Altria Group (NYSE:MO), Coca-Cola (NYSE:KO), and PepsiCo (NASDAQ:PEP) are all leaders in their respective markets. Coca-Cola and PepsiCo have dominated the carbonated soft drink market for a century and decades from now, the two companies are bound to maintain their No. 1 and No. 2 positions. However, the two soft drink giants missed the boat on a fast-growing soda substitute: energy drinks. Energy drinks have resulted in market share declines for the soda giants that show no indications of letting up. E-cigarettes have the potential to do to Altria what energy drinks have done to Coca-Cola and PepsiCo. Having learned from watching the soft drink decline, Altria is not going to let e-cigarettes destroy its market share.
Coca-Cola and PepsiCo ignore a substitute
The U.S. energy drink category grew 25-fold in a little over a decade, from just $350 million in sales in 2000 to $9 billion in 2013. Red Bull and Monster Beverage (NASDAQ: MNST) together have carved out a nearly 80% combined share of the U.S. energy drink market, making it difficult for even Coca-Cola and PepsiCo to make headway in the growing category.
After failing to acquire either top energy drink brand in the early stages, the two soda giants are left to fight over which company distributes which drinks. PepsiCo was able to get No. 3 energy drink brand Rock Star to switch from Coca-Cola in 2009, while Coca-Cola is the primary distributor for No. 2 Monster Beverage. Neither has been able to crack the top three with their own energy drinks, however causing them to miss out on much of the category's growth.
Although health concerns are to blame for the decline of the overall category, a significant chunk of Coca-Cola and PepsiCo's lost carbonated soft drink market share is due to the rise of energy drinks. Since 2000, Coca-Cola's market share has fallen 1.7 percentage points to 42.4% and PepsiCo's market share has fallen 3.7 percentage points to 27.7%. Over the same period, the rest of the industry (excluding Dr Pepper Snapple Group (NYSE: DPS)) increased its share 3.2 percentage points to 13%. When the author spoke with John Sicher in 2012, the Beverage Digest editor attributed much of the increased share of the "rest of the industry" to the rise of energy drinks.
E-cigarettes pose same threat as energy drinks
Like the U.S. soft drink market, the cigarette market is in decline due to the health hazards posed by the products. Altria's 50.6% cigarette market share puts it in a similar competitive position as Coca-Cola. Unlike energy drinks, however, e-cigarettes may soon eclipse their direct competitors; tobacco analyst Bonnie Herzog believes that e-cigarettes have the potential to outsell traditional cigarettes within the next ten years. However, she says it will take significant investment to create an e-cigarette that is viewed as a true substitute for traditional cigarettes. Altria's investment in the category might even be needed to speed up that process of innovation -- which could be a negative for the largest U.S. cigarette manufacturer -- but the category poses too great a threat to ignore it. If competitors develop e-cigarettes that are viewed as a substitute for traditional cigarettes, Altria's market share could be affected far more than Coca-Cola's was by energy drinks.
Knowing that it is vulnerable to the substitute product, Altria is making a strong early push into the e-cigarette market. This is despite the category's relatively small size; the U.S. e-cigarette market is still only 1/100th that of the tobacco market. Altria is rolling out its MarkTen e-cigarette brand nationwide this quarter after successful testing in Arizona and Indiana markets. MarkTen gained an impressive 48% market share in its test markets, giving investors reason to believe that Altria can be a major player in the e-cigarette market.
Altria also bolstered its e-cigarette offering through its recent acquisition of Green Smoke, a premium e-cigarette manufacturer. Green Smoke has been in the e-cigarette business since 2009 – making it a veteran in this young industry – and has grown to to $40 million in sales in 2013. Green Smoke's experience and market presence could help Altria make significant headway in 2014.
Regardless of how well the e-cigarette market actually performs, Altria's strong push into the market hedges its position as America's No. 1 cigarette company. If the e-cigarette market takes off, Altria will be there to profit from it. Should e-cigarettes lose traction in the U.S. market, Altria will have wasted only a small fraction of its billions in free cash flow on a promising market. No matter what happens, Altria is not repeating Coca-Cola and PepsiCo's mistakes. For that, shareholders should be grateful.