There Can Only Be One Winner In Big Tobacco's E-Cig War

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Includes: LO, MO, RAI
by: Rupert Hargreaves
Summary

The e-cig war between Altria, Reynolds and Lorillard is heating up.

There can only be one winner in this war and Lorillard is already starting to show weakness.

The company with the deepest pockets and widest distribution network will win.

This time last year everyone was raving about the electronic cigarette, or e-cig business, touting it as the next big thing in the tobacco world.

As an early mover, Lorillard (NYSE:LO), with its blu brand, quickly captured a large share of the U.S. e-cig market. However, the company's success quickly attracted the attention of peers Reynolds American (NYSE:RAI) and Altria (NYSE:MO). These two industry giants quickly set about developing their own e-cig products.

As Altria and Reynolds have now entered the market, along with hundreds of smaller competitors, the e-cig market place has become a crowded place to be. Unfortunately, as a result, profits are evaporating, a trend that can be seen within Lorillard's results.

Profits disappearing

During the third quarter, Lorillard's blu eCigs maintained its U.S. electronic cigarette category leadership position, achieving a 29.7% dollar market share. However, the company had to work hard to keep its share at this level; a level far below what it was in the year ago period.

For the first nine months of 2014, Lorillard's e-cig sales amounted to $126 million ended September 30, 2014, compared to $177 million for the first nine months ended September 30, 2013. Gross profit was $36 million, or 28.6% of net sales, for the first nine months ended September 30, 2014. This compares to gross profit of $54 million, or 30.5% of net sales, for the first nine months ended September 30, 2013. Gross profit and gross profit margin for the first nine months ended September 30, 2014 were negatively impacted by the mix of the new, lower priced rechargeable kits as well as higher retail distribution costs.

Reported selling, general and administrative costs were $84 million for the first nine months ended September 30, 2014, compared to $45 million for the first nine months ended September 30, 2013. Adjusted selling, general and administrative costs were $71 million for the first nine months ended September 30, 2014, compared to $45 million for the first nine months ended September 30, 2013.

Reported operating /income for the Electronic Cigarettes segment was $(48) million for the first nine months of 2014, compared to $9 million for the first nine months of 2013.

So, from a profitable position, as selling and distribution costs increased, Lorillard's e-cig division has been thrown into a loss making position. The company has even failed to maintain its market share.

During the third quarter, Lorillard's year-on-year e-cig sales figures were down by 50%. Net sales were $38 million for the third quarter ended September 30, 2014, compared to $63 million for the third quarter ended September 30, 2013. The brand was negatively impacted by competitors' new national product launches which were supported by aggressive introductory "free trial" promotional programs. Reported operating loss for the Electronic Cigarettes segment was $14 million for the third quarter of 2014, compared to $0 million for the third quarter of 2013.

Commenting on these results, Lorillard's management stated that:

"... We faced a dramatically heightened e-cig competitive environment, highlighted by two new national competitive product launches and their associated "free trial" promotions during the quarter. We are encouraged by blu eCigs' performance during the quarter in the face of this competition, while also maintaining its premium positioning and avoiding discounting... "

Key figures

These sales figures from Lorillard are key as the company is currently the only one of the 'big three' tobacco companies that gives a breakdown of e-cig divisional results. So far, both Reynolds and Altria have refused to comment on their sales figures when quizzed by analysts. For example, Goldman's analyst asked the following question on Altria's third quarter conference call:

Goldman Sachs … is there anything you can talk about just in terms of how much the national expansion of the Nu Mark [Altria's e-cig subsidiary] would have helped the revenue line, just to get a sense of, if we're actually seeing progression on the MarkTen sales side, I understand there is a lot of investment that's going on, but just trying to just sort of reconcile with what we're seeing from a Nielson market share data perspective and sizing the MarkTen number, from that data to kind of what you're actually reporting from a shipment perspective?

Management: Yes, I'm not going to provide any further detail on a quarterly comparison basis.

But it seems as if all three national competitors are now becoming really aggressive in their marketing strategy for e-cig products. Altria's Nu Mark and MarkTen e-vapor products achieved distribution in nearly 80,000 retail stores during the third quarter and as of September 30, 2014, MarkTen continued to be ranked in the top three e-vapor brands in the Western US based on retail market share. Nu Mark plans to further expand MarkTen in the Eastern half of the US and complete its national expansion in the fourth quarter. Additionally, Nu Mark has a pipeline of other vapor products under development.

As Altria expands, Reynolds is quickly catching up. The company's VUSE Digital Vapor Cigarette is available in almost 70,000 selected retail outlets across the country and an additional wave of expansion is expected early in the New Year. VUSE production capacity is still being ramped up and Reynolds continues to invest in the brand.

One thing to note with Reynolds' VUSE is the fact that 80% of VUSE sales are replacement cartridges. One of the problems companies in the e-cig space have is getting consumers to stay with the product and continue to buy without switching to a competitor. It seems as if VUSE has managed to achieve this goal.

If the merger between Lorillard and Reynolds does go ahead, then VUSE will become the combined entities e-cig of choice, the blu brand is being sold off to international tobacco giant, Imperial Tobacco (ITYBY). Unfortunately, with blu going to Imperial, the e-cig war will only intensify as Imperial will have its international firepower behind it. All in all, the market is only going to become more competitive from here on out.

Speculation

Nevertheless, it remains to be seen to what extent these e-cig investments are actually having on the bottom line of Reynolds and Altria. With Lorillard it's quite clear; the company is spending heavily but still losing market share as competition heats up. If this trend continues, then it's clear that the company with the deepest pockets and best relationship with suppliers will win, that's going to be Altria. This raises the question -- is it worth Lorillard spending to try and get ahead when it will be pushed out of the market?

Unlike Lorillard, Altria is actually hedging its bets. Not only is the company competing within the e-cig space but it's also working on a line of 'reduced risk' products. These are based on the iQOS platform is being rolled out now in two countries by Philip Morris International (NYSE:PM). Altria and Philip Morris are currently awaiting FDA approval on the reduced harm claim of these products. When the green light is given, the company will be able to offer consumers alternatives for those who want them.

The bottom line

There's no doubt the e-cig war is heating up and the way things are currently moving, there's no doubt that Altria will eventually gain control of the market. It simply comes down to the fact that Altria can outspend its smaller peers. Further, Altria is working on the development of other reduced risk products that can win over and sway the consumer towards its brand. And this is without mentioning the fact that Altria has sway over the national market with a 50% share of the cigarette market.

Disclosure: The author is long MO, LO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.