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Will evolving e-cigarette policies help or hinder vape stocks?

The vaping industry is experiencing exponential growth and Big Tobacco has made its entry, but the future of vaping could still go up in smoke and the issue remains highly controversial. We have a look at the current picture and how the top vape stocks are shaping up.

Source: Bloomberg

'The story of tobacco is a paradigm case of what happens when drug companies are allowed to create markets of millions of addicts, and what governments can do to rein in those markets without making a drug illegal,' – Professor David Nutt, former head adviser on drug policy to the UK government and author of Drugs Without The Hot Air.

There is over one billion cigarette smokers in the world today and tobacco will claim its billionth life before the end of the next decade. Despite the indisputable harm that the industry inflicts on the global population, Big Tobacco (the five largest tobacco companies) continues to fight for its right to survive as it has done for over half a century.

The vape industry and the transition from tobacco

The tobacco industry has been virtually crippled in western markets since governments finally realised the need to discourage smoking in the 1970s. They first limited and then completely stripped the industry’s right to advertise and began restricting where smokers could enjoy their cigarette, banning it in offices and impractical places like hospitals and planes. It has been a slow realisation but government efforts have accelerated over the past 15 years. Today, many countries do not allow smoking inside public premises whatsoever, have raised the legal age that someone can buy tobacco products and made cigarettes extremely expensive through ever-higher taxation. Many have even forced the tobacco industry to use generic packaging awash with graphic health warnings and banned them from being on display.

But Big Tobacco has resisted every single effort by governments and health bodies to damage their business. Their tact has had to change over the decades as they have had no choice to but to accept the undeniable, modern-day evidence on the harm that their products cause.

Nobody truly started to understand the real health implications of smoking until the 1950s. Ironically, the tobacco industry was more than happy to claim cigarettes actually had health benefits without proof but was unsurprisingly the first to question the validity of the research that started to condemn smoking as detrimental to people’s health. Politicians (many who smoked) were lobbied and doctors were used in adverts to cite how one brand of cigarettes was healthier than another: one famous slogan even read ‘more doctors smoke Camels than any other cigarette’. One campaign in the late 1920s linked cigarettes to female empowerment, dubbed as ‘a torch of liberty’ for repressed women, which helped the industry encourage women to smoke. Soldiers were even given cigarettes as part of basic rations in both World Wars, snaring those that managed to survive war with a deadly addiction and creating a boom for the tobacco industry’s profits for decades to come.

Big Tobacco continues to fight for survival as it has done for decades

While the industry was thriving in ignorance it had to start to come to terms with the fact it was selling a lethal product in 1953, when a simple study opened the eyes of the public in a way previous studies into the effect of the contents of tobacco couldn’t. Instead of compiling data and causal effects of smoking and diseases, like cancer, Dr Ernst Wynder smeared tobacco tar on mice who then developed tumours: a very real image that both the press and consumers could grasp unlike previous scientific studies.

The impact of Wynder’s study was so damning that the following year was dubbed the ‘1954 emergency’ by the tobacco industry. Big Tobacco made its decision, and it was to fight. The US industry released a joint statement in national newspapers playing on the validity of the research, correctly stating there was no concrete evidence at the time to suggest smoking caused diseases and that many elements of modern-day life could be equally to blame. It even set up an ‘independent’ task force that went on to send 200,000 politicians, doctors and journalists a booklet compiling all the dubious and inconclusive evidence on the matter.

However, Big Tobacco had to slowly resign itself to the evidence by the 1960s, but this is when it started its efforts to market smoking not as a healthy choice but one linked with the likes of rebellion.

Their ability to compete and do anything but stock their products in Western markets is all but gone, so the industry has concentrated on emerging economies in the likes of Asia-Pacific where regulation is much more lax and it can pursue growing middle classes with increasing amounts of disposable income.

Smoking reaches its peak but still over one billion smokers worldwide

But the tobacco industry knows it won’t have the free rein in these new markets for as long as it did in the West and, at the bottom line, the tobacco industry has been staring at its own demise for years. The amount of smokers worldwide has peaked, falling from about 1.14 billion in 2000 to 1.1 billion today, according to the World Health Organization (WHO).

In many countries tobacco can’t compete on anything but brand loyalty from before bans on advertising, packaging and displays were introduced, and on price (which is more difficult due to high taxes). Working in the marketing department for a UK tobacco operation, for example, is redundant. This is partly why tobacco companies, as far as investors are concerned, have become renowned for their reliable and progressive dividends as the industry has less and less to invest in.

Vaping: the saving grace for Big Tobacco

But the rise of vaping is proving to be the savour of the industry and Big Tobacco has invested billions of dollars over the past ten years. Branding, packaging, design and even flavours – including menthol which has been increasingly banned in tobacco form – are all back on the table. The tobacco industry has managed to press reset and now finds itself starting all over again.

Vaping and alternatives to traditional tobacco products were originally spearheaded by small, independent companies as Big Tobacco watched from the sidelines concerned over what future regulation for the likes of e-cigarettes would hold. But, as the consensus in favour of vaping has grown, the biggest tobacco companies started to consolidate the market. Today, while many of the most popular brands have escaped the clutches of Big Tobacco, they still own most of the best-selling vape brands thanks to their financial firepower and global scale.

Consensus in support of vaping is growing but debate rumbles on

The US, UK and Japan are (in that order) the top three biggest vape markets that lead their respective geographical regions, but the attitudes in these countries are taking different paths and in some countries vaping and products like e-cigarettes are banned outright, including in Brazil and Saudi Arabia. New Zealand epitomised the state of affairs last year when it made a U-turn, reversing its total ban on vape devices with policies that seem to have been inspired by UK policy.

The debate around vaping is still controversial today. Those in support of vaping in the UK are mostly arguing it is a safer alternative to traditional tobacco products and that it is the key to getting people to ‘stop’ smoking, not encourage a new generation of vapers. The idea being floated is that vaping or other alternatives are to be marketed as health products, in other words, a smoking cessation aide. UK Health bodies are suggesting they be made available on prescription and supporting calls from some MPs that centre on ‘non-vapers having to accommodate vapers’. In addition, the growing consensus is that there is little evidence to suggest children are taking up vaping or that vaping acts a gateway to other drugs, an important point considering smoking is a habit that most pick up in their teenage years. However, the US, where the vaping market is much more commercial, is less convinced on this front and regulators are still investigating the relationship between vaping and children.

The World Health Organisation (WHO) sums up the crucial point of the debate about vaping in just one sentence from its cautious but very reasonable stance over vaping: the long-term effects are unknown. But, just as they did in the 1950s, Big Tobacco and the rest of the vaping industry are benefiting as a result of the confusion and the debate that continues to rumble on.

The role of vaping in society raises several key questions for industry

‘We’re trying to help the current generation of smokers… I’m not concerning myself with 100 years’ time,’ – BAT Scientific and Research & Development director, David O’Reilly.  

If vaping is to get the go-ahead on the basis that only those smoking traditional tobacco products will use them and that they are a smoking cessation aide then this raises another question which, regardless of an investor’s view on the health debate of vaping, will be one for concern. If the amount of people smoking traditional tobacco has peaked and in decline then how can the vape market be sustainable? Many would say while it could not be sustained indefinitely on this model, the industry is far from having to worry about that with over one billion people to target.

Juul: showing the real intent of the vaping industry?

Juul, one of the biggest e-cigarette brands in the US that recently launched in the UK, embodies several problems for the industry. Although there are many different types of vaping devices they have mostly conformed to a select few models that have focused on functionality. Juul, on the other hand, is a sleek and stylish e-cigarette that is increasingly being called the ‘iPhone of e-cigarettes’.

This exposes the idea that vaping for smoking cessation is nothing but smoke and mirrors. Juul is selling itself as a stylish product and some have argued it is encouraging young people to start vaping and, when you consider the variety of sweet flavours and the growing ‘hobbyist’ customer base that learn things like how to blow smoke rings using their vape device, it is fair to argue against claims the industry isn’t trying to create a new generation of vapers nor targeting young people. If you saw a Juul device on a school desk you would think it was just a rather long USB drive.

This shows the lack of agreement between the governments of the biggest vape markets. While the UK is embracing the idea to help people stop smoking in the US it is much more of a commercial opportunity, which Juul encapsulates in its entirety.

Big Tobacco does not monopolise the vaping scene like it does tobacco, and if there is a lack of agreement on how to market vaping, whether as a health aide or as a recreational device, then it could undermine the entire industry. However, it is worth considering that the argument for vaping to be used as a health device is already undermined by the fact Big Tobacco still sells billions of cigarettes each year, and that the idea of accepting it as a recreational activity at this stage would be making the same mistakes we did with cigarettes.

How big is the vape industry and how fast is it set to grow?

The vape industry has seen exponential growth and is expected to continue growing for the foreseeable future. Data from BIS Research states the e-cigarette and vaping market was worth $11.4 billion in 2016 and set to grow at Compound Annual Growth Rate (CAGR) of over 23% between 2017 and 2025, when it estimates it will be worth $86.4 billion.

Separate data from Euromonitor shows there were around 35 million vapers worldwide in 2016, having surged from just seven million in 2011, with estimates for up to 55 million vapers by 2021.

What are the different types of vaping and tobacco alternative products?

There are various different types of vaping and tobacco alternative products to choose from and different markets have proven to have different tastes. Broadly, the two main types are: e-cigarettes, which are the vaping devices that those in the US and the UK are more accustomed to, and heated tobacco products (also known as heat-not-burn), which are conventional cigarettes that are thought to be safer because the tobacco, as the name suggests, is heated to create a vapour rather than burnt, which is thought to release less toxic chemicals. These are particularly popular in Asia, led by Japan.

The biggest players are developing both types, suggesting they have not quite figured out which product will go on to dominate.

The nature of vaping has seen demand for bricks and mortar stores where users can try out devices before committing to purchasing one. These stores, some of which are also operating as ‘vape coffee houses’, are also where the hobbyists socialise. However, there is the suggestion that while many want to try out their first device people eventually transition online, where sales are growing.

Top five vape stocks

Big Tobacco, aware that its core industry is in decline, has been snapping up designers, manufacturers and distributors of vaping devices and consumables, and used its financial firepower and scale to catch up and become leaders in the most advanced markets.

Philip Morris International and vaping: leading heat-not-burn

Philip Morris currently has four ‘smoke-free’ products at various stages of development, one of which has already been launched. The firm’s tobacco heating product, IQOS, has made headway in several key markets, particularly in Japan and South Korea where it holds a 13.9% and 5.5% market share, respectively. 

While these two markets have set high expectations for growth in other markets (particularly as it only launched in Korea in May 2017), it reported growth in IQOS volumes in almost all other markets with notable increases in the Czech Republic, Greece, Portugal and Romania. That comes after it began phasing its factories in most of these markets from producing cigarettes to heated tobacco products last year. Distribution has been a key part to the success of IQOS, with its substantial market share in Asia boosted by competitors suffering supply shortages last year. 

However, the missing piece of the jigsaw still needs to be put into place. Philip Morris is still waiting to secure approval to launch IQOS in the US. 

Philip Morris has other products in the pipeline, some of which are actively being tested in the market. In addition to the tobacco heating IQOS product it has created TEEPS, a ‘breakthrough’ carbon-heated tobacco product that uses patented technology, and MESH, which is a ‘completely new approach’ to vapour products. The fourth product, STEEM, aims to create a nicotine-containing vapour in the form of a nicotine salt. 

These next generation products account for just 5% of its volumes but 13% of total net revenues, demonstrating the opportunity on offer. Almost 75% of its research and development spend is being funnelled into this area. Its overall portfolio of next generation products generated net revenue of $3.6 billion in 2017 compared to just $733 million in 2016. That looks certain to grow further in 2018, with first-half revenue amounting to $2.1 billion.

Altria Group and vaping: strong US position

Altria Group's strength lies in the US, where it is a major player in both the tobacco and next generation markets. The firm’s MarkTen vapour brand has been at the forefront of its efforts, where it holds a national market share of 12.5%. However, its strategy for the heated tobacco market relies on Philip Morris securing approval for IQOS to launch in the US, as Altria has already signed exclusive distribution rights for the product in the US. 

Its distribution channels in the US are strong, with MarkTen stocked in 25,000 stores, accounting for about 70% of retail stores that sell e-cigarettes.

Although Altria holds a strong position in the largest market for vaping at present it does lack firepower abroad, which could pose a problem in the future as growth shifts to Asia.

BAT-Reynolds American merger makes ‘world’s leading vapour company’

British American Tobacco (BAT) took full ownership of Reynolds American in the middle of 2017 to create the ‘world’s leading vapour company’. BAT’s flagship brand, Vype, was launched in 2013 and, having become the leading brand in the UK, is now available in almost all the major vaping markets. However, the acquisition of Reynolds American added the market-leading vapour product in the US, Vuse, which was launched in 2012. 

BAT expects western markets to take up these types of vapour products going forward, meaning it is already well-placed in countries like the US and Europe where uptake will be the greatest. However, the company is also pursuing the heat-not-burn market. Its main tobacco heating product, glo, was launched in Japan at the end of 2016 and has since expanded into new territories, some where it is directly challenging Philip Morris’s IQOS. 

Last year, BAT’s vapour and heat-not-burn products generated £397 million, but if Reynolds American’s results had been included for the whole of 2017 it would have amounted to £500 million. BAT originally expected to double that in 2018 to £1 billion but said at the midway point that it should manage to exceed its target as it prepares to launch new heated tobacco products before the year is out. In the six months to the end of June, revenue from vapour products more than doubled to £116 million while heated tobacco sales were up more than six-fold to £289 million. 

BAT expects for annual sales of vapour and heated tobacco products to soar to £5 billion by 2022. For perspective, BAT’s overall annual revenue in 2017 was £20.29 billion, suggesting its next generation of products will make up a substantial chunk of its sales in the near future.

Imperial Brands and vaping: ramping up expansion of blu brand

Imperial Brands is throwing its efforts behind vapour products and concentrating on expanding its blu brand, which is currently sold in the US, UK, France, Germany and Russia. It has stepped up its efforts this year with plans to open in another five markets before the end of the year and a further ten in 2019. The company has a variety of vapour types on offer and intends to introduce new flavours to customers in the near future.  

Imperial Brands has been building its capabilities for many years. It still earns royalties from other companies that use technology developed by Dragonite, which it acquired back in 2013. Last year the firm bought Nerudia, which manufactures e-cigarettes and other similar products on behalf of third parties. 

The company is not ignoring the heated tobacco market, but the company does describe it as a ‘much smaller’ opportunity, albeit one that is growing. It launched trials of its own heated tobacco products late last year, but investment going forward will still be channelled into its vapour products.

Turning Points Brands: small but growing vapour operation

Turning Point Brands purchased VaporBeast in late 2016, acquiring a firm with strong distribution channels supplying e-liquids and devices to thousands of retailers across the US. It followed that up with the acquisition of Vapor Shark, who manufacture their own-branded products and sells them through 35 stores. 

In April of this year the company purchased Vapor Supply, an e-commerce marketing and distribution platform serving businesses. The company also makes its own e-liquids under the DripCo brand and has a small retail network of eight stores. It has been yielding cost-savings and synergies by integrating the small brands it has purchased, particularly in the logistics department. 

Although Turning Point Brands is a small player, its business is more geared toward next generation products than the big players that have a long way to go before their earnings no longer rely on cigarette sales. Turning Point Brands makes over one-third of its total revenue from its next generation products, amounting to $53.6 million in the first half of 2018 with growth accelerating in the second quarter (Q2) compared to Q1.

Many doubt the vape industry and take more cautious approach

Although the biggest tobacco companies have quickly consolidated the fragmented vaping market in the hope this new industry can counter the demise of their core business, not every company is convinced it is the best route to go down, and some believe the market is more challenging than others.

Supreme: owner of 88vape and KiK postpones London IPO

Supreme was to be the first vaping company to list its shares on the London Stock Exchange (LSE) when it announced it was preparing for an initial public offering (IPO) in May, but it then placed it on hold due to ‘market conditions’ despite receiving ‘encouraging institutional support’. 

Although the business is one of the largest battery distributors in the UK (distributing for Duracell, Panasonic, Eveready, Energizer and JCB) and sells tens of millions of lighting products internationally each year, the business said it was expecting about 60% of its profit to come from its vaping division.

In March 2018 the company sold 130,000 bottles of e-liquids each working day in the UK. It also sold 690,000 devices that month, suggesting sales have rapidly accelerated from a monthly run-rate of about 333,333 over the course of 2017.

Again, logistics has played its role in building its two brands, 88vape and KiK. In addition to owning an e-liquid producing factory in Manchester (which it describes as a ‘differentiator’) it has strong sales outlets as customers including discount chains like B&M, nationwide retailers including Walmart-owned ASDA (which is merging with Sainsbury’s) and wholesalers such as Tesco-owned Booker Group.

Learn more about the Sainsbury's-Asda merger

Vector Group cautious on e-cigarettes due to US uncertainties

Vector Group is the fourth-largest cigarette producer in the US and although its subsidiary, Zoom E-Cigs, launched in the country in 2013 it has failed to gain traction. Vector Group has been deliberately cautious and tight with investment because it has concerns over the changing regulatory landscape in the US and the emergence of new technologies, with consumers still deciding what type of next generation product they want. Zoom E-Cigs is still in the red but its operating losses have narrowed significantly, from $13 million in 2015 to $900,000 in 2017.  

For now, Vector Group is still all about cigarettes. Its strategy for e-cigarettes is to ‘stay prepared to pursue opportunities if they occur’.

22nd Century Group: looking to monopolise with alternative approach

While others believe vaping is where the money lies as people look for an alternative to smoking cigarettes, 22nd Century Group offers investors an alternative. The company genetically engineers plants to regulate the nicotine content of tobacco plants. This has seen it focus on producing extremely low nicotine content cigarettes marketed as ‘cessation aides’, as well as cigarettes with particularly high levels of nicotine. 22nd Century Group is not a friend of Big Tobacco. 

The company sells its ‘very low nicotine’ cigarettes under brands like Magic 0, Magic 2, Red Sun and Moonlight outside the US. However, 22nd Century Group is also developing a very low nicotine brand of cigarettes named X-22 that it is trying to develop as a prescription smoking cessation aid found in US pharmacies rather than the local supermarket or vape shop. 

The firm is in a unique position as the only company capable of producing very low nicotine cigarettes. This has allowed it to secure niche work, such as manipulating the content of cigarettes to be used for research. This has also given it a way to encourage the US government to support its products. 22nd Century Group could be in line to benefit if proposals to make all cigarettes in the US to contain very low levels or minimal amounts of nicotine go ahead, following tests carried out using 22nd Century Group’s products. 

The company is aggressively pushing for the Food and Drug Administration to approve the proposals, and is arguing that its technology should be needed by all tobacco companies to improve the health of Americans and save the industry the billions of dollars it claims they would need to develop very low nicotine cigarettes on their own. For big tobacco, this is bad news on all fronts as it would force them to turn to 22nd Century Group to lower their nicotine levels, and present more direct competition for heated tobacco products that others are developing. As 22nd Century Group says, it ‘will be interesting to see which Big Tobacco companies genuinely care about smokers… and which are determined to keep their customers addicted to the deadliest consumer product available on the market’.

What are the biggest challenges for the vape industry?

The two immediate threats facing the vape industry are how government policy develops and how public perception evolves. The US may be the biggest market for vaping but regulators are far from convinced and are still questioning their role in society, starting with those that flout the rules that apply to cigarettes regarding flavours and branding.

How the government moulds its policy on vaping and how the public perceives it will be dependent on one another. The BBC’s latest headline on vaping sums up the message that consumers (in the UK at least) are receiving: ‘Vaping – good, bad or not clear?’ The answer: it is a ‘debate clouded with uncertainty’.

Additionally, both BAT and Philip Morris have admitted consumers already believe current vaping devices are reaching their limits in terms of performance. If the vape industry continues to steam ahead then product development, something Big Tobacco has not had the chance to do for a while, will be all-important to compete in what would become a more competitive market.

Conclusion: will the vape industry be history repeating itself?

It took centuries for the world to realise the devastating effect tobacco has on the world. Smoking was not even recognised as an addiction in the US until 1989, having been classed as ‘habitual’. But it is those governments that have taken the most extreme measures against the tobacco industry that are the lead advocators of vaping.

It is worth considering that while overall levels of smoking are declining, the effects will last much longer and the cost to the public purse will continue to grow well after the world, if it ever manages it, eradicates smoking altogether. Governments earn billions in tax revenue from tobacco but the cost on health services and other provisions is thought to swallow up all that revenue, and more.

Big Tobacco has already seen a possible move by future governments. BAT has audaciously warned: ‘as the income from traditional cigarette taxation falls over the longer term, there is a clear risk of increased taxation on [next-generation products] that does not take into account their relative risks when compared with traditional cigarettes’. But if vaping is just to stop people smoking then why wouldn’t you apply the same high-tax deterrent that has proven successful so far?

This information has been prepared by IG, a trading name of IG Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication.  Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. 

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