Trouble is Brewing in the Electronic Cigarette Sector

Trouble is Brewing in the Electronic Cigarette Sector

Competition in the e-cig market is heating up. Both Altria and Reynolds American are set to join the electronic cigarette, or e-cig, market later this year or early next year. Lorillard already has its own brand of e-cig called blu, and the company has used its first mover advantage to snap up a 49% share of the retail electronic cigarettes market.

What's more, the domestic e-cig market as a whole is expected to be worth a total of $1.7 billion this year. This is double what it was worth in 2012. Indeed, if growth like this is set to continue then there might be room for all companies to have their own share.

However, the Food and Drug Administration will decide this month if it will lump e-cigs in with conventional cigarettes when it comes to regulation and taxes. Obviously, this would slow growth within the market, but there would still be plenty of room for expansion .

The rapidly growing e-cig market is already showing some signs of maturing. According to this Forbes article, while there are over 300 e-cig companies, the top three have 85% of the market. This is set to change as the big fish like Altria, Reynolds and UK-based British American Tobacco enter the fray, which is set to happen during the next few months.

Early mover
Still, Lorillard's early movement into the market has helped the company surge forward. As I have already mentioned, the company's blu e-cig brand has captured a large share of the domestic market and produced income of $9 million, or $0.02 per share, for the company during the first nine months of the year. However, it would appear that after this performance growth from Lorillard's e-cig division is going to slow down over the next few years.

Running into trouble
In particular, Lorillard's venture into the e-cig market is already showing some strain. For example, looking through the respective earnings reports, we can see that Lorillard's e-cig gross margin has declined from 37%, reported during the first quarter of this year, to 32 % during the second quarter, and finally 24% during the third quarter.

What's more, Lorillard's operating income and margin from its e-cig segment have declined from $7 million and 12%, respectively, in the first quarter of this year to 0 during the third quarter. That's right, Lorillard made no profit from its e-cig sales in the third quarter.

The reason for this? Well, the company rolled out a new, cheaper e-cig product and expanded its offering into an additional 127,000 stores, which damaged the gross margin. In addition, the company's marketing spend increased as it tried to beat competitors.

Far from being a short term effect, it seems as if higher marketing spending is going to become the norm as more competitors enter the e-cig market.

Here comes the cavalry
That said, Lorillard is only trying to compete with smaller peers. The impending entry of tobacco industry behemoth Altria into the e-cig market could change all of that. Indeed, this comment from Wells Fargo Securities researcher Bonnie Herzog sums up Altria's entry into the market."Altria has the ability to leverage its war chest of cash, its sizable infrastructure, its deep understanding of the tobacco consumer, and its entrenched position at retail."

Elsewhere, Reynolds is also claiming that its new electronic cigarette, Vuse, will be a "game changer."

There has also been some concern among smaller e-cig companies that the entrance of big tobacco could spur big tobacco to use aggressive marketing tactics. This could include telling suppliers that they cannot stock the respective brand's cigarettes unless they carry its e-cigs. .

Foolish summary
Over the next few quarters a number of new e-cig products are going to come to the market. With more products hitting the market, price-wars are likely to take hold. This will hit margins and force companies to spend more on promotion.

Unfortunately, in this situation a big tobacco company such as Altria is likely to come out on top as it uses its deep pockets and experience in the sector to grab customers' attention.

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Fool contributor Rupert Hargreaves owns shares of Altria Group. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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