Altria Group (NYSE:MO), Reynolds American (NYSE:RAI), and Lorillard (UNKNOWN:LO.DL) combine for a 91.5% share of the U.S. cigarette market. This concentration of market power gives these companies pricing power that enables them to keep growing their profits even as the cigarette market declines. E-cigarettes are the only product that could threaten the cigarette oligopoly, but proposed Food & Drug Administration, or FDA, rules may have just created an e-cigarette oligopoly dominated by Altria, Reynolds, and Lorillard. This is terrific news for the big three U.S. tobacco companies and their shareholders.
FDA creates barriers to innovation
Although they are usually meant to promote the public interest, government regulations almost always favor big business. Large enterprises can more easily comply with burdensome regulations than their smaller counterparts can, which gives the bigger businesses a competitive edge. In fact, Altria, Reynolds, and Lorillard have dominated the cigarette market for so long because marketing restrictions make it difficult to introduce new brands, so it is nearly impossible for upstart brands to challenge the existing hegemony.
The story is no different in the e-cigarette market. The FDA's proposed rules will limit innovation and increase the cost structures of companies in the market. The rules stipulate that the FDA will allow all e-cigarettes on the market that are "substantially equivalent" to devices that existed prior to February 15, 2007 to remain on the market. Companies must submit all others to the FDA for approval.
Respected tobacco analyst Bonnie Herzog says e-cigarettes will outsell combustible cigarettes only if the industry continues to innovate. Manufacturers must develop e-cigarettes that are virtually identical to combustible cigarettes for the category to reach its full potential.
If the FDA enacts its proposed rules, innovative e-cigarettes would have to undergo a costly approval process before hitting the market. According to Greg Conley, a tobacco policy researcher for the Heartland Institute, each e-cigarette application will require over 5,000 man-hours for the FDA to complete. As a result, each application will cost manufacturers millions. This effectively precludes small manufacturers from introducing innovative e-cigarettes. As a result, the e-cigarette players with the biggest budgets -- Altria, Reynolds, Lorillard, Logic, and NJOY -- have a tremendous advantage in the market.
High cost benefits big companies
Altria, Reynolds, and Lorillard are among the handful of e-cigarette manufacturers that can easily absorb the increased compliance and review costs. Each has a tremendous amount of free cash flow that can be redirected to support e-cigarette innovation and advertising.
For instance, Altria generated over $4.3 billion in cash from operations during 2013. Of that, only $131 million went toward capital expenditures to maintain its operations. The rest -- over $4.2 billion -- went toward dividends and share repurchases. Altria could easily redirect $20 million to $30 million from share repurchases to cover FDA compliance costs. An e-cigarette start-up might raise enough cash to fund one or two FDA reviews before it either succeeds or fails. Altria can fund as many reviews as it takes to get it right.
Reynolds and Lorillard also share in the funding advantage. In 2013, Reynolds generated $1.3 billion in cash flow from operations. Reynolds used cash accumulated on the balance sheet to return over $2.1 billion to shareholders through dividends and share repurchases. The story is the same for Lorillard, which paid $823 million of its $1.2 billion in operating cash flow as a dividend and borrowed money to repurchase $775 million worth of stock. Both companies are returning over nearly $2 billion in cash to shareholders each year. Reynolds and Lorillard could easily redirect $50 million to exploit their advantage in the e-cigarette approval process, justified by the potential of a high return on investment in the e-cigarette market.
Altria benefits the most
Altria, Reynolds, Lorillard and other e-cigarette manufacturers that can spend tens of millions to develop innovative products will capture most of the category's growth going forward. However, potentially long wait times for FDA approval will inevitably slow the pace of innovation. This is welcome news for Altria, the nation's largest combustible cigarette company. While Lorillard views e-cigarettes as a way to diversify its offering away from controversial menthol cigarettes, Altria sees the category as a potential substitute to Marlboro and its other top cigarette brands. Since the proposed rules not only give Altria an advantage over smaller companies but may also slow the pace of innovation, Altria's cash flow engine has protection from serious harm.
Reynolds and Lorillard will also benefit from being part of an oligopoly in the e-cigarette market. Menthol cigarettes account for about 80% of Lorillard's revenue. E-cigarettes provide much-needed diversification from the embattled category. Reynolds, which captures a 26.7% share of the combustible cigarette market, benefits insofar as e-cigarette growth exceeds combustible cigarette declines. If the big three tobacco companies split the e-cigarette market, Reynolds will surely benefit from e-cigarette growth.
On the face of it, red tape and compliance costs could hamper innovation in the e-cigarette market. However, the real effect of the FDA's rules is to concentrate innovation at just a handful of large players. This means that Altria, Reynolds, and Lorillard will likely capture the lion's share of growth in the e-cigarette market. As a result, tobacco investors should cheer on the FDA, even if it leads to slower growth in the years ahead.
Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.