Can e-cigs Save Big Tobacco?

Follow the youth, as the old saying goes, in investing. If you can predict the trends of the younger demographic, then you can make big returns.

One thing you don't see a lot of is the younger demographic picking up a cigarette. While traditional cigarette demand is falling and poised to keep falling, electronic cigarette demand is rapidly increasing.

I wrote a piece on why cigarette makers will eventually have to cut their dividends as cigarette demand has fallen from 640 billion cigarettes in 1981 to 293 billion in 2011, while payout ratios remain high. But perhaps Big Tobacco might be able to use electronic cigarettes to find growth in a perpetually-declining market.


Teenagers

According to the CDC, the number of high school students who ever used e-cigs rose to 10% of the population (1.8 million) from 4.7% in 2011. This is an increase of over 900,000 customers. While that doesn't mean that all of these customers are buying multiple e-cigs each year, it does show that interest in the product is rising.

As far as the more consistent consumer goes, the number of high school kids who used e-cigs in the past 30 days rose from 1.5% in 2011 to 2.8% in 2012. This means teenage consumers are starting to use e-cigs more often. 75% of all e-cig smokers also smoke traditional cigarettes, but that still leaves 25% of e-cig users who don't smoke traditional cigarettes. This means that consumers who are normally put off by the bad health effects of traditional cigarettes are warming up to vaporized nicotine.

Contenders

Tobacco companies like Altria , Lorillard , and ReynoldsAmerican are all trying to get into this emerging market. As of right now e-cig sales are predicted to hit $1 billion by the end of 2013. By 2018, an analyst at Wells Fargo said sales could reach $10 billion .

While sales of $1 billion in 2013 still pales in comparison to the $100 billion traditional tobacco market, if this market could reach $10 billion then whichever company is able to effectively capture the most market share will be able to offset declining cigarette sales.

Altria, the maker of Marlboro cigarettes, recently announced it was making MarkTen e-cigs. While MarkTen sales started in August only in Indiana, I expect Altria will group out distribution over the next few months.

Lorillard, the maker of Newports and Mavericks, bought out the e-cig maker Blu Ecigs in 2012 for $135 million. Blu e-cigs are very popular and currently take up 40% of the market . If the market increases to $10 billion a year, then Lorillard would make $4 billion a year in revenue from its $135 million acquisition, which would be quite the return on investment.

E-cigs represent an enormous growth opportunity, since Lorillard made $6.6 billion in revenue in 2012. If the market grows to a multi-billion dollar industry, then even with the decline of traditional cigarettes, Lorillard will be well-positioned to substitute cash flows.

Reynolds American, maker of the Camel brand, has launched an electronic cigarette under the brand name VUSE. When Reynolds announced this product, it said it would be a "game changer" and a margin enhancer. If electronic cigarettes reach volumes that will push up margins, then you don't necessarily need to recover all of the lost revenue from the decline of traditional cigarettes.

The winner

Out of these 3 companies, Lorillard is leading the pack by far. Its acquisition of Blu Ecig clearly has the potential to pay off big time, especially since it gave Lorillard 40% of a soon-to-be $1 billion market.

Altria may dominate the traditional cigarette market with close to 50% market share, but it needs to leverage that popularity to really start selling more MarkTen e-cigs. The release in Indiana is probably to test the waters, to see how the company can modify the product to best suit national demand. Once Altria is done, it should start aggressively marketing MarkTen, because it is already far behind.

Reynolds has very high hopes for its Vuse brand. The brand currently only accounts for 2% of Reynolds' total revenue, but it accounts for 50% of the company's revenue growth. Reynolds expects the e-cig market to reach $3 billion in the next 5 years, less than what Wells Fargo is predicting, but still high triple digit growth. The really exciting thing for the tobacco industry is that e-cigs could offer more than just revenue growth--they could also offer margin expansion, according to Reynolds.

Final Thoughts

While cigarette makers are still going to find it hard to keep raising prices to keep up with declining volumes, especially when you factor in increasing state and federal sin taxes, electronic cigarettes may be able to help.

Lorillard by far is the biggest beneficiary of the e-cig "revolution" and could actually generate enough revenue from e-cigs to soften part or all of the decline of traditional cigarettes. This depends on whether or not Reynolds' or Wells Fargo's predictions turn out to be true. With teenage use of e-cigs doubling in one year, there might be some logic to those bullish estimates.

Altria and Reynolds are both far behind in terms of market share and distribution, because Blu Ecigs are already sold in 80,000 stores throughout the nation. If these companies want to have a chance of still being able to pay out large dividends, they will need to enter this market quickly. If they don't, then these companies' large dividends will be at risk, because you can't keep increasing payout ratios in a perpetually-declining market.

Even if these companies do enter this market, their revenue from traditional cigarettes is too large to be easily offset by e-cigs, so they better hope that the e-cig market becomes huge.

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The article Can e-cigs Save Big Tobacco? originally appeared on Fool.com.

Callum Turcan has no position in any stocks mentioned. 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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