Will Washington Stamp Out the E-Cigarette Boom?

With the FDA proposing regulation over this up-and-coming industry, should tobacco investors be worried about their favorite stocks?

Dan Carroll
Dan Carroll
Apr 27, 2014 at 10:17AM
Health Care

There's a new spark in today's tobacco industry, but it's not lighting up cigarettes. Not traditional cigarettes, at least.

The tobacco industry's long been a favorite among dividend investors for its high yields and reliable cash flow, but the rise of e-cigarettes has lit a fire of growth potential around the market. E-cigarettes have risen from new products to a $2 billion industry quickly , convincing all the big names around the industry from Lorillard (UNKNOWN:LO.DL) to Altria (NYSE:MO) to Reynolds American (NYSE:RAI) to push for dominance in this up-and-coming market. While the e-cig industry pales in comparison to the overall tobacco market's size – according to the CDC, more than 293 billion cigarettes were sold in the U.S. in 2011 – many analysts believe that the e-cig market will surpass traditional cigarette sales in the future.

The emergence has been big for tobacco customers too, with the hype of lower costs over time for e-cigs as compared to cigarettes giving a boost to consumers' wallets. Meanwhile, federal regulators have watched and waited for this market to develop – until now.

Could the FDA halt the e-cig boom in its tracks?
The FDA proposed on Thursday to regulate the e-cigarette market and offered up new rules regarding sales; will government oversight throw cold water over this blazing-hot growth market?

Fortunately for companies counting on the market's rise, the FDA's proposed regulation doesn't go anywhere near as far as it could have. The agency proposed prohibiting anyone under age 18 from buying e-cigarette products, as well as requiring health warnings of the products and banning vending machine sales. Notably, however, the FDA didn't ban advertising or online sales.

Electronic cigarettes, shown being used by a model, convert liquid to vapor rather than burning tobacco.  Source: Wikimedia Commons, User Michael Dorausch.

That's a major breath of fresh air for tobacco manufacturers looking to make the most out of this growing niche, but it's only a proposal: Investors and companies shouldn't take today's guidelines as final, particularly after health advocates cried foul over the loose regulations offered. Individual states could also impose harsher rules even if the FDA's propositions go forward.

Scientific research has been slow to catch up with the e-cig boom, muddling claims from both supporters and opponents of e-cigs and making final industry regulations difficult to project. Some have touted e-cigarettes, which use liquid that is heated into vapor rather than burning tobacco to operate, as a safer alternative to traditional cigarettes. Select expects have said that the proliferation of e-cig use could also cut down on traditional tobacco use, helping to drive down smoking-related deaths and adding more public health-related fire to pro-industry causes.

However, industry opponents have fired back, citing a lack of studies and the potential health risks that could come from rise of children trying e-cigarettes. According to the Washington Post and a survey last year from the CDC, 10% of polled high schoolers admitted to trying e-cigarettes in 2012, more than doubling the 4.7% number from 2011.

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Still, there will be some time before any of the FDA's regulation is set in stone for this industry. It's important for investors to look ahead, however: How could the biggest names and stocks in tobacco be affected?

Big tobacco's big e-cig push
Most of the big names in tobacco have joined in on the e-cigarette boom by now, and investors should only expect more action from the top companies in the near future.

Lorillard took the first dive into the up-and-coming market by the big tobacco producers in its purchase of Blu eCigs back in April 2012. The $135 million deal helped push early leadership for Lorillard in the industry, and the Wall Street Journal reports that the company's products maintain nearly a 50% share of the market for e-cigs in convenience stores. Still, e-cigs are some distance away from becoming a big part of Lorillard's business. The company reported in its most recent earnings report that its Electronic Cigarette business recorded sales of $51 million in the first quarter, down from $57 million a year ago. By comparison, Lorillard's Newport brand raked in sales of more than $7.5 billion for the quarter, albeit at a 1.5% year-over-year revenue decline.

Lorillard might not be making a mammoth sum from e-cigs just yet, but with traditional cigarette sales struggling for growth, it's pivotal the company continue to invest in the niche's growth potential. The company's also the market leader right now, according to the WSJ, so if Lorillard can maintain its position while reigniting growth, this company could be poised for a windfall in the long term and continue its stock's rally after gaining more than 26% over the past year. In fact, Lorillard's been among the tobacco industry's best-performing stocks as of late, and boasts a 4.5% dividend to sweeten the deal.

LO Chart

LO data by YCharts

Altria, the top U.S. tobacco giant, showed up late to the game but is doing its best to rally behind e-cigs. The company's pushing to launch its MarkTen e-cigarettes across the nation sometime in the second quarter. Altria also acquired e-cig maker Green Smoke for $110 million back in February in order to catch up to the market's leaders. Green Smoke conducts much of its business online, making the FDA's refusal to crack down on online sales in its proposed regulations particularly beneficial to Altria's hopes in the market.

Altria also recently inked a deal with Phillip Morris (NYSE:PM) to license the former's e-cig products for use internationally. Phillip Morris hasn't been particularly early to the e-cig race either, but the company, which sells Altria's brands in countries outside of America, should help Altria in its push to capture a slice of the market – one that should help its own global efforts, as well.

Like Altria, Reynolds American hasn't gotten as far into the market as Lorillard has – but also like Altria, the company's planning to push for a larger rollout of its Vuse e-cigs later this year after launching the products in Colorado and Utah earlier. According to Reynolds American's most recent earnings report on Wednesday, the Vuse has risen to become the market leader in both of those states since its launch. It's yet to be seen how Reynolds will fare against tougher nationwide competition, but it's been so far so good for the country's second-largest tobacco giant.

Too much potential to ignore
Investors, consumers, and industry observers shouldn't count on anything firm from the FDA yet, considering that Thursday's proposed regulations are only the first step toward final guidelines on e-cig oversight. Even if regulators crack down with harsher regulations on this industry, however, don't expect the big names of big tobacco to ease up on their push into the e-cig market. The potential for huge growth over the coming years is too big to ignore for every investor in the industry – market-transforming potential that could add a much-needed dose of growth to dividend-friendly stocks in the long term.