The E-cig Market Is About to Light Up

The electronic cigarette or e-cig market is about to explode. Over the next few weeks, Reynolds American  (NYSE: RAI  ) is rolling out its in-house e-cig brand, VUSE, across the nation in Big Tobacco's latest drive to dominate the market.

The war for a share of the $2.5 billion e-cig market is getting hotter. Tobacco companies are rushing to get their products to market and make a quick buck before regulators or public health groups have the devices banned . As of yet there is much talk but no action with regard to banning the devices.

National roll out
Reynolds began testing VUSE in Colorado last year and has since been experimenting with the product in order to meet customer demands. The nation's second largest publicly traded tobacco company will go head to head with smaller peer Lorillard (NYSE: LO.DL  ) in the e-cig market. Reynolds is actually in the process of trying to buy Lorillard; you can find your one-stop guide to the potential Reynolds American-Lorillard merger here

Lorillard already dominates the domestic e-cig market with its Blu e-cigs brand, which it acquired in 2012 for $135 million. So far, the brand's growth has been explosive. When Lorillard acquired Blu, the start-up had combined sales of only $50 million and the product was only available within 12,000 retail outlets. Lorillard quickly threw its weight behind Blu and the company now dominates the U.S. domestic e-cig market. Blu's annual sales now exceed $200 million and the product is available in just under 150,000 retail outlets. Blu e-cigs have a leading market share of approximately 50%.

With Reynolds and sector behemoth Altria about to enter the national market, Lorillard is going to have its work cut out for it. The entrance of the sectors big two players should, according to Wells Fargo analyst Bonnie Herzog, "catapult growth of the entire category."

The big winners
The big winners from this e-cig war will be the media agencies. Tobacco advertising, especially on television, has been banned since 1971, although e-cig advertising is allowed. Marketing spending on e-cigarettes more than tripled to $79 million in 2013.

This is really reflected within Lorillard's numbers. For the three months ended March 31 Lorillard's Blu reported sales of $51 million for this year; this was down slightly from the $57 million reported in the year ago period. However, as marketing spending increased, the company was catapulted from an operating profit of $7 million reported during 2013 to a loss of $11 million for 2014; that's a big difference.

Unfortunately, it would appear that things are only going to get worse for Lorillard as Reynolds and Altria enter the market. More and more cash will have to go towards advertising, and this will only push margins down further.

Regulatory concerns 
There is also the FDA's position on e-cigs to consider. In April, the FDA issued proposed rules banning the sale of e-cigs to anyone under 18 and requiring all companies to list their ingredients. FDA rules will also soon require e-cigs to be branded as "tobacco products," an extensive and expensive process .

Luckily, being big tobacco companies, Lorillard and Reynolds have plenty of experience dealing with regulators. It should not be too hard to alter the products to fit FDA requirements.

Still, this will be yet another expense that will push margins down. On the other hand, stringent FDA regulations are likely to push smaller peers out of the e-cig market.

Foolish summary
It would appear that the e-cig market is set to explode over the next few months as Reynolds and Lorillard go head to head. This clash of tobacco titans will lead to a surge in advertising spending, which should hopefully increase awareness of the products. Rising advertising spending is crushing profit margins, however, and this will be the deciding factor; will big tobacco continue to chase e-cig customers if it means making a loss?

That said, it's not likely that big tobacco will leave the e-cig market anytime soon. Expect to see an explosion in e-cig sector activity over the next few months. 

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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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