Is the E-Cigarette Industry Going Up in Smoke?

After electronic cigarettes burst onto the scene just a few years ago, Big Tobacco investors had big hopes for the fledgling smoking subsector. But the business is looking riskier by the day. The Food and Drug Administration recently issued new e-cigarette regulations, including banning the sale of e-cigs to minors, as well as requiring that adults under the age of 26 show photo identification to buy them.e-cigarette industry
In addition, e-cig device manufacturers and vape shops will need to submit applications to get products approved, which could cost more than $2 million per product.
Just a few years ago, it was widely thought that e-cigarettes were the next great growth engine for Big Tobacco. Sales of e-cigarettes were on fire, and some of the biggest tobacco companies – including Altria Group (NYSE: MO) and Lorillard, now part of Reynolds American (NYSE: RAI) – were investing in the concept.
Today, it all looks like a distant memory. After a brief boom, sales of e-cigarettes are collapsing – and they are poised to decline further still, now that regulations are about to get even tougher. Fortunately, Altria and Lorillard resisted the urge to spend heavily on e-cigs, and they look much better off for having discipline. E-cigarettes could be about to go up in smoke.

Sound Management Strategies

Industry behemoths Altria and Lorillard set their sights on e-cigs several years ago, but only dipped their toes. The two companies invested slowly in the e-cig business, taking a wait-and-see approach that has served them well.
Initially, Altria’s MarkTen brand of e-cigarettes was a fledgling operation. The company first rolled out MarkTen in just two states: Indiana and Arizona. After promising test results, Altria took the brand national.
In addition, in 2014, Altria’s NuMark subsidiary purchased Green Smoke’s e-vapor business for $110 million to further boost its presence in e-cigarettes.
Similarly, Lorillard bought out Blu eCigs in 2012 for $135 million. It immediately took the lead in the emerging e-cig category, but neither company went overboard – Altria and Lorillard still made the bulk of their sales from traditional cigarettes.
Altria should be fine even if the e-cigarette industry flames out. Approximately 89% of Altria’s revenue still comes from smokeable products like traditional cigarettes and cigars.
Reynolds American in particular looks extremely savvy. Back in 2014, when the company bought out Lorillard for $27 billion, a key part of the deal was that it would divest the Blu eCigs brand to Imperial Brands (OTC: IMBBY).
In order to help the deal earn regulatory approval, Reynolds American and Lorillard agreed to sell the Kool, Salem, Winston, Maverick and Blu brands for $7.1 billion. In hindsight, this appears to have been a brilliant move.
On the surface, it looked like Reynolds American and Lorillard were too eager to get the deal done and gave up a prized asset. This was a notable move, because prior to the deal, Lorillard held nearly half of the e-cigarette industry market share, thanks largely to Blu.
Reynolds American now looks to have gotten the better of Imperial Brands. Perhaps management was shrewd enough to see that e-cigs were a passing fad and sold Blu at the peak of the trend.
Similarly, there were signs that Altria’s foray into e-cigs wasn’t panning out as the company had hoped. Altria’s MarkTen e-cigarette product is tucked away in the company’s “All Other” operating segment. Sales in this segment have fallen consistently, from $211 million in 2013 to $71 million last year.

The Final Puff

It is understandable for investors to be disappointed that the FDA is clamping down on e-cigs, a product that was once hoped to be the next growth engine for the Big Tobacco industry in an environment of falling smoking rates in the U.S.
But the decisions by Altria and Lorillard to proceed with caution in the e-cigarette business turned out to be the right strategies to take. Now that the FDA is tightening its grip on e-cig regulation, it is much easier for Altria and Lorillard to walk away from the business entirely if need be.
The e-cigarette industry faces an uncertain future in the United States, but the good news for investors is that neither Altria nor Reynolds American got ahead of themselves during the e-cig boom. Both companies invested resources in e-cigarettes, but neither bet the farm.
The downside is that Big Tobacco needs to come up with a new growth catalyst.

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