E-Cigs Revolutionizing the Tobacco Industry

Bonnie Herzog, Wells Fargo Securities LLC

9/19/2013

The sector is embarking on a new era of growth and technological innovation

Based on our in-depth analysis of the tobacco industry over the next decade, we now anticipate the electronic cigarette market will approach $2 billion in retail sales (including online) by the end of this year and eclipse $10 billion by 2017.

Importantly, our analysis indicates that e-cigarettes could be margin enhancing to the combined category in the near term and by 2017, we predict e-cigarette margins could approach the mid-40-percent range, higher than the current conventional cigarette margins of approximately 40 percent.

Furthermore, we increasingly believe the entrance of the “big three” tobacco manufacturers (Altria Group Inc., R.J. Reynolds Tobacco Co. and Lorillard Inc.) could catapult the growth of the e-cigarette category, driving the total conventional cigarette and e-cigarette profit pool up by a compounded annual growth rate of 7 percent over the next decade. We reiterate our “overweight” rating on the tobacco sector as the industry embarks on a new era of growth and technological innovation.

Based on our analysis of the combined market in our proprietary, interactive model, we have increased conviction that consumption of e-cigarettes could surpass consumption of conventional cigarettes within the next decade (by 2023). Furthermore, as volume decline of conventional cigarettes accelerates, the big three manufacturers’ Master Settlement Agreement (MSA) payments decrease due to the volume adjustment. This results in higher margins for conventional cigarettes, driving total margin expansion.

WHO WILL WIN THE E-CIG WAR?

We believe the e-cigarette battleground is heating up, especially as the big three tobacco manufacturers push further into the category. We expect the big three to ultimately have a meaningful presence and likely accelerate growth of the category due to:

Their war chests of cash to invest, further boosted by billions of dollars from the non-participating manufacturer (NPM) credits and the elimination of the Federal Buyout Fee;
Their entrenchment with retailers, ensuring broad, scalable distribution; and
Their expertise at building successful brands and vast marketing databases of adult tobacco consumers.

While the big three are a triple threat — treasure troves of cash, distribution power at retail and superior brand-building capabilities — we think there is plenty of room for several of the other e-cigarette players, including NJOY, Mistic, Fin, Logic and Krave.

We are particularly impressed with NJOY’s early entrance into e-cigarettes and the strong brand and business it has built within the category it played a role in creating. We believe this has given NJOY a clear competitive advantage.

REGULATION LIKELY, BUT WON’T DERAIL GROWTH

We’ve long believed the e-cigarette category will be regulated, possibly similar to the conventional cigarette category, and that e-cigarettes will likely be taxed, but in a way that better reflects the potential relative risk. Despite this, we still believe the long-term growth trajectory of the category will be robust. Furthermore, regulation may actually be positive since it ultimately entrances existing e-cigarette players as it increases barriers to entry.

MIX SHIFT

E-cigarette packaging and consumer buying behavior is rapidly changing and we believe as more consumers try the product, there will be a mix shift — penetration of rechargeable e-cigarettes and starter kits should increase, while disposables decrease as a part of the overall mix.

We believe the industry will evolve to a razor/razorblade model, in which less margin is made on starter kits and rechargeable e-cigarettes and more margin is made on refill cartridges or cartomizers. Sales of these cartomizers will drive industry profitability.

We also believe technology is a competitive advantage, but the ultimate winners of the e-cigarette category will be those that create successful brands. Undoubtedly, technology is a crucial part of driving e-cigarette consumption, but building compelling brands is equally, if not more, important. Also, given that marketing and advertising are likely playing a larger role for e-cigarettes given fewer restrictions compared with conventional cigarettes, these costs are likely greater for e-cigarettes, but we believe they are offset by lower taxes.

Bonnie Herzog is managing director and senior beverage, tobacco and convenience store analyst for Wells Fargo Securities LLC. During her 14 years as a sell-side equity research analyst, Herzog has been a top-rated institutional investor analyst.

Editor’s note: This column is excerpted with permission from Bonnie Herzog’s June 12 research report. The opinions expressed are the author’s and do not necessarily reflect the views of Convenience Store News.