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Tobacco's Vapor Labor Looks Good on Paper

MARKETWATCH 4:09 PM ET 04/22/14

Symbol Last Price Change
FB 63.0301 +1.7901 (+2.92%)
LO 55.01down 0.21 (0.38%)
MO 38.64 0.22 (0.57%)
RAI 55.01 -0.07 (-0.13%)
QUOTES AS OF 04:00:00 PM ET 04/22/2014


"A million dollars isn't cool. You know what's cool...a billion dollars."

That line was famously attributed to early Facebook(FB) Inc. backer Sean Parker in "The Social Network." Nowadays, what he thinks is cool is a possible replacement for smoking: "vaping."

So are U.S. tobacco giants Lorillard(LO) Inc., Altria Group(MO) Inc. and Reynolds American(RAI) Inc. Expect plenty of discussion about their vapor-product strategies during earnings calls this week by investors excited about e-cigarette startup Njoy Inc.'s$1 billion valuation. Mr. Parker is an early investor.

Of course, those companies are still called "big tobacco" for a reason. Retail cigarette sales of $90 billion are about 90 times as much as the e-cig market. But sales of the latter doubled last year; cigarette volume is dropping around 4% annually.

Lorillard (LO), the smallest of the three in tobacco sales, is the leader with a 47% share nationally in e-cigs--slightly ahead of Njoy. Though Lorillard(LO) earned essentially zero last year from e-cigs, its Blu e-cig division might be worth 5% or more of its market value based on Njoy's recent fundraising. Reynolds and Altria(MO) are in the process of rolling out competing products nationwide.

Investors resigned to a shrinking business that produces wads of cash suddenly find some of it being poured into a rapidly growing, unpredictable industry. Lorillard(LO), with just 14% of the U.S. tobacco profit pool, compared to Altria(MO) with 51%, could be top of the heap if today's e-cig situation prevails. It won't.

Already, analysts at Wells Fargo estimate e-cigs are losing share to other vapor-delivery methods dominated by smaller firms. Regulators and the taxman will leave a mark, too. The Food and Drug Administration has said it would soon propose e-cig regulation.

That could help big tobacco. Regulation and higher barriers to entry may help them become "big vapor." In the best case, e-cigs could arrest the industry's decline and, assuming gross margins rise to the 50% enjoyed by cigarettes, grow earnings more quickly.

Another possibility--and one not factored into big tobacco's valuations--is that e-cigs cause sales to fall more quickly. Today's $15 billion tobacco profit pool may not just be smaller, it may be spread among more players.

Where there's smoke there's vapor.

-Spencer Jakab; 415-439-6400; [e-mail]

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04-22-141609ET
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