Why a Major E-Cigarette Company Is Lobbying for More Regulation

Reynolds American (RAI) is lobbying the U.S. Food and Drug Administration for tighter restrictions on the e-vapor market. It may seem counterintuitive, but Reynolds American's lobbying efforts could end up helping it and Altria Group (MO 0.12%) boost the profitability of their e-cigarette and combustible cigarette operations, as what they suggest would hurt competitors offering different types of vapor devices. If the Food and Drug Administration implements Reynolds American's policy suggestions, Reynolds American and Altria could dominate the market.

Setting the stage for domination

The FDA outlined a first round of e-cigarette regulations earlier this year. The proposed rules appear to benefit larger e-cigarette companies by requiring special approval for devices that are not "substantially equivalent" to products that were on the market prior to Feb. 15, 2007. The FDA estimates that each application for a new device could cost several million dollars, the Winston-Salem Journal reported at the time. This would make it prohibitively expensive for small e-vapor companies to invent new products, thereby limiting innovation to a handful of well-capitalized players.

Reynolds American and Altria also have an advantage in distribution. Reynolds American's Vuse e-cigarette captured 61% of the Colorado market within months of being released, the company said. Altria's MarkTen e-cigarettes achieved 48% market share in Arizona within seven weeks of its introduction, that company said. Moreover, MarkTen is already distributed in over 60,000 stores just months after its nationwide launch. These quick market share grabs demonstrate big tobacco companies' distribution advantage.

Lobbying for regulation

However, the e-vapor industry doesn't belong to big tobacco just yet. The FDA's proposed regulations do not include a ban on vapors, tanks, and mods. The so-called VTMs are "open systems" that can use a variety of flavors and brands of nicotine liquid and other parts. Reynolds American's and Altria's "cig-alikes," on the other hand, are closed systems that can only use cartridges designed for the specific device.

Vapors, tanks, and mods make up about 36% of the $2.2 billion e-vapor market, according to a research note from April.

Reynolds American argues that VTMs should be prohibited because, unlike with cig-alikes, enthusiasts could easily modify the contents of the cartridges to include cannabis or new flavors that may appeal to underage smokers. The company argues that, at the very least, the FDA should regulate VTMs the same way it regulates cig-alikes.

Why it matters

It may seem strange that Reynolds American is fighting so hard against e-vapor enthusiasts making mods, but it makes business sense. Wells Fargo tobacco analyst Bonnie Herzog reports that the typical VTM user is a former cigarette smoker who first tried cig-alikes and then abandoned them for tanks and mods. VTMs usually offer stronger batteries and a superior vaping experience than Vuse and MarkTen, according to Herzog. This means that Reynolds American and Altria must continually upgrade their technology in order to keep pace with the evolving e-vapor market.

More importantly, the open devices are a platform for flavor innovation that could make it difficult for big tobacco companies to keep up. Any number of flavors and sensations can be created and used by open systems, making it difficult for one or a handful of companies to corner the market -- even if the big tobacco companies were to open their systems.

VTMs are already making their presence felt. Herzog estimates that VTMs account for more than one-third of the $2.2 billion e-vapor market. Continued growth of these products could result in a fragmented market that does not confer a durable competitive advantage to any one company. Moreover, the flavors and variable nicotine content could make VTMs a viable alternative to combustible cigarettes, thereby encroaching on Reynolds American's and Altria's cash cow.

As a result, restrictions on flavors and mods are paramount to the protection of big tobacco's profits. Without further restrictions, Reynolds American and Altria could begin a faster slide toward irrelevance.