Altria (NYSE:MO) has had a tough year so far as declining cigarette consumption in the U.S. has accelerated recently on growing adoption of e-cigarettes. The company’s shipment volume declined 6% y-o-y for the first half of this year. As a result, Altria announced its entry into the emerging category this year. It launched MarkTen e-cigarette into a lead market through one of its subsidiaries, NuMark. We believe this is a positive move and reflects the management’s focus on sustainable long-term value creation for its shareholders amid a rapidly declining market for cigarettes. Here we take a look at Altria’s opportunity in the e-cigarettes market. 
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An electronic cigarette is essentially an electronic inhaler, which has three main components: a cartridge, which contains the nicotine solution and also forms the mouthpiece; an atomizer, which converts the liquid into vapor when activated; and a battery, which powers the atomizer. They are similar to traditional cigarettes in form but work differently.
In traditional cigarettes, nicotine raises the level of nervous activity in the body, which is the main factor responsible for the addictive properties of tobacco smoking. Nicotine is not regarded as a carcinogen but it’s primarily tar, smoke particles and other chemicals present in the smoke of traditional cigarettes that cause health problems to smokers.
E-cigarettes still contain nicotine, but they are considered substantially less harmful since the vapor produced has not been proven to contain carcinogens in harmful concentrations. E-cigarettes are currently not subject to the kind of regulations and restrictions imposed on traditional cigarettes, and are therefore seen as potential long-term replacement for traditional cigarettes. However, there are multiple studies going on to determine the health impact of nicotine vapor and the FDA has already stated its intentions to regulate e-cigarettes.
$5 Billion Value
We believe that Altria can potentially add $5 billion in value by selling e-cigarettes. Most of the value is expected to come from the fast growing market for e-cigarettes, and the company’s expertise in building brands and handling tobacco litigations. We expect the e-cigarettes category to grow quickly off of a small base on increasing awareness and penetration as well as expanding retail distribution. Harmful health effects and high excise taxes on traditional cigarettes are increasingly driving consumers towards the niche category. Moreover, e-cigarettes also provide consumers with a cheaper way to satisfy their nicotine addiction, which is also fueling growth in this category. At $500 million in 2012, the market for these vapor devices is expected to double to $1 billion in 2013.
We expect the volume of traditional cigarettes sold in the U.S. to decline at ~4% CAGR in the long run on growing alternatives and rising excise taxes. To approximate the size of the e-cigarette market, we estimate that 75% of the decline in traditional cigarette volume gets converted into e-cigarette consumption in the long run and that one e-cigarette is equivalent to 15 traditional ones. With this, the consumption of e-cigarettes in the U.S. could reach 3.2 billion units by 2020. At an assumed average price of $3 per unit, inclusive of charger and battery prices, this will be equivalent to a roughly $10 billion market opportunity by 2020.
Although Altria has yet to launch its first e-cigarette brand nationwide, we expect the company to slowly grow its market share to ~10% in the long run on high marketing and brand building capabilities. The company has done it before with Marlboro, which holds more than 40% of the traditional cigarette market, and can potentially do it again. 
Cash EBITDA margins are also expected to grow to the company-wide average in the long run on increasing capacity and reducing marginal costs. Indirect cash expenses, which include capital expenditures, taxes and change in net working capital, average at around 35% of cash EBITDA for Altria, according to our current model. We expect these indirect cash expenses to also tend to the company-wide average in the long run. Based on all these assumptions including weighted average cost of capital (WACC) of 7% and a terminal growth rate of 3%, we believe that Altria has an ~$5 billion opportunity in the e-cigarettes market.
Source: Trefis Estimates
Caveats To Our Assumptions
Regulation: The FDA has had its eyes on e-cigarettes, and there might be some regulations in the future that can materially impact some of our assumptions.
Conversion: We expect 75% of the consumption to shift from traditional to e-cigarettes in the long run. The actual conversion rate might vary based on several factors including relative pricing, regulation and penetration of e-cigarettes.
Market Share: Altria’s Marlboro grew strongly in the traditional cigarette space since its launch in 1964 and holds more than 40% of the market today. However, the company might not be able to repeat the same success in the e-cigarettes category.
Acquisition: Altria has seen growth in categories like cigars and smokeless tobacco primarily through acquisitions. Therefore, a potential deal by the company in the emerging category cannot be completely ruled out.
We currently have $39 price estimate for Altria, which implies ~15% upside to the stock from its market price.Notes: