High taxes and the negative health risks associated with traditional tobacco products have pushed investors away from tobacco companies and their stocks during the past decade. However, over the past few years, a revolutionary technology has become mainstream and now investors are jumping over one another to get a piece of the action.
Of course, the technology I'm talking about is electronic cigarettes, or e-cigs, which are widely considered to be one of the most disruptive new technologies to hit the market during the past few years.
The U.S. e-cig market is expected to be worth around $1 billion at the end of this year, and many companies are scrambling to get a piece of the action. That said, with so many products now under development, the market is at risk of becoming overcrowded.
In particular, traditional tobacco has many different styles and flavors; each flavor, cut, and blend comes from a different producer, region or factory, all giving the end user a different "experience" and allowing for the thousands of different types of tobacco in use today. In comparison, e-cigs are essentially similar in all factors apart from flavor, which can easily be replicated if you know the recipe.
Currently, Lorillard(NYSE:LO.DL), Reynolds American(NYSE:RAI), Imperial Tobacco, British American Tobacco, and Altria all have e-cig brands in development. In addition, Vapor (NASDAQOTCBB: VPCO) (the only fully reporting publicly traded electronic-cigarette company within the U.S.) and privately held NJOY are the largest pure-plays in the sector.
With so many competitors in such a relatively small but rapidly growing market, it is highly likely that price wars will soon start to ripple across the market. Rising competition means smaller margins, which will inevitably push some smaller competitors out of the market.
Lorillard acquired Blu eCigs last year for $135 million, and so far growth has been explosive; the brand is already in 80,000 stores.
Lorillard and Blu have the "first mover" advantage. Blu already has a 40% share of the e-cig market within the U.S., and sales during the second quarter alone totaled $57 million. For the first half, the gross margin stood at 33% although the net margin was only 8%. However, this did include the cost of rolling out the product across the country; margins should expand into the third quarter and second half of the year.
Unfortunately, in comparison, Vapor is hardly able to compete. Vapor's sales for the first six months of the year totaled $12.5 million and the gross margin was 40%. Nonetheless, the company's tiny size means that it is not able to achieve the economies of scale that Lorillard can, and the net margin was only 0.5% for the first half of the year. That said, performance in the second quarter was poor and the company lost $54,600 while the gross margin contracted to 39%.
When we compare Lorillard's performance to that of Vapor, we can easily see how hard it is for smaller companies to break into this industry. On the other hand, it also shows how easy it is for larger, existing tobacco companies to enter the industry. Moreover, as Lorillard already controls nearly half of the market, it's going to be even harder for more competitors to enter the market.
All of these factors point to one conclusion: Big tobacco has the ability to lock out smaller competitors. The CEO of yet another small e-cig producer, Logic Technology, states: "We're hoping they don't tell their customers, 'If you want to carry our cigarettes, make sure you have our e-cigs.' "
However, with such a huge amount of choice hitting the market, underhanded tactics like this may start to take hold.
In the past two months alone, Altria and Reynolds American have started the roll-out of e-cig brands: Altria with the MarkTen e-cigs and Reynolds with Vuse -- both on the back foot of Lorillard.
But it's not just e-cigs. Sales of existing smokeless products notched high single- to double-digit growth as Americans puffed on fewer cigarettes and other traditional smoking-tobacco products.
Reynolds American leads the U.S. smokeless-tobacco market when it comes to snuff, so the company is well placed to break into other smokeless markets. Indeed, Reynolds' adjusted operating income from cigarettes sank 2.2% in 2012 while earnings from snus advanced 10%.
The company's key brand is Camel snuff, which accounts for 81% of the $175 million United States snus market. The closest competitors are Altria's Marlboro and Skoal brands. What's more, according to leading tobacco company Swedish Match, the U.S. snus market has grown at a rate of 5% annually for the past five years and this is expected to continue -- cigarette consumption is expected to continue declining, however.
All in all, e-cigs may be one of the fastest-growing and most disruptive technologies to hit the market this year. With so much competition now hitting the market, however, it could be wise to stand back and only back the winners -- when they emerge.