Altria Group (NYSE:MO) is making fast moves in ramping up its presence in the growing e-cigarettes market. The company recently announced that it will start a national roll-out of its MarkTen e-cigarettes, which are currently limited to the test markets of Indiana and Arizona, in the second quarter of this year. Earlier this month, Altria acquired premium e-cigarette manufacturer Green Smoke for $110 million. This was after the company signed a cross-licensing agreement in December last year with Philip Morris International (NYSE:PM), the world’s largest cigarette manufacturer by revenues. Clearly, the company sees great potential in the emerging category and is trying to quickly establish a strong foothold in the market. 
Altria is one of the largest tobacco companies in the U.S. with over a 50% market share in cigarettes and smokeless tobacco products. Its brand portfolio includes well-known names such as Marlboro, Copenhagen, Skoal and Black & Mild. Cigarettes and smokeless tobacco products make up more than 75% of Altria’s total value, by our estimates.
Our $41 price estimate for Altria is about 15% above its current market price.
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National Launch Of MarkTen
The U.S. e-cigarette market has been growing strongly over the past few years. It is estimated to have tripled in size from around $500 million in 2012 to $1.5 billion in 2013. In comparison, total e-cigarette sales in the U.S. stood at just around $10 million in 2007.  We believe that largely unrestricted marketing, increased awareness and trials, as well as a growing retail distribution are some key factors driving growth in this category. According to Altria’s estimates, ~90% of adult smokers in the U.S. are now aware of e-cigarettes and around two-thirds of them have tried it. 
With a sharp rise in consumption, competition is also heating up in the industry. Almost all established tobacco companies are trying to gain a foothold in the emerging category, which is still largely controlled by small manufacturers. Other than Altria, Reynolds American (NYSE:RAI), the second largest tobacco company in the U.S., also plans to launch its Vuse e-cigarettes nationally this year, while Lorillard (NYSE:LO) already owns the top-selling e-cigarette brand in the country, Blu.
We believe that Altria has been relatively late in entering the e-cigarettes market. The company began selling its MarkTen e-cigarettes in test markets of Indiana and Arizona only in the second half of 2013. However, it plans to start rolling out the product nationally this year, as the test results have been promising so far. MarkTen gained ~48% share of the retail cartridge market in Arizona in just over seven weeks after introduction.  However, the market is still in its nascent stage, and FDA regulations and increased consolidation could potentially impact market dynamics significantly in the long run.
Acquisition Of Green Smoke
Earlier this month, Altria announced the acquisition of Green Smoke Inc.’s e-cigarettes business for $110 million. The transaction is expected to close during the second quarter of this year. Founded in 2008, Green Smoke sells e-cigarettes in the U.S. and Israel. In 2013, the company’s total e-cigarette sales stood at ~$40 million, which implies a market share of over 2.5%. It deals in rechargeable as well as disposable e-cigarettes sold under its namesake brand primarily through the online retail channel. However, its convenience store sales are expected to receive a boost from Altria’s established distribution network going forward. 
Green Smoke, being one of the premium e-cigarette brands in the U.S., fits well with Altria’s overall marketing strategy focused on premium brands. The tobacco giant’s portfolio includes brands such as Marlboro and Copenhagen that hold leading positions in their respective categories. The strategy is one of the key factors behind Altria’s strong financial performance over the past several years. This is because tobacco companies rely primarily on pricing for their growth, which is easier to implement with premium brands.
Another key aspect of Altria’s operating strategy is its focus on product diversification. The company’s leading position in the smokeless tobacco category has somewhat insulated it from consumers opting for chewing tobacco and snuff instead of cigarettes, as its Copenhagen and Skoal brands hold more than 50% share of the U.S. smokeless tobacco market. The company aims to work with a similar strategy in the e-cigarettes market. Unlike MarkTen, Green Smoke e-cigarettes are not meant to closely mimic traditional cigarettes in look and feel and have a bigger, stronger battery. Therefore, it is expected to complement Altria’s in-house developed offering and would help expand the company’s addressable consumer base.
In December last year, Altria entered into a strategic agreement with Philip Morris International involving cross licensing of their lower risk products to tap the fast-growing market. While Altria controls more than half of the U.S. cigarettes market, Philip Morris International, which was spun off from the former in 2008, leads the international market, excluding China.
According to the agreement, Altria would provide Philip Morris International an exclusive license to commercialize its e-cigarette brands internationally. On the other hand, Philip Morris International would provide Altria an exclusive license to commercialize two of its “reduced risk” products in the U.S. The two companies also agreed to work together on regulatory engagement related to heated tobacco products with the FDA and e-vapor products with international regulatory authorities.
In our view, the cross-licensing agreement improves Altria’s long-term growth prospects, as it will help the company’s e-cigarette brands gain recognition internationally while generating royalty income at the same time.Notes: