Tuesday, 20 August 2013

E-cigarettes: e-xciting or e-xaggerated

"People smoke for nicotine, but die from tar". It is therefore surprising that the tobacco companies have not, until now, found a solution. E-cigarettes enable smokers to enjoy the sensation of smoking and nicotine without having to inhale tar, carbon monoxide and other chemicals. As well as the health benefits, e-cigarettes currently offer more freedom to smoke in public places, such as pubs and restaurants.

The market for reduced harm nicotine products is huge. Consumers are well aware of the health benefits of quitting or reducing smoking, however many are never able to so, due largely to nicotine addiction. In the UK, there are estimated to be 1.3 million e-cigarettes consumers, up from 700,000 last year. We estimate that the industry already generates £100m a year in UK sales, and interest in them continues to grow, as demonstrated by the number of Google searches.

Source: Brewin Dolphin, Google, Chamber photography

E-cigarettes could ultimately become more popular than cigarettes, as consumers are able to feed their nicotine addiction without the health concerns of smoking, however we believe their ultimate popularity depends on Government regulation and legislation.

Exponential growth?

E-cigarettes offer the tobacco industry the first real product diversification for a century and the first product innovation in decades. Although they currently account for a tiny proportion of industry volumes and profits, growth projections make exciting reading, with 50% annual compound growth expected over the next few years. This is, however, off a very low base, as e-cigarettes currently account for less than 1% of US annual tobacco sales of around $100 billion. Growth rates like this are attractive for investors in an industry which has been experiencing declining volumes in developed markets for many years.

Lorillard has one of the largest e-cigarette brands in the US, the largest e-cigarette market globally, and e-cigarettes accounted for just over 1% of sales in 2012, however management expect it to account for up to nearly 5% of net sales this year. In the UK, British American Tobacco recently launched its first e-cigarette brand and you can now buy its disposable e-cigarette “Vype” online. British American Tobacco’s CEO believes that alternative products could account for as much as 40% of tobacco company’s revenues in 20 years time.

E-cigarettes a healthier option

If all the smokers in Britain switched to e-cigarettes the death of five million people who are alive today would be prevented, according to Professor John Britton, chair of the Royal College of Physicians Tobacco Advisory Group. E-cigarettes are thought to be 99% safer than cigarettes, but this has yet to be proved as they were invented just under a decade ago. However, a recent study by Tobacco Control, reported that the vapours contained some toxic substances, but that these were 9 to 450 times lower than those found in cigarettes.

Enticing advertising

For an industry that has been banned from TV advertising since the 1970’s, it is hardly surprising that tobacco companies were eager to start advertising e-cigarettes. Advertising spending has increased sharply in recent years, up around 700% year-on-year in 2011 and another 400% in 2012. Lorillard ran an advert for its e-cigarette product “blu” during the last Super Bowl, in what has historically been the most expensive slot for US TV advertising. Interestingly Lorillard was the first company to advertise tobacco in the US, with an advert in the New York daily paper in 1789.

Extending regulation

We believe regulation will increase over time, much like we have seen in the tobacco sector. If over-regulation were implemented, the potential benefit to consumer’s health will be stifled. Under-regulation and the industry open itself up to undesirable entrants which in time leads to over regulation. If regulators allow the industry to educate the public about the potential benefits compared to smoking, this could provide a substantial boost to the industry; but this is a pretty big if.

In June the UK Government announced it would regulate e-cigarettes and that they would be sold subject to medical licences from 2016 onwards. The Government delayed implementation as it believes e-cigarettes create far less harm than smoking and to allow manufacturers time to apply for licences. We would expect authorised products to be as widely available as cigarettes are currently. In the US, we expect the FDA will issue similar legislation to cigarettes, banning flavours, internet sales and use indoors (six states have already banned e-cigarettes in enclosed public spaces, including California).

Eventual winner and losers

The worst case scenario for the tobacco companies is that, due to the current low barriers to entry and high margins, the market remains attractive to companies outside the industry. However, rising regulation is making this increasingly unlikely. Therefore we believe that rising regulation could be of benefit to the tobacco majors, which are best placed to deal with complex regulation and approval processes and have the financial resources to deal with the required clinical trials.

In the UK, British America Tobacco has first mover advantage of the majors, however the market is current very fragmented with a number of smaller entrepreneurial player dominating supplying the supermarkets. In the US both Lorillard and Reynolds American have widely available products.

Elaine Coverley
Head of Equity Research

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