Altria Group’s Potential In The E-Cigarettes Market

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Although Altria entered the e-cigarettes market a little late, we believe the recent moves made by the company can help it add up to $4 per share to its total value. We had earlier estimated the value of Altria’s e-cigarettes business at $5 billion or $2.5 per share. (See Altria Could Add $ 5 Billion In Revenue By Selling E-Cigarettes). We believe that Altria can potentially add $8 billion in value by selling e-cigarettes. The increase of $3 billion is primarily on account of Altria’s improved market share outlook in the burgeoning category.

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The increase in value is expected to come from the fast growing market for e-cigarettes, and the company’s expertise in building brands and handling tobacco litigation. We expect the e-cigarettes category to grow quickly 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 alternate to satisfy their nicotine addiction, which is further fueling growth in this category. Wells Fargo analyst Bonnie Herzog estimates the e-cigarette market in the U.S. to likely hit $10 billion by 2017. ((New Estimate Doubles The Size Of US E-Cigarette Market)) Our estimate at Trefis is more conservative, as we expect the market to grow to only $8.4 billion by 2017.

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We also expect Altria’s share in the U.S. e-cigarettes market to go up to 15% by 2021. This is on account of the few moves it has made in this segment recently. In December 2013, Altria announced a cross-licensing agreement with Philip Morris International. This gives Altria exclusive rights to market Philip Morris’ heat-not-burn cigarettes in the U.S. During the first quarter of 2014, Altria also completed the acquisition of Green Smoke Inc.’s e-cigarette business. 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. Most recently, Altria also initiated the national rollout of the MarkTen e-cigarettes. MarkTen gained an ~48% share of the retail cartridge market in the test market of Arizona in just seven weeks of launch. (See Altria Set To Pose A Stiff Challenge To Existing E-cigarette Leaders)

Moving on to profitability, we expect Altria’s cash EBITDA margins on e-cigarettes 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 a ~$8 billion opportunity in the e-cigarettes market.

Caveats To Our Assumptions

Regulation: The FDA has proposed to extend the same regulations that apply for tobacco to e-cigarettes as well. This is expected to moderate the growth of the market. Big tobacco companies can be expected to extend their capabilities in dealing with regulation to outmaneuver their smaller competitors.

Conversion: We currently expect 75% of the consumers giving up traditional smokes to shift 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. The company’s e-cigarette brand MarkTen gained ~48% share of the retail cartridge market in Arizona in just seven weeks of lunch. Hence, we expect good performance from Altria in terms of market share in the e-cigarette segment as well. Market share gains could also be aided by cross licensing with Philip Morris International.

Acquisition: Altria has seen growth in categories like cigars and smokeless tobacco primarily through acquisitions. In early 2014, Altria completed the acquisition of Green Smoke Inc.’s e-cigarettes business for $110 million. Founded in 2008, Green Smoke sells e-cigarettes in the U.S. and Israel. This inorganic growth could contribute to a healthier short term performance of Altria group.

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