Investing in e-Cigarettes

Written By Jason Stutman

Posted October 14, 2013

“Do you think we’re the oldest people here?”

My date posed this question to me last week as we stood in the middle of a chic D.C. music venue, waiting for the show to start.

It seemed like a strange question coming from a pretty 27 year old… but when I surveyed the crowd, I noticed we did seem a little out of place.

(Of course, I didn’t tell her that. Women seem to hate the prospect of aging, and I wasn’t going to risk sparking any pent-up anxiety. Instead, I made quick use of my natural-born “Where’s Waldo?” prowess and pointed to the nearest man with a receding hairline as proof of our youth.)

She seemed to be satisfied with my response, but just to be safe, I redirected our conversation to the promotional electronic cigarette stand stationed in the corner to the left of the stage.

In exchange for your name and email, you were rewarded one free e-cigarette.

I figured this was more than a fair trade. Despite never having smoked a cigarette in her life, so did my date. And it seemed our sentiment was shared by the majority of concertgoers that night…

As we looked out into the crowd, we saw what looked like a congregation of blue fireflies as countless members of the audience triggered their artificial butts.

Plowing the Fields

This would have been a strange sight just a few years ago, but it should hardly be surprising today. Annual e-cigarette retail sales have more than doubled since 2010.

In fact, Goldman Sachs has recognized the technology as one of the eight most disruptive trends this year.

By the end of 2013, e-cigarette retail revenue is expected to reach $1 billion. And that’s just a fraction of this growth story.

If you were to include online sales, e-cigs have already passed the billion-dollar mark. E-cigarettes are catching on so fast that Wells Fargo Securities projects total sales to hit $1.7 billion by the end of the year, a 240% increase from the $500 million mark in 2012.

The growth rate is almost hard to believe, but ultimately there’s good reason for the breakout…

It’s estimated that one out of every five adults in the United States smokes conventional cigarettes. This puts the total market at about 50 million consumers. With 74% of these smokers wanting to quit, the e-cig industry has a flood of consumers wanting to make the switch.

By 2020, e-cigarettes are expected to strip the tobacco industry of 16% of its total profit share.

And I believe that to be an incredibly conservative estimate.

Sparking the Flame

“I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s a fantastic brand loyalty.”

That’s what Buffett had to say about tobacco in 1989 — and it’s pretty close to what I have to say about e-cigs today.

Buffett mentions three themes: high margins, addiction, and brand loyalty.

These apply to the e-cigarette industry as much as they did to tobacco fifteen years ago.

Margins

Since Buffett made the statement above, he has since retreated from his bullish position on the tobacco industry on grounds of increased regulation. Taxes and fees have stripped tobacco companies of both their margins and their customers.

For every cigarette pack sold in the U.S., about $3.16 goes to government agencies. With the average smoker going through 573 packs a year, that’s more than $1,800 in taxes alone. It’s no wonder 36% of smokers report wanting to quit because of cost.

E-cigs, on the other hand, are not subjected to additional taxes and settlement fees.

Not only does this make smoking an economically viable habit for consumers, but it increases margins as well…

According to a report from Goldman Sachs Global Investment Research, the average trade margin for E-cigs is 35%, compared to just 7% for conventional cigs.

While it’s expected that agencies will eventually attempt to regulate e-cigs as well, don’t expect those rates to come anywhere close to what the tobacco industry has seen.

The truth is that there’s going to be far less pressure to curb e-cig usage than there has been with cigarettes.

Cigarettes stink up restaurants, litter our streets, and poison the air we breathe. E-cigarettes do not.

Tobacco is attributed to 8 million deaths and nearly $96 billion in medical fees every year. Nicotine vapor is not.

Curbing tobacco use actually helps the general population in the long run, but that just isn’t the case with e-cigarettes. In the fight against tobacco, cigarette opponents had medical facts and grotesque pictures of blackened lungs, hairy tongues, and hollowed-out necks on their side.

The arguments against e-cigs are far less compelling.

Addiction

While it’s true that e-cigs are considered to be 99% less harmful than tobacco products, they do still contain nicotine, the notoriously addictive substance found in conventional cigarettes.

On average, e-cigarette users are drawing about 150 puffs and going through five nicotine cartridges per day. For perspective, that’s only about half the puffs it takes to get through one pack of tobacco cigarettes.

However, we must keep in mind that each e-cig cartridge contains between about 6mg and 24 mg of nicotine.

Using a midpoint of 15 mg per cartridge, e-cig smokers are going through about 75mg of nicotine every day. With vapor, only about half of this nicotine gets absorbed into the body, so we’ll reduce that number to 37.5 mg.

When we consider the fact that a conventional cigarette pack contains around 20mg of nicotine, it becomes clear that the number of puffs doesn’t really matter; what matters instead is the quantity of nicotine being consumed.

E-cigarette smokers are absorbing close to double the amount of nicotine as conventional smokers, which can only mean higher levels of addiction.

On top of the physical addiction from nicotine, the psychological draw of smoking is also still present.

A large aspect of cigarette addiction comes from oral fixation. It’s actually one of the main reasons many smokers gain weight when they quit… Smokers are in the habit of constantly making use of their mouth, and so they gravitate towards gum chewing, nail biting, or excessive snacking to curb their cravings when trying to quit.

E-cigarettes seek to replicate the full experience of smoking, and part of that experience includes an oral fixation.

Brand Loyalty

Here’s where we should be a little cautious about the e-cigarette industry…

There are literally hundreds of e-cigarette brands, and most consumers don’t know which one they are buying. In fact, 68% of retail consumers couldn’t name the brand of their last two e-cigarettes in a 2012 survey.

While this information is concerning, the lack of brand awareness can largely be attributed to an influx of new consumers who are simply not yet familiar with the products they’re buying.

As e-cigs become more mainstream, brands like Njoy and blu E-cigs are gaining traction. blu has more than 350,000 dedicated customers and is now available at 10,000 retail locations across the country.

Major cigarette companies such as Lorillard (NYSE: LO) are swiping up companies like blu and SKYCIG to get in on the action.

With a 40% market share already, I strongly believe blu will be the Marlboro of e-cigarette brands. This could easily allow Lorillard to move from the third largest player in the cigarette industry to the No. 1 spot.

Other majors betting on e-cigs include Altria Group (NYSE: MO) and Reynolds American (NYSE: RAI).

There’s also plenty of opportunity building up in small caps, but we’ll save that discussion for another day.

Turning progress to profits,

  JS Sig

Jason Stutman

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