Tobacco giants Altria (NYSE:MO) and Philip Morris International (NYSE:PM) recently announced that they would expand their agreement to sell e-cigarettes. This deal isn't surprising, since the two companies used to be a single entity. Altria, which generates all of its sales domestically, spun off its overseas operations as PMI back in 2008.
Two years ago, Altria granted PMI the exclusive right to sell its e-cigarettes overseas, in return for the right to sell two of PMI's "heat-not-burn" tobacco products in the United States. Under the new agreement, both companies will also share their research, development, and technologies to jointly produce new e-cigarette products. Will this new partnership help both companies diversify away from traditional cigarettes?
The business of e-cigarettes
Reynolds American's (NYSE:RAI) Vuse brand is currently the market leader with 36% of the U.S. e-cigs market, according to Nielsen's May figures. Vuse was notably one of the first e-cigs to regulate puffs and deliver consistent flavor with a computer chip. The second most popular brand is Blu, with 23% of the market. Lorillard sold Blu to Imperial Tobacco prior to its acquisition by Reynolds. The third largest player is Japan Tobacco's Logic, with a 14% market share.
Only Lorillard has reported e-cig sales separately. During the first quarter of 2015, it stated that sales of its Blu e-cigarettes fell 45% annually to $28 million due to aggressive competition. By comparing that figure with Blu's market share, we can assume that e-cigs aren't generating much meaningful revenue for the top players in the U.S.
The entire worldwide e-cigs market was only worth $1.4 billion last year, according to Nielsen. By comparison, Altria and Philip Morris respectively generated $24.5 billion and $80.1 billion in revenues last year.
Where does that leave Altria and PMI?
Altria entered the e-cig market last year with its MarkTen brand, which only claimed about 6% of the U.S. market. It also acquired premium e-cig brand Green Smoke last year to complement Mark Ten's growth.
Last year, PMI acquired U.K. e-cigs maker Nicocigs, which controlled over a fourth of the nation's e-cig market. It sells Altria's MarkTen as "Solaris" in Spain. It also introduced its iQOS e-cigarette in Italy and Japan. But unlike traditional e-cigarettes, which vaporize nicotine cartridges into water vapor, the device heats a tube of tobacco known as a "Marlboro Heatstick." Since the tube doesn't burn the cigarette and produce smoke or ash, it's arguably "healthier" than traditional cigarettes. A pack of 20 heatsticks costs about the same as a pack of traditional Marlboro cigarettes.
Altria and PMI's 2013 agreement diversifies both companies' e-cig portfolios. Altria can sell heated tobacco products to Americans who aren't accustomed to e-cigs, while PMI can sell Altria's vapor-based products overseas. Sharing R&D and tech will also reduce expenses at both companies. That's important for tobacco companies like Altria and PMI, which often use price hikes and job cuts to offset declines in cigarette shipments.
Potential pitfalls ahead
Despite this apparent land grab in the e-cig market, investors should remember that increased regulations, higher taxes, public bans, and the competition in the vapor market could derail that growth.
The FDA hasn't starting regulating the e-cig market yet, but the American Lung Association warns that early studies show that e-cigarettes still contain carcinogens. The Surgeon General has also warned that nicotine can still adversely affect fetal development and adolescent brain development. The CDC reports that e-cig usage among U.S. teens has tripled in a single year, which could increase pressure for tighter regulations. Several states plan to raise taxes on e-cigarettes, which could diminish their appeal with higher prices. Many cities are also extending their bans on cigarettes in public places to include e-cigarettes, which could further throttle growth.
Another major issue is the rising popularity of refillable vaporizers, which can be customized with more liquid and battery power. These vaporizers, which are sold at "vape shops," offer more types of flavored liquids at lower prices than regular e-cig manufacturers. This mix-and-match model undermines Altria and PMI, which sell proprietary cartridges on a traditional razor-to-razor blades model.
The bottom line
Tobacco giants like to talk a lot about e-cigarettes, but the overall market is still tiny. Instead of simply focusing on e-cigs, Altria and PMI investors should see whether or not they can keep raising prices to offset shipment declines. PMI investors should also beware of the strong dollar, which wiped out its top and bottom line growth last quarter. The e-cig market is certainly growing, but it would be premature to claim that they can replace traditional cigarettes.
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.