Is the Electronic Cigarette the Right Product for Lorillard?

Lorillard (LO.DL) continues to dominate the electronic-cigarettes market despite the strong competition it faces from other leading tobacco companies such as Reynolds American (RAI) and Altria (MO 0.26%). Is Lorillard's decision to expand its e-cigarettes business the right course of action? Here are three factors that put into question the potential upside the e-cigarettes business may offer for Lorillard. 

Growing competition
The e-cigarettes market has expanded in recent years as more tobacco companies, including Reynolds American and Altria, have entered this business with their own brands. Reynolds American has its VUSE Digital Vapor Cigarette, which is slowly gaining market share. It is a top-selling vapor product in Utah and Colorado. 

Altria has recently completed the purchase of Green Smoke via its Nu Mark subsidiary for roughly $120 million. Green Smoke's e-vapor makes Altria a prominent competitor against Lorillard in this market. Nu Mark plans to launch its e-cigarette brand MarkTen during June, which will only intensify the competition in this market. 

The past quarter shows that this growing competition has already taken its toll on Lorillard's revenue; during the first quarter of 2014, Lorillard's e-cigarette net sales declined by more than 10% year-over-year. Nonetheless, the company still reported a rise in its blu eCigs volume sold during the quarter. Moreover, Lorillard stated that its market share in the e-cigarettes market remained high at 45%. Alas, the intensified competition also translates into lower profits. 

Low profits
Lorillard reported a 24% year-over-year plunge in its gross profit from its e-cigarettes business segment during the recent quarter. As a result, its gross profitability slipped from 37% in the first quarter of 2013 to 31% in the past quarter. In comparison, its gross profit margin from regular cigarettes was around 39% in the first quarter of 2014. The lower profit margin from selling e-cigarettes indicates that this product is less profitable than regular cigarettes.

Currently, e-cigarettes account for only 3.3% of Lorillard's total sales. However, if the company further expands into the e-cigarettes market, its profit margin is likely to contract. Finally, during the first quarter, Lorillard recorded a modest operating loss from e-cigarettes due to a rise in selling, general, and administrative costs. These costs grew because Lorillard made further investments in order to improve its blu brand in the U.S. and launch this brand in the U.K. These investments could translate into higher revenue in the coming quarters, but they're likely to keep Lorillard's operating profit margin low. 

Unclear future
Strong competition and low profits aren't the only downsides of the e-cigarettes business; the future of this market remains unclear, especially if regulators treat e-cigarettes like regular cigarettes. According to the Food and Drug Administration's recent report, the FDA labeled e-cigarettes "tobacco products" because of the nicotine they contain. If FDA eventually succeeds in its efforts to regulate e-cigarettes as regular cigarettes, this could restrict the marketing and sale of e-cigarettes. With such an event, the progress of this market could slow down in the U.S. 

In conclusion...
Lorillard is still leading the way in the U.S. e-cigarettes market (in terms of market share). Despite this status, this product hasn't led to a sharp rise in revenue or wider profit margins for the company in the past quarter. These factors and the market's unclear future suggest that Lorillard might not benefit from this product.