Electronic-cigarettes or E-Cigarettes, are battery-powered devices that heat liquid nicotine in a disposable cartridge and produce a vapor that’s inhaled. Consumers can buy refill cartridges in various flavors and often customize nicotine levels. They also come in a disposable format, although the “rechargeables” are much more economical over time. Also referred to as “vaping,” these e-cigs are not combustible so they produce none of the ash or smoke of traditional cigarettes……a lot more on this later.
Chief parental counselor Mayor Michael Bloomberg notwithstanding, cigarette smoking in America has been on a steady decline for the last several decades. There are few certitudes in life that transcend the assurance of raising taxes on tobacco. It’s one of many a great irony of a society so overburdened with an obsession of progressive taxation that there exist utter blindness to perhaps this most regressive of all revenue collection methods. Domestic tobacco companies slog forward under relentless siege, enduring offensives from both the federal and state bureaucrats as well as negative campaigns from any number of public health organizations.
The above issues plus ever harsher constraints on advertising, interminable legal attacks, coupled with a growing national zeitgeist promoting healthy nutrition and exercise means it is an industry with fewer and fewer friends. And the desired effects are spoken in the statistics. Per Capita cigarette consumption peaked in 1975 at about 145 packages (20 per pack) and by 2011 had plummeted to 48.5 packs or two thirds the per person peak level. That’s good, but keep in mind our population increased by 45 percent during those 36 years so in absolute terms cigarette consumption has decreased by half from the all-time high.
While all the litigation, promulgating fears of lung cancer and heart disease has taken a toll on cigarette demand, at the end of the day it’s the exponential expansions of state and federal excise taxes that have done the most harm. Federal excise taxes increased to $1.01 per pack in 2009 but sometimes it is at the state level where the most draconian tariffs are levied. As I write, another $.94 cent Federal increase is under consideration in Congress now.
Altria Group (MO), also referred to as Philip Morris USA, is the stand-alone cigarette maker which spun off its “rest of world” division, Philip Morris International (PM) in 2008. It may be facing some daunting headwinds. Strictly a domestic seller, the company, by definition, (and all domestic producers) has experienced steady bleed in case volumes exacerbated after the giant tobacco settlement of 1998.
In the 2013 first quarter ended March 31, MO’s cigarette volumes declined by 5.2 percent from the same period last year. Though flagship brand Marlboro actually increased its share slightly to 43.6 percent of the shrinking U.S. market customers still bought 5.5 percent fewer packages. Philip Morris USA controls about one-half of all domestic cartons sold. Through steady price increases, despite year after year of volume contraction net income has continued a seemingly inexorable ascent. It is not a stasis that represents an enduring business model. Cigarettes account for around 90 percent of revenues with smokeless chewing tobaccos and snuff contributing 8 percent while wine and others are the balance. The stock is closed on Tuesday, May 21 within inches of its all-time high of $37.61. It trades at a seemingly reasonable 14.8 times forward earnings that are within the range of its ten year average…..but from a different angle appears expensive when growth is only projected to be in the 8 to 10 percent range. Like all “big tobacco,” it returns 80 percent or more of earnings to shareholders in the form of dividends or share buybacks. It yields a hefty 4.73 percent which in today’s Federal Reserve manipulated a market is a big number and no doubt is part of the reason “yield chasers” have driven this equity to all-time highs. MO is up 19 percent on the year, slightly outpacing the S&P 500. Can this upward trajectory continue?
There are signs that Philip Morris recognizes its conundrum: a continually dwindling market size and ever-rising excise taxes. To grow the company must either gain more market share or continue the wicked spiral of charging more for the product. No matter how inelastic the demand for any commodity, be it gasoline or tobacco, there are price points where usage declines fairly rapidly. The most expensive pack of cigarettes in America does not surprisingly come from New York City where per package federal, state, and city levies total $6.86 bringing the retail “price at the pump” to $12.50. A study disseminated by the New York State Department of Health estimated that low income (below $30,000) smokers waste an average of 23.6 percent of their income on cigarettes. The national average for a package of cigarettes is around $6.50 but depending on the taxes of the particular venue, prices can vary dramatically.
A Disruptive Technology?
Last month on April 25, Altria announced, with significant surrounding publicity, that through its Nu Mark subsidiary it would introduce an electronic cigarette in the second half of this year. The United States cigarette industry at the retail level is near $100 billion. So while growing rapidly, on a relative basis e-cigs as they are known, are still a fledgling concept with 2012 estimated industry-wide revenues measured at around $500 million. I wondered about this announcement and the timing of it. Perusing the latest 10Q, conspicuous was the number of recent judgments levied against Altria, a few greater than $50 million. Most all are under appeal but the question I asked is, “does this legal issue ever go away?” Is entry into the e-cigarette market now a realization, or maybe an admission, that cigarettes price increases cannot infinitely offset a shriveling market and maybe the rate of depletion will only accelerate from here?
The big impetus for the defection to the e-cig is, of course, the price. After purchasing a “Rechargeable Starter Kit” which comes complete with batteries, atomizer, USB charger, and a few filters to get a neophyte started, from that point forward it is a simple matter of purchasing the nicotine filled filter in the flavor to suit your taste….vivid vanilla, peach schnapps, or java jolt are a few offerings. Each filter roughly equals the same number of “puffs” in a package of cigarettes but cost 50 to 60 percent less depending on your residence. The savings can be even more with some brands if purchasing in larger quantities. So for a pack, a day smoker living in a $6.50 state, just a 50 percent discount saves almost $1,200 per year.
There are at least several dozen players dividing up what is now a highly fragmented market. Altria’s much smaller competitor, Reynolds American (RAI) aka RJR has made an e-cig offering called Vuse. According to an informal survey of retailers by tobacco analysts at Wells Fargo Securities it has not been widely distributed and it has not been well received by those who do offer it. Much more significant was Lorillard Tobacco Company April 2012 $135 million acquisition of well-established e-cigarette maker Blu eCigs. In the recent first quarter 2013 10Q it was revealed that the blue eCigs division had $57 million in revenue which when annualized translates to well over $200 million in turnover making Lorillard far and away the biggest player in this space. NJoy, a private company is the largest “non-major” e-cig purveyor. With some investigation, I discovered that there is only one pure-play publicly traded e-cigarette manufacturer; a micro-cap traded on the pink sheets called Vapor Corp (VPCO). With 2012 revenues of $20 million and a $39 million market cap this company came to life in a 2009 reverse merger. Since inception annual compound growth rates have been in the 50 percent range. Though Vapor Corp is not yet profitable, I had a chance to learn a little more about the industry in a chat with Vapor Corp CEO Kevin Frija. I wanted to know whether or not many of the small competitors were going to be able to compete against the likes of Altria, Lorillard, and RJR.
Mr. Frija: Right now, this category is growing so fast I think there is room for lots of companies to expand and have a chance to achieve profitability. Ultimately, it is going to take lots of capital to compete with the muscle of Altria. I am eager to see their (e-cig) product. (Altria) entering the fray, so to speak, is very good in that it raises the awareness of e-cigs even more which could translate to even faster growth. Ultimately, way down the road there will be inevitable consolidation which is the natural evolution for all new industries.
Richard: Speaking of growth, did you see that Wells Fargo securities in several of their reports have predicted that the e-cigarette business will overtake the traditional cigarette market within a decade.
Mr. Frija: That’s a pretty powerful statement. I do know that each day new cigarette taxes are considered, the (cigarette) market is rapidly deteriorating, and legal struggles seem interminable. I do think it’s a time to change or die. Look at the tragedy of Kodak. Time will tell, I guess.
Richard: Do you care to talk about Vapor Corp a little…. for example your 2013 outlook.
Mr. Frija: Sure. I don’t like to talk in specific numbers other than to say growth continues to be robust. I don’t think it’s appropriate to comment on earnings at this time. I will say our margins are holding up and our most popular offering “Krave” continues as one of the leading brands in the country.
I would like to add one more thing regarding all the current competitors selling e-cigs. One of the big barriers to entry could be retail shelf space. There just is not enough space for fifty companies each wanting to display ten or fifteen different offerings and Altria will flex its power to get the prime store locations. Right now, many of the sales take place on the internet. Maybe that will continue but product visibility is always important.
Richard: What about regulations and health issues?
Mr. Frija: Currently there is no FDA oversight for these products. The regulatory landscape moving forward is less certain. As this niche grows large, as I believe it undoubtedly will, the government revenue sniffers will undoubtedly try to cast a net on this industry.
Regarding safety, in an e-cigarette there is no tar or hundreds of other carcinogens released in the cigarette combustion process. E-cigarettes produce no smoke, just vapor. That said it is far too early for any declaration that e-cigs are completely benign for our health. After all the big source of e-cig stimulation is the nicotine, long accepted as a highly addictive substance. The FDA is heavy into their investigations so reports will be dribbling out over time.