Smoking Rates Are on the Decline, but Not So Big Tobacco

PARIS, FRANCE - JUNE 19:  A woman shows an electronic cigarette at a store on June 19, 2013 in Paris, France. French Social Affairs and Health Minister Marisol Touraine announced the government's intention to ban the electronic cigarette in public places and for smokers under 18 years.  (Photo by Antoine Antoniol/Getty Images)
Antoine Antoniol/Getty Images
For years now, the tobacco industry has battled a declining U.S. smoker base and a barrage of anti-smoking campaigns. Yet the major players in the industry continue to prosper.

Despite smoking prevalence in the U.S. declining to all-time lows since the 1940s, when Gallup began tracking smoking rates, Reynolds American (RAI), Lorillard (LO) and Altria (MO) -- the three American tobacco giants -- have stocks trading at their five-year highs.

But now, these companies might soar higher than ever on the back of a new trend -- one that gets around pesky smoking laws and quarantine-esque smoking lounges.

It's Electrifying
In the U.S. as well as abroad, electronic cigarettes are fast becoming a common sight. These relatively new products take liquid nicotine and vaporize it, allowing the smoker to inhale normally while avoiding the carcinogenic tobacco smoke and smell.

A Morgan Stanley (MS) research team recently concluded that e-cigarettes will replace 1.5 billion traditional cigarettes this year alone. An executive with Lorillard was quoted as saying the rapidly growing segment will account for 1 percent of the business by the end of the year -- a startling growth rate. Wells Fargo analyst Bonnie Herzog puts sales of the products at more than $10 billion by 2017.

Clearly, at least one tobacco company is bullish on the trend. Lorillard's CEO went as far as to smoke a Blu e-cig at the New York Stock Exchange.

With the three big guns releasing or updating their products to combat the start-ups who have gotten to market first, is "big tobacco" destined to become "big e-tobacco"?

Selling a Breath of Fresh Air
For tobacco marketers, e-cigarettes must seem like a breeze to sell compared to pushing real smokes.

For one thing, e-cigs can be advertised on television and radio, as opposed to normal tobacco products, which have been off the airwaves for 40 years. The products can be promoted with kiosks and sold at checkout counters.
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Blu, one of the biggest early players in the space, has celebrity-endorsed commercials advocating users to "rise from the ashes." In 2012, Lorillard bought the company for $135 million, mirroring the actions of Reynolds American, which is relaunching its Vuse e-cig, and Altria, which is getting ready to introduce its MarkTen e-cig.

Right now regulators are behind the ball, enabling marketers to make whatever claims they want. Some makers -- though not the major tobacco companies -- are claiming electronic cigarettes are a formidable method of kicking the habit, appealing to smokers (as a way to satisfy nicotine cravings in nonsmoking environs) and trying-to-quit smokers.

On the business side, the big question is whether e-cigarettes will kill big tobacco's core product -- actual tobacco.

Don't Call an Ambulance Just Yet
Before you begin to worry about the future of tobacco, consider that the declining U.S. smoking rates, while certainly troubling, do not spell apocalypse for the industry. Even the tremendous anti-smoking momentum in places such as Australia, the U.K., and Canada is not enough to bring these businesses down.

The reason for cigarettes' staying power is simple: the third world.

In the developing areas of the world, smoking reigns supreme and is even gaining momentum.

A study published in the medical journal The Lancet found that nearly half of men in low- and middle-income countries are smokers, and women are starting at a younger age. In Russia, 60 percent of men smoke, followed by 53 percent in China.

Anti-smoking advocates are pushing for intervention in developing nations, with the World Health Organization, in particular, citing the potential for 1 billion tobacco-related deaths in the 21st century.

The only problem here, well, aside from the global epidemic concerns, is that American Big Tobacco does not have meaningful international exposure.

Altria, formerly the full owner of Philip Morris and the iconic Marlboro brand, spun off its international interests into a separate company -- Philip Morris International (PM). From 2010 to 2012 the company's sales have grown by nearly 13 percent, proving that a pure place on the cigarette business, without the diversified interests such as e-cigarettes (or even plan leasing, for Altria), is still a growing business in other corners of the world.

The Bottom Line
The tremendous growth of e-cigs will, without a doubt, take market share away from the old-school cigarette, and big tobacco will have to make some changes to address the new trend.

But this isn't a story akin to Blockbuster and Netflix (NFLX).

Reynolds America, Altria, and Lorillard aren't relics of a vanishing world. They will be a major part of the e-cigarette revolution, and they will find plenty of tobacco-huffers in the developing world -- if they can build out their international presence.

As investors, do not fear the technology disrupting the industry. The important factor is to keep an eye on the progress of regulation. Some states and cities have taken motions to ban e-cigs and outlaw them from sale to minors (yes, a minor can currently buy an e-cigarette in some areas), and the federal government is working fast to control this new Wild West of nicotine delivery.

In the meantime, though, expect those big tobacco companies to continue their profitable ways.

Motley Fool contributor Michael Lewis has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix and Philip Morris International.

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