As E-Cigarette Growth Booms, 3 Major Challenges Loom

The war on tobacco has been one of the largest conflicts that has ensued within the U.S. over the past 50 years.

Led by public campaigns packed with knowledge, as well as a recent print, media, and online ad campaign from the Centers for Disease Control and Prevention - the first of its kind for the CDC -- the U.S. adult smoking rate in the U.S. has dropped from 42% in 1965 to just 18% as of 2011. This is what you would call a successful reeducation campaign.

Source: Centers for Disease Control and Prevention.

Unfortunately, this still means that somewhere in the neighborhood of 40 million Americans are classified as smokers. With the negative health effects of smoking well known, the CDC, Food and Drug Administration, and U.S.regulators would like to persuade as many people as possible to put down their cigarettes and quit for good.

Electronic cigarette growth is booming
However, nicotine is a highly addictive substance and most smokers won't be able to simply quit "cold turkey." This is where electronic cigarettes come in, and why a number of smokers have turned to these devices as a way to wean themselves off cigarettes.

Source: Lindsay Fox, Flickr.

Electronic cigarettes, or e-cigs for short, heat a flavored liquid solution containing nicotine inside a metal tube, turning the liquid into an inhalable vapor. The allure of these devices is that they contain the nicotine that smokers are addicted to without a number of the harmful chemicals typically found in cigarette smoke. In other words, the perception would be that e-cigs are a safer alternative source for nicotine.

Growth in e-cigs is absolutely soaring, at least according to a study published this week by my alma mater, the University of California, San Diego. Researchers at UCSD's School of Medicine noted that "10 new e-cigarette brands have entered the Internet marketplace every month, on average, from 2012 to 2014, and that there are currently 466 e-cigarette brands online, offering more than 7,700 flavors."

UCSD's study also demonstrated a distinctive shift between established e-cigarette brands and newer brands. As lead author Shu-Hong Zhu noted, older e-cig brands tended to focus their marketing message around the cost-effectiveness and comparable health benefits of e-cigarettes compared to traditional cigarettes. Newer brands try and avoid any comparisons to cigarettes whatsoever, emphasizing flavor and choice instead. 

Three major challenges loom for e-cigarette industry
Growth might be off the charts for the e-cig industry, but that doesn't mean it won't face a number of challenges over the near-term. Specifically, I see three hurdles it will need to overcome in the coming years in order to be successful.

Source: Alex Proimos, Wikimedia Commons.

One we dove into just last month: the Food and Drug Administration's initial proposal to classify e-cigarettes as tobacco products. The truth of the matter is that we don't know a lot about the long-term effects of e-cig vapor as of yet, and until more is known the FDA would much rather take a conservative approach to classification. More so, the FDA wants to ensure that minors aren't allowed access to e-cigarettes as this could actually cause tobacco addiction rates to rise.

While these seem like fair concerns, the FDA's decision could have an adverse impact on the bottom-line of e-cig manufacturers like Lorillard , the company behind the dominant Blu E-Cigs brand, while potentially boosting insurers' profits. If insurers choose to classify e-cigs as tobacco products they could jack up the premium rates of those using the inhalable devices and would likely reap significant financial benefits as the long-term health effects of inhaled vapor versus traditional cigarette smoke is portrayed as night and day by the e-cigarette industry. If insurance costs rise because of e-cigarette use it's possible that companies like Lorillard could see their sales growth stall. For the moment we're still waiting to see where most insurers will stand on their classification of these devices.

Secondly, while pundits have focused to no end on the possible health benefits and risks of e-cigarettes, they've ignored the potential for market oversaturation that UCSD's study exposed. Competition is good for the consumer, but it can be bad for businesses as it has the potential to reduce pricing power and pressure margins. More e-cigarette manufacturers means higher advertising budgets just to stand out from the crowd.

Furthermore, the rapid growth of e-cigarette brands creates a Catch-22-like dilemma for consumers and investors.

E-liquid vapor shop, Source: Lindsay Fox, Flickr.

On one hand, I'd be concerned about the quality of product given the rapid influx of new brands. As UCSD's study points out, newer e-cig brands appear to be more focused on flavor, which lends concern that they could be enticing the wrong audience (i.e., minors) or sending the wrong signal. The FDA has been pretty clear that e-cigs are to be used as smoking cessation tool and nothing more.

On the other hand, if the FDA does choose to regulate each new brand that comes to market we could be looking at a veritable mountain of paperwork that could slow new e-cig brand emergence to a crawl and divert FDA attention away from where it should be - regulating pharmaceutical drug development.

Finally, investors have been gung-ho about the potential for the e-cig industry -- and with good reason given initial consumer demand -- but the question no one seems to be asking is whether or not this is a viable business model over the long-term.

In 2013, for example, e-cigarette sales crossed the $1 billion mark. By comparison, total tobacco revenue for the largest six tobacco companies in the world - China National Tobacco, Philip Morris International, British American Tobacco, Japan Tobacco International, Imperial Tobacco, and Altria - tallied $346 billion with $35 billion in profits in 2010. Put simply, the impact of e-cigarettes is but a blip on tobacco producers' radars at the moment.

Lorillard, which controls 45% of U.S. e-cigarette market share based on its first-quarter results, actually saw sales slip year-over-year to $51 million from its Blu E-Cigs brand from $57 million in the year-ago quarter. Additionally, a near-doubling in selling, general and administrative costs pushed its e-cigarette segment to an $11 million net loss. If the biggest e-cigarette maker in the U.S. is having trouble turning a steady profit with 45% market share, then what exactly does it take for this industry to be economically viable? 

For now I'd suggest that there are far too many questions and few answers. While the industry does offer rapid revenue growth opportunities, the potential for industry regulation and slower growth through tougher competition remain distinct possibilities. Until we see healthy profits from e-cigarette manufacturers, it's probably best not to fall for their smoke and mirror growth promises.

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Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.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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