they never really took off and came under scrutiny from regulators. Reynolds made the mistake of labeling them as 'safer' than traditional smoking.

That cost the company an $8.3 million fine.  Philip Morris has been very careful to ensure that its products are labeled 'reduced risk'.

Philip Morris' first product is set to hit the market next year in a national test market and we'll have to wait until then to see how this new dawn in the tobacco industry pans out. The company has already started construction of a 30 billion unit HeatStick tobacco stick factory in Bologna, Italy, which the company plans to complete by 2016. It expects the factory to cost $800 million in total, so the company obviously has big things planned. 

Across the pond
Meanwhile, British American is adapting the technology found within asthma inhalers to produce another hybrid product similar to Philip Morris' offering.

Both Philip Morris and British American aim to create products that lessen the health risks of smoking while at the same time mimicking, as closely as possible, the taste, nicotine delivery, and behavioral experience of traditional smoking.

How will shareholders benefit?
Unfortunately, due to the facts that these products have not yet hit the market, and big tobacco is trying to keep its secrets to itself, as of yet, data on the size of the market, potential sales and profit margins are not in the public domain yet. 

Now, as these products are more technologically advanced than normal cigarettes, their profit margins are likely to be thinner. There are also start up costs to consider, so to begin with, it's likely that these products won't be a money spinner for either Philip Morris or British American. 

Over the longer term, it is likely that these products could prove to be more popular than traditional cigarettes, and this could lead to wider profit margins. What's more, governments may try and promote these products as the 'healthy' alternative to smoking, levying lower taxes on them.

Over the long-term then these products could prove to be very lucrative, although as of yet, they are still in their infancy. 

Foolish summary
So as the volume of cigarettes sold around the world continues to decline, Philip Morris and British American are innovating to drive growth. 

This new range of reduced risk products has been under development for some time now and these two tobacco giants have spared no expense in getting their development processes just right. 

Unfortunately, we will have to wait a few years before the results come through, but with Philip Morris' construction of a 30 billion unit factory within Italy, it would appear that the company has every confidence in the success of these products. 


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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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