The advertisement features a scowling granny in an Argyle cardigan. “Dear Smoking Ban,” she says, brandishing a middle finger.
The ad, which has appeared in several U.S. publications, touts Blu Ecigs, a maker of electronic cigarettes acquired earlier this year by Lorillard Inc. (LO:US) for $135 million in cash. “Take back your freedom to smoke anywhere with blu electronic cigarettes,” the ad continues. “It’s the most satisfying way to tell smoking bans to kiss off. OK, maybe the second-most satisfying way.”
In recent years, U.S. tobacco companies have rolled out a range of smokeless products, from battery-powered e-cigarettes to lozenges laced with tobacco. Lorillard, Altria Group Inc. (MO:US) and Reynolds American Inc. have tried various marketing tactics, including positioning the products as a way for nicotine addicts to thumb their noses at the anti-smoking police.
Yet because it’s hard persuading smokers that an e-cig or lozenge is a substitute for lighting up, these alternative products account for about 1 percent of the $90 billion U.S. cigarette market, said David Adelman, a Morgan Stanley analyst.
“Consumers like the tobacco products they currently consume,” said Adelman, who is based in New York. “This isn’t like asking someone to change their laundry detergent or the type of mop they use.”
The industry is trying to goose sales as U.S. smokers, increasingly hemmed in by higher cigarette taxes and smoke-free zones, puff less and less each year. Cigarette volume has been falling at an annual rate of 3 percent to 4 percent. Meanwhile, sales of smokeless products, including traditional snuff, grew about 7.5 percent from 2010 to 2011, according to Euromonitor International.
The trend has weighed on tobacco companies’ shares. The Standard & Poor’s 500 Tobacco Index has traded at an average 18 percent discount to the broader S&P 500 during the past decade on a price-to-earnings basis. The index consists of Lorillard, Altria, Reynolds (RAI:US) and Philip Morris International Inc.
The U.S. Food and Drug Administration, which in 2009 won the power to regulate tobacco products, has yet to impose rules on these new cigarette alternatives. That means the industry has an opportunity to test-market its new wares without FDA oversight, said Mitch Zeller, a former director of the agency’s Office of Tobacco Programs who works for Pinney Associates, a health policy consulting firm based in Bethesda, Maryland.
“This isn’t like test-marketing a new cigarette, where companies have decades of experience and the most highly developed set of consumer insights and expertise,” Zeller said. “These are brand new styles of nicotine delivery these companies have no experience with. These are real-life sales, not paying people to participate in a focus group.”
The “holy grail” for the tobacco companies is “a cigarette-like product that accomplishes the flavor, the ritual and all the cravings of a cigarette,” said Thilo Wrede, an analyst for Jefferies & Co. Inc.
Dissolvables, which contain tobacco and are consumed like lozenges or mints, sometimes look like candy. Reynolds sells Camel Orbs, whose appearance has been compared to Tic Tacs. Last year, Altria, which is based in Richmond, Virginia, began testing a dissolvable stick, much like a toothpick, under its Marlboro and Skoal brands. In May, the company debuted Verve, a disc containing nicotine.
Many smokeless products have failed in test markets because they lack the nicotine punch of cigarettes and are too removed from the smoking ritual, said Greg Connolly, director for the Center for Global Tobacco Control at the Harvard School of Public Health. Reynolds pulled Camel Dissolvables and re- released them in a few markets last year with new packaging. They cost between $3 and $5 compared with an average price of $5.98 for a pack of cigarettes.
“If dissolvables were going to catch on, they would have already,” said Michael Lavery, a CLSA Credit Agricole Securities USA Inc. analyst. “It’s a tough proposition. This stuff is weird.”
E-cigarettes, electronic tubes that use nicotine and flavor cartridges, are an attempt to mimic the look and feel of traditional cigarettes without the smoke and ash. About 2.5 million people use e-cigs in the U.S., according to the Tobacco Vapor Electronic Cigarette Association, an industry group.
A blu Ecig “starter kit,” which includes a wall charger, two batteries and five flavor cartridges, sells for $80. Flavor cartridges, including Pina Colada and Classic Tobacco, run about $12 for a five-pack. The rechargeable devices feature a glowing blue tip.
At a conference in May, Lorillard Chief Executive Officer Murray Kessler justified acquiring Blu Ecigs by saying such products will generate $1 billion in annual sales in the next few years. The niche now generates about $300 million, he said.
Eric McCone, a 29-year-old radiology technician from Columbia, Maryland, has tried electronic cigarettes a few times.
“The electronic cigarette is better than products like nicotine inhalers,” McCone said. “But it’s no replacement for a real one.”
More promising are products that mimic chewing tobacco, which is already widely used in the U.S., according to Tom Russo, who manages more than $4 billion, including shares of Altria, for Gardner Russo & Gardner. Reynolds and Altria both sell snus, a variant of Swedish snuff, that comes in pouches and doesn’t require the user to spit.
Last year, Reynolds ran newspaper ads promoting Camel Snus Frost in New York to coincide with the city’s ban on smoking in outdoor public spaces. “Enjoy freedom without the flame,” the ads exhorted smokers. “Reclaim the world’s greatest city.”
Camel snus sales, which account for a penny per share of Reynolds’s earnings, grew by about 20 percent in 2011, according to Lavery.
“This is a very profitable category,” said Jack Russo, a St. Louis-based analyst for Edward Jones & Co. “Gross margins are higher than they are for cigarettes, and the companies are always happy to provide something like that.”
Though tobacco companies haven’t found the ideal cigarette alternative, they need to keep investing in these products to compensate for declining cigarette sales, Lavery said.
“Right now, there is a big size disparity between the cigarette and smokeless categories,” he said. Still, over the long haul, “the picture is changing.”
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