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Vaping or cannabis: where’s the growth for Big Tobacco?

Tobacco was a business in decline as smoking rates continue to drop, but now the industry is pursuing new growth opportunities as vaping gains popularity and more countries legalise cannabis.

Growth for Big Tobacco Source: Bloomberg

The cigarette business is one that has been in decline for decades. Over a billion people from around the world still smoke today, but overall prevalence continues to rapidly drop as more countries encourage their citizens to give up the deadly habit. The percentage of the world population puffing on cigarettes and other tobacco products has fallen dramatically over the past 20 years alone, from around 27% at the turn of the millennia to just 20% today, according to the World Health Organisation (WHO).

High-income countries that were traditionally the biggest market for cigarettes have continued to disable the industry’s ability to grow for decades – whether that be through higher taxation, bans on branding and advertising, or government-funded stop-smoking campaigns. For example, the number of daily smokers in the US dropped from over 52 million in 1980 to just 38 million in 2012, representing a drop of 27%. In the UK, where the crackdown has been more severe, the number of smokers has plunged even further, dropping 37%.

Today, Big Tobacco is pursuing the final frontiers of growth for the cigarette industry in low-to-middle-income countries that are still developing and have a growing middle class with more disposable income. Most nations in Africa, South-East Asia and in the Eastern Mediterranean have a higher percentage of their population that smoke today than they did three decades ago. China, the world’s largest tobacco market, is the best example. In 1980, 182 million Chinese people smoked daily, accounting for about 18% of the population. Today, that figure has almost doubled to 350 million and the share of the population that smokes has jumped to 25%. However, most tobacco companies haven’t been able to capitalise on major markets like China because it is effectively controlled by one state-owned business: China Tobacco International, which listed in Hong Kong in 2019.

But increased cigarette consumption in developing nations is not enough to offset the overall decline in smoking rates around the world. The industry knows that what little growth is left won’t last forever as developing countries will undoubtedly follow in the footsteps of developed nations eventually.

Read more: Top 12 tobacco stocks

Big Tobacco turns smoke into vapour

While some countries continue to provide growth for tobacco companies, the overall fall in the number of smokers worldwide meant Big Tobacco was ultimately regarded as a business in decline. But the industry has discovered a major new opportunity over the past decade as vaping has been embraced by some of the world’s largest economies.

In fact, Big Tobacco is so sure that their future lies in vaping and other ‘smokeless’ alternatives that it has fundamentally changed the industry’s entire mindset, albeit ironically. Philip Morris, the second largest cigarette company in the world and the biggest outside of China, now follows a mission to deliver a ‘smoke-free future’ while its peer British American Tobacco (BAT) is aiming to ‘transform tobacco’ with what it calls ‘reduced-risk products’.

Sales of these products have been surging, but they still represent a fraction of what the industry earns from cigarettes. Philip Morris has made the most headway as its ‘reduced-risk products’ account for nearly one-fifth of all revenues, compared to BAT at just 4% and Imperial Brands at 3.5%.

The introduction of vaping and other alternatives, such as heat-not-burn products, has been a win-win situation for Big Tobacco. Those that quit cigarettes and turn to vaping, as recommended by health professionals in the UK, now remain customers while rather laxed regulation (compared to traditional tobacco) has also allowed them to, albeit controversially, introduce a nicotine habit to an entirely new generation of consumers. For example, Philip Morris said around 13.6 million people are currently using its heat-not-burn IQOS product, but only 9.7 million of them are former smokers, implying the rest have found a new vice.

Still, these ‘next generation products’, as most of the industry calls them, remain divisive and have only been embraced by a handful of countries. The US is by far the largest market, followed by the UK, France and Japan. The top three are thought to account for $10 billion of the $19 billion global market.

Many, including Brazil, Thailand and India, have banned the sale of e-cigarettes outright, either because they remain unconvinced about the effect they have on people’s health, or fears they are introducing a new generation to nicotine.

Vaping: UK and US take different approaches … with different results

The US vaping market is currently under the spotlight. Vaping has been commercialised for ten years, it is largely unregulated and the US government is only just starting to take action following two serious crises.

The first has been the popularity of vaping among teenagers, particularly of one brand named JUUL that styles its vape pens to look like a USB stick. Unbelievably, the US only made it illegal to sell e-cigarettes to minors in 2015 even though they became widely available from around 2007. There is thought to be almost five million ‘youth e-cigarette users’ in the US, around 1 million of which use them daily, according to the Food & Drug Administration (FDA). This was a consequence of allowing flavours clearly targeting younger audiences, such as cotton candy, and largely unrestricted marketing, including on social media.

There has also been over 2,700 ‘e-cigarette, or vaping, product use-associated lung injuries’, or EVALI, in the US, resulting in 60 deaths, according to the Centers for Disease Control & Prevention (CDC). The number of cases has dropped sharply since peaking in September 2019, but the precise cause of the injuries has been linked to several things. The first is the use of vaping products that contain tetrahydrocannabinol, or THC, the psychoactive component of cannabis that has been sourced illegally, or as the CDC puts it, ‘from informal sources like friends, family, or in-person or online dealers’. The second is the use of Vitamin E acetate in these THC-ladened products, which has been used to either thicken or dilute the vaping liquid.

Both these crises have been prompted by the same thing: a lack of regulation. Only this year has the FDA required all companies that sell vaping products to secure pre-authorisation. This means every existing product will have to be put up for review before May 2020, and that every new product will have to be vetted before being launched in the future. All vape pens, e-cigarettes and the liquids used in them will have to go through the ‘pre-market tobacco product application’, or PMTA process this year.

Comparably, there is little concern over children using e-cigarettes in the UK, and there has been no vaping-related deaths reported to date, partly because cannabis is still rarely prescribed legally. Instead of allowing vape pens to be offered as commercial products like in the US, e-cigarettes and alternatives are sold as ‘smoking cessation aides’ designed to help people quit smoking rather than as a new habit to take-up. Overall regulation is much tighter than in the US. For example, nicotine content is capped in the UK but not in the US and there are stricter rules on advertising.

Altria’s JUUL investment costs it dearly

JUUL is thought to control over 70% of the US vaping market and it was initially regarded as one of the leading start-ups to have entered the space, so much so that one of the biggest tobacco companies in the country, Altria, happily ploughed a staggering $12.8 billion to take a 35% stake in the e-cigarette firm. That in turn, was a key reason why Philip Morris wanted to merge with Altria to reunite the two companies after they were separated in 2007 – but those plans were abandoned in the wake of the fallout from the country’s vaping crisis.

The impact on JUUL has been so significant that Altria has had to wipe billions of dollars off its investment in the company. In the final quarter of 2019, Altria had to book a $4.1 billion impairment against its investment in JUUL, taking the full year charge to $8.6 billion and slashing the value of its stake to just $4.2 billion. Altria warned that the impairment was primarily due to the increased number of legal cases pending against JUUL, which have risen by 80% since the end of October 2019. It said it expected that the ‘number of legal cases against JUUL will continue to increase.’.

There are also concerns that JUUL won’t survive the PMTA process as it is the primary target of regulators looking to crackdown. Altria has already ‘revised’ the terms that governs its relationship with JUUL, including greater supervision when it comes to regulation and a shuffle to the vaping brand’s board. It has also removed the non-compete clause of its deal should JUUL be banned from selling vape products in the US for longer than one-year, or if the value of Altria’s investment falls below $2.8 billion.

Altria has warned that it won’t receive any earnings from JUUL for at least the next three years, which will severely hit its earnings. Altria has already lowered its compounded annual adjusted diluted EPS growth objective to 4% to 7% for the years 2020 through 2022, from its previously announced objective of 5% to 8%.

US vaping crisis highlights importance of a diverse portfolio

The US market is expected to take a hit this year as a result of the tighter regulation that will take illegal or poor-quality product off the market, plus the minimum age being pushed up to 21 from 18. Bloomberg reported figures from data provider ECigIntelligence that suggested vape sales in the US could fall as much as 13% 2020, having previously forecast a 10% year-on-year increase. The data suggests sales will return to annual growth straight away in 2021, but that the market won’t fully recover the lost value until 2023, implying it could set the market back by up to four years.

Big Tobacco should welcome tighter regulation in the US. Firstly, being regulated is better than being banned, which has been the choice some countries have made. Secondly, verification from the US could influence other countries that are find themselves torn on the issue. Thirdly, processes like the PMTA should favour big tobacco companies that can afford to meet new rules and better understand legal processes compared to the newer start-ups.

The number one lesson to be learnt from the crisis in the US is that it is better to have a broad portfolio of smokeless products rather than throw all your weight behind one alternative to smoking. This has been demonstrated by Altria’s unsuccessful big bet on JUUL.

Imperial Brands has also suffered after heavily investing in its vaping brand blu eCigs. Its next-generation products grew by over 52% in the year to the end of September 2019, but Imperial said this was below expectations and prompted it to ‘reduce and reprioritise’ its investment in new products so it can deliver ‘sustainable and scalable growth’. Earlier this month it said adjusted earnings per share in the first half of this financial year would be down 10% from the year before because of the ‘US FDA’s ban on certain flavours of cartridge-based vapour devices and weaker than expected consumer demand for vapour’. It said revenue would be broadly flat for the full year (which runs until the end of September) and that adjusted EPS would be ‘slightly lower’. ‘Regulatory uncertainty and adverse news flow continues to affect demand in the US and Europe. We estimate this will result in significantly lower year-on-year NGP net revenue as well as increased provisions for slow-moving stock,’ Imperial said at its annual general meeting in February.

After abandoning plans to reunite with Altria, Philip Morris has instead thrown all its weight behind its heat-not-burn (HNB) product IQOS. Whereas e-cigarettes and vaping devices tend to produce a vapour from a liquid, HNBs heat tobacco to a precise temperature to produce a nicotine-containing aerosol. Philip Morris has seen success with IQOS in Japan and is hoping to replicate this in the US. Despite the merger falling through, Philip Morris struck a deal for Altria to distribute IQOS in the US. It seems like perfect timing to launch the IQOS in the US as it could prove popular if people decide to stop using e-cigarettes, and it will help Altria diverse its portfolio and lower its dependency on JUUL. Philip Morris says IQOS is currently the ‘only heat-not-burn product authorized through the FDA’s PMTA pathway as appropriate for the protection of public health’. Philip Morris sold 60 billion heat-not-burn units globally in 2019 and aims to hit 90 to 100 billion by 2021.

One company that looks well positioned is British American Tobacco (BAT), which has reorganised its smoke-free portfolio around three brands: Glo for heated tobacco, Vuse for vaping and Velo for its oral nicotine range. Still, BAT said growth in sales of its new generation products would be at the lower-end of its 30%-50% growth range because of the slowdown in the US vaping market, having previously said it would be in the middle of that range. Still, BAT’s share price has proven more resilient than the wider market during the fallout from the vaping crisis, partly because it sells nearly twice as much heated tobacco products than vaping ones. BAT is still aiming to generate £5 billion in annual revenue from its next generation products by 2023 or 2024 – up from just £901 million in 2018.

Can Big Tobacco thrive as cannabis legalisation gains momentum?

The other big potential growth area for Big Tobacco is the legalised cannabis market. There are obvious harmonies between Big Tobacco and marijuana. There are agricultural crossovers and tobacco firms have the legal expertise to understand how to navigate tough scrutiny and legal challenges.

Legalising or decriminalising cannabis remains a divisive issue and there is no international consensus on the matter, much like vaping. Only 30 countries have taken steps toward legalising marijuana, either for medicinal or recreational use, or both, although most have favoured the former. Over 30 countries have taken steps toward legalising medicinal marijuana but only a few, including Canada and Uruguay, have given the green light to recreational use.

Canada has brought legal marijuana into the spotlight, but the focus is again on the US, where the situation is more complicated. Marijuana has not been given the go-ahead at a federal level, leaving individual states to make up their own mind. 31 states have approved medicinal use but only 11 of them allow recreational use. The state-by-state regulation has caused uncertainty for the market and only some firms have been willing to invest serious sums into the industry, with most waiting for federal approval before committing to anything.

The global legal cannabis market is estimated to have grown 46% in 2019 to $14.9 billion, according to Arcview Market Research and BDS Analytics, and that is forecast to soar to nearly $43 billion by 2024. The market will be shared by numerous big industries: pharmaceuticals will take a slice, while beverage and food companies have already started to make headway with edibiles and cannabis-infused drinks. There will definitely be a place for Big Tobacco, but the industry will have to decide how involved they want to get.

Altria gets stung for early move into cannabis

For now, only one big player has made a material investment in a cannabis company, with Altria having spent $1.8 billion on a 45% stake in Canadian cannabis firm Cronos Group with an option to take a controlling stake if it wants. But, much like its ambitious bet on JUUL, it has been punished for making an early move into cannabis after it also had to write -down the value of its investment in Cronos last year.

Most of the tobacco industry has refrained from making any big moves into the sector while the regulatory picture remains so uncertain. Philip Morris has said it is not prepared to enter the nascent market because it believes it would distract from its main goal of pushing the IQOS. However, it has suggested it could consider making a push if the US legalises it at a federal level. Similarly, BAT has not made any moves in terms of cannabis, although it has recently been reported that the boss of the firm’s research facility in Southampton has said the firm is ‘evaluating’ using CBD and cannabis flavourings.

Can vaping and other smokeless devices become key to the cannabis market?

The big question for Big Tobacco is how involved it wants to be in the cannabis market. The obvious route, and the one taken by Altria, is to gain direct exposure by investing in producers – but, as Altria has demonstrated, this comes at a risk. The other, possibly lower-risk strategy would be to adapt their vaping or other smokeless devices so they can be treated more as devices that deliver medical treatments rather than vices. This would allow Big Tobacco to provide the key delivery systems needed for medicinal marijuana and, further down the line, other drugs, without necessarily having to be directly involved in the production or marketing of the controversial plant. Imperial Brands looks to have recognised this potential after announcing last year that it had struck a research and development partnership with Canadian cannabis company Auxly Cannabis Group, under which it will take a 20% stake over three years. The deal involves Imperial providing Auxly access to its vaping technology business to see how it can be adapted for the legalised cannabis market, and builds on a previous investment it made in Oxford Cannabinoid Technologies in 2018.

Find out more about the cannabis market with IG

You can find out more about the emerging legalised cannabis market by tuning in to IG’s Investing in Cannabis podcast series, which is freely available on all major streaming platforms.

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