The diminishing use of cigarettes in the developed world suggests the biggest global tobacco companies will eventually be running on vapours.
That's not so bad, though, if the vapours in question come from electronic cigarettes and other new products that simulate the sensation of smoking, absent all that burning tobacco in conventional smokes. Faced with one of their biggest challenges yet, most of the big cigarette companies are embracing the devices that are designed to put their legacy products out of business. In the process, they're finding a way to bring growth back to what had become a story of slow decline.
Investor excitement over e-cigarettes has helped prop up – and even boost – the companies' shares, with a number of the U.S.-based concerns hitting 52-week highs in recent days. Lorillard Inc., the biggest player in e-cigarettes among the large tobacco companies, now may be the acquisition target of one of its peers, Reynolds American Inc.
The rising valuations are a change of pace for tobacco shares. A number have lagged the broader market since the financial crisis, and nearly all have remained cheap, despite providing their holders with healthy cash flow and ample dividends. The danger, however, is that investors may be overlooking some key risks. Analysts project that e-cigarette customers will put far less on the companies' bottom line than tobacco smokers. Regulation of the products is in the early stage, so new rules could crimp sales and profitability. And just as e-cigarettes are becoming part of the big companies' product portfolios, the introduction of even newer technologies by smaller companies means they may fall behind again.
It's enough to suggest that today's investors may see their hope for gains go up in smoke.
Electronic cigarettes and their variants heat water until it turns into a vapour that allows the user to simulate smoking; most contain nicotine in order to satisfy the primary addiction of the tobacco smoker. A study in Britain this week suggested that smokers who are trying to quit are 60 per cent more likely to succeed with e-cigarettes than with other nicotine products such as patches or gum, or by simply going cold turkey.
All the major tobacco companies have either acquired young e-cigarette makers or are developing their own. Lorillard bought the blu brand in April, 2012, and Britain's SKYCig late last year, and is the market leader for e-cigarettes in the U.S. Reynolds American introduced its VUSE product in Colorado last year and plans to roll it out nationally this year. Altria launched its MarkTen brand last year and purchased a company called Green Smoke earlier this year. British American Tobacco introduced Vype in Britain last year. Philip Morris International and Imperial Tobacco plan to launch products later this year.
"E-cigs are a small but fast-growing niche," Morningstar analyst Tom Mullarkey wrote in a recent report. "We believe that e-cigs will likely be a disruptive catalyst to industry profits because of the category's hastening the decline of cigarettes in advanced economies, and the likelihood that the e-cig market will become much more competitive than the traditional tobacco market."
Bonnie Herzog, an analyst for Wells Fargo Securities, sees the sales of packs of traditional "combustible cigarettes" declining at mid-single-digit rates until 2017, when double-digit declines begin. She forecasts vapour product sales rising from 400 million pack equivalents in 2013 to 5 billion in 2022.
It's better for a tobacco company's profits to sell former smokers something, rather than nothing, but the profitability of this shift is problematic. Analyst Michael S. Lavery of CLSA estimates the average "customer lifetime values" for the big three U.S. companies – Altria, Lorillard and Reynolds American – to range from $1,929 to $2,527 (U.S.) for traditional cigarettes. His "best case" estimate for the dollar value of average profit per e-cigarette customer of these companies range from $865 to $1,378, and his preferred estimates range from just $334 to $444.
"We believe an e-cig user's customer lifetime value is structurally lower than that of a smoker, a potentially serious long-term risk to the industry profit pool," he writes. "E-cig sales [come] from smokers, but barriers to entry are low, and brand equity must be built from scratch; tobacco incumbents are not automatic winners for share. Even if margins achieve cigarette levels, price points are lower (so less dollar contribution), and customer retention rates are likely lower without the benefit of strong brand equity."
Meanwhile, Ms. Herzog, of Wells Fargo, says the future of no-smoke cigarettes belongs to a new subset of the category, devices that eschew the "e-cigarette" name and are instead known as "vapours," "tanks" or "mods."
These products, primarily sold online or in "vape shops," allow users to draw in vapour more efficiently, Ms. Herzog says, have special customizable flavours and cost about 30-per-cent less than e-cigarettes for a week's worth of use.
"While we believe the combined profit pool of combustible cigs and e-vapour will continue to grow, we increasingly question which company(ies) will capture the bulk of the profits," she says. "We question how the Big 3 will or could get involved, especially given part of the vaping culture is a disdain for Big Tobacco and not wanting to be associated with smoking or be considered a smoker."
The prices for the major tobacco companies' shares don't reflect these concerns, however; their forward price-to-earnings ratios range from 15 up to nearly 18, higher than they've been in years. This makes sense: On the surface, the shares are more appealing than in some time, because they combine ample dividend yields with a sexy technology story. But if things shake out the wrong way for Big Tobacco, today's investors will look back and wonder what they were smoking when they bought the shares.
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