As the biggest player in the US cigarette market, Altria Group (MO +2.62%) needs to stay ahead of its peers. So, it was somewhat of a surprise when Lorillard (LO +0.00%), one of the smallest cigarette companies in the country, became one of the largest players in the domestic electronic-cigarette market.
It was also a surprise when Philip Morris International (PM +0.79%), without a doubt the world's largest cigarette company, revealed that is was also behind the rest of the industry when it came to developing e-cigs, lagging international peers such as British American Tobacco. However, despite being late to the party, Philip Morris and Altria are now catching up.
Still trying to crack the market
Altria rolled out its first e-cig product back in August under the MarkTen brand name. Initially launching in Indiana, Altria has since expanded into Arizona. When questioned by analysts, however, Altria did not release sales figures for the product. On the fourth-quarter conference call management said that e-cig sales were off to a strong start in Arizona.
Still, what Altria and Philip Morris International have is the world famous Marlboro brand name, which could be used to leverage their control over the e-cig market. Indeed, with hundreds of e-cig products chasing a relatively small market in comparison to that of the traditional tobacco market, big tobacco companies could become aggressive in trying to drive e-cig sales. Refusing to supply stores with Marlboro cigarettes unless they stock either Philip Morris' or Altria's e-cig product could be an underhand tactic these companies use to gain market share.
In addition, Altria has just jumped into the international e-cig market with the acquisition of Green Smoke for $110 million. Green Smoke is an international e-cig company that had sales of $40 million during 2013, mostly within the US and Israel. Furthermore, Green Smoke has its own well-established supply and distribution chain.
All in all, this should be a great deal for Altria, as $110 million is a drop in the ocean for the company and gives it exposure to the rapidly-growing international e-cig market.
Working together
Altria is also set to benefit from Philip Morris' donation of 'reduced-risk' products to the company's arsenal of products for sale within the United States. Reduced-risk products are, according to Philip Morris, products that reduce the risk of tobacco-related illnesses. Altria already has several of these products on the market, such as the company's Verve chewable nicotine product and Denmark, a type of gum containing tobacco. Altria is receiving these products as part of a technology-sharing deal agreed upon recently within Philip Morris. In exchange for the 'reduced-risk' products, Philip Morris is receiving exclusive rights to market Altria's e-cig products outside of the US. As of yet, it is unclear how the Green Smoke deal will reflect in this.
This is actually a great deal for both companies. You see, to some extent Philip Morris, although leader of the tobacco world, has gotten things wrong; the company has not taken the rise of the e-cig seriously. Specifically, while peers like Altria have had e-cig products under development for months, Philip Morris only announced its intent to enter the market in November. As a result, Philip Morris has found itself lagging the field when it comes to the subject of e-cig technology.
Early mover struggling
These products should help Altria continue to gain market share within the US tobacco market. Actually, Altria needs to market this move, as the e-cig market within the US is starting to become somewhat saturated. Indeed, Lorillard, one of the first domestic tobacco companies to move into the e-cig market, is already reporting almost no profits from its e-cig operations as marketing and selling costs rise.
For example, looking through the respective earnings reports, we can see that Lorillard's e-cig gross margin declined from 37%, reported during the first quarter of this year, to 29% during the fourth quarter. What's more, Lorillard's operating income and margin from its e-cig segment have declined from $7 million and 12%, respectively, in the first quarter of this year to zero for the full year. That's right, during 2013, despite a strong start to the year, Lorillard made no profit from its e-cig sales.
The reason for this? Well, the company rolled out a new, cheaper e-cig product and expanded its offering into an additional 127,000 stores, which damaged the gross margin. In addition, the company's marketing spend increased as it tried to beat competitors.
Far from a short-term issue, it seems as if higher marketing spending is going to become the norm as more competitors enter the e-cig market.
Foolish summary
So all in all, tobacco giants Philip Morris and Altria are now working together in the e-cig and reduced-risk markets, and this combination should be beneficial for both companies. It opens up markets that were previously outside of their reach.
