While 2017 was a year marked by consolidation in the tobacco industry, with British American Tobacco (NYSE:BTI) acquiring the 58% of Reynolds American it didn't already own, 2018 looks to be the year when electronic cigarettes come into their own.
Shares of most tobacco companies posted gains last year, with British American, Altria (NYSE:MO), Philip Morris International (NYSE:PM), and Vector Group (NYSE:VGR) all in the black, while Japan Tobacco (OTC:JAPAF) and Imperial Brands (OTC:IMBBY) showed minimal losses.
Here's a look at which tobacco stocks in 2018 will make your best buys.
E-cigs will smoke the industry
Arguably the biggest story of 2018 in the industry will be the one that comes almost right out of the gate: the Food and Drug Administration hearings later this month on Philip Morris' iQOS reduced-risk device. Although we're not going to get an immediate answer on whether it's approved or not, it is the story that will set the tone for the rest of the year.
Japan is the market where iQOS has been introduced longest and already Philip Morris is quickly dominating the industry with a better than 11% share of the market and growing, perhaps explaining why Japan Tobacco is slipping. Although it finally introduced its Ploom Tech e-cig to the Japanese market, it hasn't slowed down the roll of the iQOS.
Shipments of the iQOS surpassed those of combustible cigarettes for the first time ever in the third quarter, and they accounted for about 40% of Philip Morris' total shipments during the first nine months of 2017. The heat-not-burn technology will soon be the biggest product it has in Japan, and it may replicate that experience elsewhere.
That's why whether it gets marketing approval in the U.S. is such a big deal. The FDA is proposing to reduce nicotine in combustible cigarettes to nonaddictive levels, which would likely be a negligible amount and could doom their existence (though a bruising fight would undoubtedly be fought by the industry and Congress before that happened). But even at greatly reduced levels, it could hasten the exodus of smokers, who already are leaving in droves, particularly as states ramp up the taxes they impose.
A gateway to competition
British American Tobacco is also eyeing the hearings for clues about how its own marketing application for its iFuse glo heat-not-burn device will go. It's promised to submit one this year, but because most of the industry studies have been a result of the work Philip Morris International has completed, doubts about their veracity that were raised in recent weeks will undoubtedly play a role in how it plays out and what British American can expect.
Although it's still an important player in the e-cig market through its Reynolds American division, the Vuse device has quickly lost market share to relative newcomer Juul Labs, whose JUUL device has leapfrogged to the forefront and captured 40% of the market. Vuse has slid to second place with a 24% share.
Reynolds will also be going for a reduced-risk designation for its snus, a finely powdered chewing tobacco type of tobacco that has captured a subset of the market.
Altria, while it has its own e-cigs on the market, is a distant third with an 15% share, so it, too, is counting on Philip Morris International's success before the FDA. Because it will be the one marketing the iQOS in the U.S. under its Marlboro brand as HeatSticks, it needs the hearings to go well.
As the Marlboro brand is the leading cigarette brand in the country with a near-50% share of the market -- and in some states like California it has more than a 50% share -- its fortunes are closely tied to the declining combustible market. When California raised taxes on cigarettes last year, it was Altria that bore the brunt of the fallout.
Vector Group is the fourth-largest cigarette company in the U.S., owning the legacy business of Liggett Group, the first tobacco company that broke ranks with the industry and became the first cigarette maker to settle smoking-related lawsuits. It also only produces traditional combustible cigarettes and doesn't have an e-cig on the market. With the traditional cigarette industry in decline, Vector could have to rely increasingly on its smaller real estate business to make up for declines in its tobacco sales.
Similarly, Imperial Brands had the opportunity to make a mark on the market because of the brands it acquired from Lorillard and Reynolds when the two merged. But as was suspected at the time, Imperial was too small to make enough of a dent to keep growing so that blu eCig, once the biggest electronic cigarette in the U.S., is now far behind all the others.
And the winners are...
It's hard to argue against Philip Morris International because even if it doesn't gain a reduce-risk label, it still ought to be able to sell the iQOS device, and the new technology could attract a lot of smokers and competing e-cig users looking for an experience closer to smoking. As a result, Altria should also win, since the device will be marketed under its Marlboro brand, and that will only further stoke speculation on Philip Morris acquiring the U.S. company.
And last, British American Tobacco, although it's running a me-too effort across all smoking alternatives, its combined size and portfolio breadth ought to allow it to maintain the growth trajectory it's been on.
Tobacco stocks have largely been enjoyed because of the rich dividends they pay, and while most of the payouts are not at risk in 2018, some may not fare as well as others. It will continue to be an environment skewed toward the largest players as the smaller ones are moved further toward the periphery.