Are Electronic Cigarettes A Genuine Threat To Big Tobacco?

Includes: BTI, LO, PM, RAI
by: Equitable Research

Life is not getting easy for the tobacco industry these days. With the increasing taxes and widespread and concerted anti-smoking campaigns, more and more smokers are kicking the habit. Sales are slowly but surely going down and a horde of smaller players in the smokeless alternatives market are eating away at their core demographic of customers. Established players like Philip Morris (NYSE:PM), RJ Reynolds (NYSE:RAI) and British American Tobacco (NYSE:BTI), who constitute the so called Big Tobacco are feeling the heat from electronic cigarette pioneers like privately held Bull Smoke who have literally turned the high margin and extremely profitable conventional cigarette business upside down by promising to deliver a realistic smoking experience with their vapor generating electronic devices. The question that begs an answer is -- how will the "empire strike back"?

Electronic Cigarettes: Riding the anti-smoking wave

The rise in this new smoking (or vaping as enthusiasts charmingly call it) technology has been meteoric to say the least. From an idea that never really managed to get off of the drawing board in the 1960s, to a rebirth in the early years of the new millennium in China, the smokeless electronic cigarette has certainly had an eventful journey. Introduced into the Chinese market in 2004 as an aid to quitting cigarettes, the electronic cigarette eventually found its way into other markets worldwide. The rest, as they say, is history; or rather, history in the making. In the last 4 years, electronic cigarette sales have skyrocketed, culminating in sales in excess of three and a half million this year alone. With no prospects of any slowdown in the near future, smokers that are looking for a cheaper and healthier alternative to cigarettes see these new e-cigs as the way to go. And therein lies the potential problem for Big Tobacco.

Not everybody is a fan, certainly not the FDA

The authorities are not exactly pleased with the widespread popularity and the kind of publicity that electronic cigarettes are attracting. The FDA and FTC have been decidedly unfriendly in their stance towards electronic cigarettes. The initial attempts by the FDA to block electronic cigarette imports into the US and their classification as drug delivery devices rather than as tobacco products were struck down by a Federal District Court a couple of years back. Electronic cigarette proponents have noted the irony that an FDA-approved failure like going "cold turkey" is better than an unapproved success when it comes to smokers trying to quit.

The FTC is also challenging electronic cigarette advertising claims

At the same time that the FDA has their proverbial spotlight focused on the electronic cigarette industry, the Federal Trade Commission is increasingly becoming focused on the advertising claims made by manufacturers. Specifically, the FTC is interested in claims made that electronic cigarettes are a safe alternative to traditional cigarette smoking. Simply visit any reputable electronic cigarette website, like the one belonging to the aforementioned Bull Smoke brand for instance, and you will find scores of disclaimers that electronic cigarette companies are forced by their respective compliance departments to display. Despite some reputable testing that suggests that there is a benefit to electronic cigarette use over conventional tobacco, there admittedly has not been adequate scientific tests carried out that prove that electronic cigarettes are healthy or even less harmful compared to smoking tobacco. However, recent independent research out of Boston University has concluded that electronic cigarettes are indeed safer than their tobacco counterparts. So this begs another question -- why is there a crusade against this new and potentially safer technology?

Big Tobacco and electronic cigarettes

These last few decades have not been kind to the tobacco industry. After the devastating flurry of lawsuits by several US states, and the ensuing tightening of legislation at both the state and federal levels, this culminated in the Family Smoking Prevention and Tobacco Control Act of the Obama Administration. The writing is clearly on the wall for Big Tobacco. Sure, they have promising emerging markets in less developed nations where they can expand, despite hostile legislation. But still, if they want to prosper in the western hemisphere, they will have to look beyond conventional tobacco. They are already exploring the possibilities offered by smokeless alternatives like snuff and snus in the European markets. However, the rise in popularity of electronic cigarettes has put the major players in a sure quandary.

If you can't beat them, eat them!

Electronic cigarette technology is a product that is clearly hostile to Big Tobacco's already flagging interests in the tobacco market. One that contributes to the acceleration of the decline of their global sales numbers. It would have been surprising to say the least, if they, with their considerable economic resources and lobbying clout, did not try get on board themselves with this new technology. So the question remains, what do you do when you are sitting on piles of cash that exceeds the GDP of several small nations, let alone the entire electronic cigarette industry? The simplest move would be to move in and start buying the emerging electronic cigarette competition. It is as simple as that, and they are already doing it. The recent acquisition of blu Cigs by Lorillard (NYSE:LO) is evidence of this new initiative. The tobacco giant, best known for their iconic Newport menthol brand of cigarette, easily gobbled up the largest electronic cigarette company in the US, for a paltry (for them) $135 million.

Why hasn't Big Tobacco swallowed the entire electronic cigarette market?

Well, there could be a few reasons that are playing around in the minds of Big Tobacco. For starters, just one cursory glance at the electronic cigarette market throws up a whole gaggle of smaller players all looking for a slice of the proverbial pie. Big Tobacco is better off biding their time waiting for established electronic cigarette companies to rise in the medium term to long term future and then deal with them -- they can always out-muscle and takeover the competition, rather than swallowing them whole. Besides, they would not want to get on the wrong side of US anti-trust laws, which can be harsh when it comes to dealing with oligopolistic conduct that may be deemed as anti-competitive. A group of companies (Big Tobacco) buying out the competition across the board would decidedly come under the purview of "anti-competitive." Also, the electronic cigarette market still needs consolidation in terms of regulatory framework. The federal government's stance towards electronic cigarettes, judging from the conduct of FDA and the FTC so far, still gives some measure of hope to tobacco companies. So at the moment, their conduct so far can be described as cautious and defensive, where they try to maintain a foothold in the electronic cigarette market by starting their own subsidiaries and buying a few of the bigger players at present (Lorillard acquiring blu Cigs), while waiting for further developments. Given the precarious position that they are already in, they definitely cannot afford throw caution to the wind.

Why should investors be aware?

Of all the alternatives to smoking tobacco, electronic cigarettes present the most promise. RJ Reynolds has already started its own line of electronic cigarettes under the Vuse brand. Rivals Philip Morris, British American Tobacco, Imperial Tobacco and Japan Tobacco are also planning to enter the market. However, as an industry observer, I would argue that their recent foray is late to the game and their offerings and planned releases to date have not been very attractive. As the electronic cigarette market continues to grow rapidly and presumably cannibalize traditional tobacco sales, Big Tobacco seems to be a step behind on every move and is now only playing catch up. This after previously writing off the rapidly growing industry as a fad and now being forced to pay up for acquisitions. Despite sitting on piles of cash and paying out healthy dividends, as an investor I would be very leery of backing any Big Tobacco names. This is simply due to the strong global trend away from conventional cigarettes and into this new disruptive electronic smoking technology whose dominance has so far escaped the grips of Big Tobacco.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.