Should Altria Enter The E-Cigarette Market To Support Growth?

Altria (NYSE:MO) is the largest cigarette manufacturer in the United States. The stock is a popular due to its high dividend yield, and the company’s strong brands such as Marlboro and L&M. However, there are a number of inherent risks in the U.S. cigarette industry which Altria investors should be wary of. These include the declining market for cigarettes in the country, rising excise duties and the threat of increased and stricter regulation from the government against the industry.

We believe that these risks are long-term and sticky in nature and that Altria will not be able to maintain the growth of its top line and dividend payout without entering into markets for alternative tobacco products. The company has already ventured into smokeless tobacco, and through its brand names Copenhagen and Skoal, has gained the top spot in the market for the products. It also recently launched a nicotine flavored lozenge under the brand name Verve. Here we examine Altria’s potential entry into the market for another alternative tobacco product, electronic cigarettes.

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What are e-cigarettes and what is the projected size of the market for these products?

Electronic cigarettes are nicotine-infused, battery heated tubes that create vapor instead of smoke. The primary selling point for these products over other tobacco alternatives is their close similarity to traditional cigarettes, compared to whom they are substantially less harmful. Further, these products are currently not subject to any regulation from the government or other authorities, and are thus priced at lower rates. E-cigarettes are thus touted as a potential long term replacement for cigarettes.

The market for e-cigarettes, which is currently around $300 million in size, may grow to over $1 billion over the next 3 years, according to some projections. This translates to an annual growth rate of almost 50% over the next 3 years. E-cigarettes have been around for a while, but we believe that the market could reach an inflection point in its growth and see much higher growth in the coming years.

Why does Altria need to enter this market?

Altria is currently the leader in U.S. cigarettes market but faces declining revenues and a shrinking user base due to the factors mentioned earlier. In 2011, the market size of cigarettes in the U.S. was around 270 billion units. We project a gradual decline over the course of our forecast period, with the market reaching 235 billion units by 2019. With the market for cigarettes declining, Altria is restricted to driving top line growth for the division through price increases, which is unsustainable.

Altria’s competitors, such as Lorillard and Reynold’s, have already embraced e-cigarettes and have entered the market through the acquisition of Blu cigs and the development of a computer chip based “digital” cigarette respectively. Altria, on the other hand, has yet to make a move and stands to lose out on what could be a highly lucrative and rapidly growing market if it does not act soon.

How will Altria enter the market?

There are several ways in which Altria can enter the e-cigarette market. One would be to acquire a well established e-cigarette maker in the US, similar to Lorillard’s acquisition of Blu ecigs. According to Wells Fargo analyst Bonnie Herzog, Altria may be looking to acquire NJOY, an e-cigarette maker with a 40% share of the U.S. e-cigarette market. On the other hand, the company could be looking at developing e-cigarette products in-house. Altria reported earlier this year that it has entered into a partnership with Okono A/S, an affiliates of Fertin Pharma A/S, to develop “innovative, non-combustible nicotine-containing products”.

We currently have a Trefis price estimate of $30 for Altria, which is about 10% below the market price.

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