The two biggest players in the U.S. cigarette market, Altria (NYSE:MO) and Reynolds American (NYSE:RAI), are clashing over a steadily shrinking market. Altria controls around half of that market, while Reynolds will control roughly 34% after its $27.4 billion merger with Lorillard (NYSE:LO) closes next year.

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Altria's iconic Marlboro brand. Source: Wikimedia Commons

The number of adult smokers in the U.S. has declined from 42% in 1965 to 18% in 2012, according to the Surgeon General's Report on Smoking and Health. To compensate for that decline, Altria and Reynolds slashed jobs, raised cigarette prices, and expanded into other product categories like snuff and e-cigarettes. Altria also sells wine and cigars, while Reynolds sells nicotine gum.

E-cigarettes are the most closely watched alternative product category at both companies. That market was worth around $1.7 billion in 2013, but climbed to roughly $2.5 billion by late August, according to Wells Fargo analyst Bonnie Herzog. Will this new "vaping" craze last, and will it be enough to offset losses in traditional cigarettes?

The business of vaping
Reynolds' Vuse e-cigarettes control less than 3% of the U.S. market. That's why investors were surprised when Lorillard spun off and sold Blu eCigs, which accounted for 30% of the U.S. market last quarter, to rival Imperial Tobacco Group in July.

The U.S. market share for Altria's MarkTen e-cigarettes is unclear, although the company claims that it ranks among the "top three" vapor brands in the western half of the country, with a 48% market share in Arizona. Altria intends to complete the national expansion of the MarkTen brand in the fourth quarter, which should give investors a clearer perspective on its national growth by next year. Altria also recently acquired Green Smoke's "premium" e-cigarette business in February for $110 million. As a result of that aggressive expansion, Altria could control 15% of the U.S. e-cigarettes market by 2021, according to Trefis.

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Altria's MarkTen e-cigs. Source: Altria

Why could the e-cigarette market fail?
The problem is that the growth of the e-cigarette market isn't guaranteed. Much of the market's earlier growth was fueled by the lack of regulations and excise taxes on e-cigarettes.

The FDA currently states that e-cigarettes "have not been fully studied," so the risks and smoking cessation benefits are unclear. The WHO has already called for tighter regulation of the industry and bans on indoor use, advertising, and sales to minors. Although e-cigarettes lack cancer-causing tar, nicotine (which is vaporized in e-cigarettes) has been implicated in causing heart disease and high blood pressure. Partial public vaping bans have already been passed in New York, Chicago, and Los Angeles.

Refillable vaporizers which offer over five times the liquid and battery power of Altria and Reynolds' "cigalike" products are now gaining market share via "vape shops" across America. This is highly disruptive, since Altria and Reynolds have been rolling out their e-cigarettes in convenience stores, which still account for around seven out of 10 cigarettes sold. As a result of that shift and "free trial" products from Altria and Reynolds, Lorillard reported that its e-cig sales in the first nine months of 2014 fell 29% year over year to $126 million. That decline, along with possible antitrust issues from merging with Reynolds, likely convinced Lorillard to sell Blu.

Excise taxes could also make e-cigarettes more expensive than traditional smoking cessation products like nicotine gum and patches. Minnesota and North Carolina have already imposed excise taxes on e-cigarettes. Minnesota taxes both e-cigarettes and "e-juice" at 95% of their wholesale cost. North Carolina imposes a tax of $0.05 per fluid millimeter of the liquid, which is significantly lower than its tax of $0.45 per pack of traditional cigarettes.

Which is the better stock?
Altria and Reynolds American's stocks have both rallied nearly 30% since the beginning of the year. But when we look closer at several key figures, we see that Reynolds could be a better bet at current prices.

 

Forward P/E

YOY rev. growth (mrq)

YOY EPS growth (mrq)

Cigarette sales growth

Forward annual dividend yield

Altria

17.8

(0.1%)

0.1%

0.2%

4.2%

Reynolds American

17.5

4.9%

2.2%

(2.9%)

4.1%

Advantage

Reynolds

Reynolds

Reynolds

Altria

Altria

Source: Yahoo! Finance, Nov.10, and company quarterly reports

Reynolds' core cigarette business looks wobbly compared to Altria's, but that weakness should be negated by acquiring Lorillard, which reported 1.6% sales growth in cigarettes last quarter. Moreover, the megamerger is expected to achieve cost savings of around $800 million on a run rate basis, which should eventually boost its bottom line.

The road ahead
When it comes to tobacco stocks, investors should mainly focus on earnings and dividend growth. In my opinion, e-cigarettes are an interesting way to diversify away from the traditional cigarette market, but their long-term growth potential is hardly guaranteed. Instead, investors should see if cigarette price hikes can keep offsetting slowing unit sales, and how other noncigarette products -- like snuff, wine, and nicotine gum -- are selling instead.

 

Leo Sun owns shares of Altria Group. 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.