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Big Tobacco Invests in E-Cigarettes. Should You?

Richard Satran

U.S. sales of electronic cigarettes are expected to jump past $1 billion this year, and where there's growth like that you can bet someone is making money - whether it'll be new companies or Big Tobacco remains to be seen.

While still a tiny fraction of total tobacco sales, the market is already a lucrative one for some fledgling e-cigarette firms, though companies that promote and advertise the products are receiving much of the benefits, not manufacturers themselves. Longer term, the burning question is: Who is best positioned when government regulators take control of a market that's so unfettered it can legally target adolescents with candy-flavored smokes.

Nationwide, e-cigarettes are sold with little restrictions except for one big one - they cannot claim to be a cure for habitual smoking or they risk U.S. Food and Drug Administration sanctions (several states also restrict sales to minors). Instead, sales have grown slowly in a curious niche - a hybrid of traditional smokers and those trying to quit. The battery-operated smokes heat nicotine-infused vapors that can be inhaled like a regular cigarette, making them safer than carcinogenic tobacco, but not necessarily risk-free, according to the FDA. Studies about their safety or effectiveness in quitting tobacco are not conclusive, and health officials say more research is needed.

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In economic terms, e-cigarettes hit a classic inflection point last year when, after years of gradual sales growth, they became too big for the $100 billion tobacco business to ignore. Suddenly, celebrities like Leonardo DiCaprio are puffing on black-tube, blue-tipped e-cigarettes and touting them on commercials on MTV. E-cigarettes are becoming cool, and marketers have taken notice.

E-cigarette maker NJOY, with about 40 percent of the market, isn't selling itself based on its hipness factor. It's positioning itself as the choice of Main Street smokers who just want to quit tobacco, says S&P Capital IQ equity analyst Esther Kwon, who covers the tobacco industry. Targeting "smoke-quitters" makes business sense, she says. The Centers for Disease Control and Prevention says about 70 percent of smokers want to quit. To reach that group, Kwon says NJOY tries to duplicate the look and feel of a real cigarette.

Still, if its mainstream focus lacks downtown hipness, NJOY has generated buzz with its high-profile investors and anti-smoking "cred." NJOY's roster of supporters include billionaire Sean Parker, of Facebook and Napster fame, and former U.S. Surgeon General Richard Carmona, who will head a NJOY research committee that will study the e-cigarettes. The company is positioned for a possible takeover by one of the major tobacco players or a possible initial public offering, analysts say, though that could be some time into the future.

"Some smaller players will be taken over by Big Tobacco, and NJOY could eventually go public," says Adriana de Lozada, an analyst for private company research firm PrivCo. "NJOY has done a great job of positioning itself, but it's not ready to do an IPO, not yet. Growth is important, but so is size to be able to go public and to compete in this market."

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Lorillard, the scrappy No. 3 cigarette maker behind giants Altria and Reynolds American, has moved aggressively with its blu brand, says Kwon, adding that the company has "always been an innovator." It's trying to bring a touch of Mad Men-style glamour to cigarettes, and bringing smokes back to the tube for the first time in four decades with ads featuring television celebrity Jenny McCarthy puffing up the benefits of e-cigarettes by saying "it's not sexy" to smell like an ashtray and pointing out she doesn't have to freeze outside to smoke a cigarette.

Lorillard trades at about the same relative price-to-earnings as the other tobacco makers. Its market cap of $17 billion is far less than Altria's $70 billion. A successful IPO or acquisition of its startup competitor, NJOY, could boost its valuation further, according to Kwon. "They could get rewarded by the publicity of NJOY's IPO," she says. "It might get their value noticed more."

Lastly, Vapor is the pure play, the lone publicly traded e-cigarette company. Its performances suggest that the economics of e-cigarettes are difficult, as it trades at 85 cents a share and has lost money on flat earnings the past year. But others, like Swisher, have succeeded in building market share with savvy marketing, de Lozada says.

"There is a window with a bit of an opening now, but if they have to compete with big brands that are already established, their profit margins will be squeezed," Kwon says. "And Big Tobacco has the advantage of huge distribution no one can match."

More broadly, media firms could be a big winner regardless of which e-cigarettes prevail, because they're being advertised on television - a venue where traditional cigarettes have been banned for years. It's a new front for the tobacco industry, which still spends billions of dollars on other media, including magazine ads, promotions and sponsorships. That trend will probably accelerate in an all-out marketing e-cigarette war as Altria and Reynolds enter the market this year. And e-cigarettes already have outspent traditional cigarette makers advertising in major media this year, according to data by Kantar Media.

New frontiers in advertising and social media may win some of that spending. The Internet advertising industry could benefit from e-cigarettes supported by people online via the likes of Google's recently launched "shared endorsement" service, which sells information about users' endorsements. (It's not a coincidence that digital entrepreneurs like Parker have entered the space.)

And what about Big Tobacco's role? Altria and Reynolds need to compete, but the cost of a massive new marketing push in a sector where regulatory issues are still being sorted out might not make perfect sense, at least for now, analysts say, especially if such new costs mean any trade-off for tobacco company shareholders who purchase the stocks in part for their high dividend yields. "They are in a business that is highly profitable that does not require a whole lot of investment," says Kwon, while noting a changing market could upend such reluctance. "This could be much different in the future, and this is something they will have to invest in. It's in its very early stages, but it has potential to become something big, and it could have an impact."

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Analyst Bonnie Herzog of Wells Fargo Securities sparked media attention with a report earlier this year that e-cigarette growth will continue for the next decade and overtake traditional smoking sales for U.S. tobacco companies. A number of analysts declined to comment, citing a pending earnings period for tobacco companies, and Herzog was not available for comment. However, big brokers have generally been recommending the stocks for their dividends and steady earnings, and analysts have expressed skepticism that e-cigarettes, with less than 1 percent of the total market, will make much impact anytime soon.

Meanwhile, the regulatory and legal issues surrounding their marketing has been slowed by Washington's budget stalemate that led to government shutdown. A number of decisions are due soon that could bring clarity and more regulation.

"All of these big gains [for e-cigarettes] are coming at a time of zero regulation, no taxes and a lot of hype," says one analyst who requested U.S. News to not use his name. "The bottom line is that only a limited number of people will switch once the playing field is leveled. Our research shows that it won't happen because e-cigarettes are just not as satisfying."

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