E-cigs and regulation – what do investment analysts think?

The investment analysts are always interesting on tobacco and e-cigs, and in a usefully dispassionate ‘follow-the-money’ kind of way.

Here’s a small collection of quotes I’ve seen in recent analyst reports mainly as they relate to regulation of e-cigarettes.  I don’t see all reports of course so this is necessarily selective. For ease of reference, I have highlighted some parts of quotes in red – these are my emphasis.  The bold emphasis is in the original.

BNP Paribas has set up its own e-cigarette operation to find out how it works.  It notes low barriers to entry that characterise the existing industry, which it sees as a threat to the tobacco industry, but sees medicines regulation  ending all that and putting most existing suppliers out of business and leaving the market to the tobacco industry (Sept 2013)

We have started our own e-cigarette brand. Convinced that e-cigarettes are a material threat to the Tobacco industry in part because barriers to entry are so low, we decided to test it ‘for real’ ourselves. Our brand is ‘Electric Dreams’, our initial market is the UK, our objective is discovery.

Barriers to Entry are extremely low. Procuring our own branded products from China to sell in the UK was both cheap and easy. Setting up a website, and acquiring the means to sell on-line, likewise. Marketing costs and retail distribution are the largest barriers, but to those with a little more capital these are more easily surmounted.

Regulation can change everything: Medical regulation of e-cigs could fundamentally change the category. We believe many current suppliers would struggle to meet medical standards, and for the UK they may have to by 2016. Big players with deeper pockets would survive and prices could rise – a hugely preferable outcome for Tobacco.

Euromonitor International: in an online article, tobacco industry analyst Shane MacGuill notes the dead hand of regulation on e-cigarette growth (and hence health impact)

A Sober View – the Trend to Medicalisation Threatens to Stifle E-cigarette Growth. Medicalisation risks dampening or reversing e-cigarette growth and therefore becoming a costly exercise in the art of pleasing no one.

Fitch the ratings agency: points out via Reuters on 11 October 2013 that more regulation will raise barriers to entry and favour the tobacco industry while limiting the impact of e-cigarettes on cigarette sales: 

Further regulation or demand for scientific studies could make it easier for the tobacco companies to bridge the gap – thanks to their deep pockets and experience of dealing with a highly regulated trading environment. Tougher regulation, as well as providing a relative advantage to their e-cigarette divisions, would result in higher prices for e-cigarettes – which could also benefit tobacco companies by limiting their attraction for smokers and slowing the decline in tobacco sales.

Goldman Sachs on the 8 October argues that the European Parliament vote argues against medicines regulation improves prospects for e-cigarettes.

“a win for the burgeoning e-cigarette market, these will not be broadly classified as medicines, which would have restricted sales“

Wells Fargo Securities is positive about e-cigs, but identifies key ingredients in future success – innovation, advertising and buzz.  The very things that are suppressed or rendered bland and unappealing by by regulation… (April 2013)

We remain very bullish on the vast potential of e-cigs given the rapid pace of innovation. [We believe] that the benefits of e-cigs are becoming increasingly apparent to consumers, helping to drive trial and repeat purchases aided by stepped-up advertising and a lot of internet “buzz”

Wells Fargo Securities is among the bulls on e-cigarettes growth and expects this to cannibalise the cigarette market (a fair proxy for positive health impact).

Disruptive Innovation, Increased Affordability, Perceived Lower Health Risk, and Convenience Driving E-Cig Trial and Accelerated Conversion – Our proprietary, interactive model predicts the potential volume that will be displaced from conventional cigs to e-cigs based on a number of factors over the next decade. Based on our analysis of the combined market in our interactive model, we have increased conviction that consumption of e-cigs could surpass consumption of conventional cigs within the next decade (by 2023).  

Wells Fargo Securities does not see all regulation as fatal to growth of the e-cigarette industry – it believes that American ‘deeming regulation’ (which it believe will be based on treating the e-cigarettes more like tobacco rather than a medicine) and modest risk-based taxation would not derail growth, though would create barriers to entry and consolidation (June 2013).

Deeming Regulation and Taxation of E-Cigs Likely – But This Shouldn’t Derail the L.T. Growth Trajectory of the Category – We’ve long believed the e-cig category will be regulated, possibly similar to the conventional cig category, and that e-cigs will likely be taxed, but in a way that better reflects the potential relative risk. Despite this, we still believe the long term growth trajectory of the category will be robust. Furthermore, regulation may actually be positive since it ultimately entrenches existing e-cig players as it increases barriers to entry.

Morgan Stanley sees innovation as the key to e-cigarette sector growth and believes this will threaten (= ‘headwind’ in analyst-speak) the cigarette industry (August 2013) – something they think is already happening [note: 50 basis points = 0.5%].

US cigarette category volumes are soft and e-cigs are the likely culprit. When we made this call in March we took some risk, whereas today it is conventional wisdom. We believe e-cig growth is reducing 2013 US cigarette consumption by about 50 basis points.

While surprised by category growth, we believe the ultimate scale of the US e-cigarette segment will hinge on further improvement in technology/taste. Importantly, E-cigs may present a real headwind to the existing US cigarette industry business model

Morgan Stanley reports BAT’s view that the costs of its investments (probably to approach pharma standard manufacturing for its MHRA licensed products) would mean it was loss-making.  This obviously has implication for e-cig companies that are not supported by the well-endowed balance sheets of tobacco companies and would find it hard to bear losses (Sept 2013).

…while BAT believes that the current products are “generation 1.0” and that there is room for improvement / growth, it does not believe the category will be significantly profitable over the next few years given the level of necessary upfront investment.

Citi sees regulation, notably through bans on vaping in public places, as making e-cigs less attractive and therefore will disrupt the development of this market for quitting or cutting down;

E-Cigs: Can the Category Move Beyond the Early Adopter? We believe that indoor smoking restrictions on e-cigs could prove to be disruptive to consumer trial / retention, as the convenience and freedom of use of e-cigs is one of the key value propositions for smokers that opt to dual use or switch to e-cigs.

Citi pursues this theme, pointing out that indoor vaping bans will make it harder for smokers to make the switch to e-cigarettes and this will tend to slow the uptake of e-cigarettes (June 2013).

…several confounding obstacles for switchers that could meaningfully impact adoption rates
1. No more convenience factor. For consumers that are dual-using the product, the advantage of e-cigarettes as a substitute is eliminated by indoor smoking rules. 
2. Lower retention rates. For those users who are using e-cigarettes as a switching / quitting option, they will have a much harder time sticking with the technology, when they are forced to stand outside with analog cigarette smokers. There is nothing harder for a quitter (especially early days) than to be around smokers! 

In summary, a pretty clear pattern emerges from analyst reports.

• There is enormous potential for e-cigarettes (though there are bulls and bears on the eventual prospects) and this threatens to disrupt the tobacco industry, challenging incumbent market shares and creating opportunities and threats for the tobacco firms in an otherwise ‘mature’ industry;
• Regulation, especially medicines regulation, will potentially create high barriers to entry, diminish the appeal, reduce diversity and raise the costs of e-cigarettes;
• Heavy regulation will be benefit the tobacco industry by making it more likely and able to dominate the e-cig industry, by reducing competition and by making e-cigs less competitive relative to cigarettes.  The presence of the tobacco industry is inevitable and (in my view as well) desirable for growth of the category, but excessive regulation could reduce competition and create a narrow tobacco based oligopoly;
• Innovation is key to developing future generations of vapour products that create a satisfactory alternative to smoking with mass appeal – we are at the relatively early stages of the development of these products. The extent to which regulation supports or inhibits innovation is therefore critical to the development of e-cigs.
• Indoor vaping bans destroy one of the valuable selling point for e-cigarettes so will slow the rise of e-cigarettes and reduce switching, meaning more will smoke or relapse from vaping to smoking.

A final thought from me … we can’t just assume e-cigs will develop into a large and profitable market (as some appear to) challenging the dominance of the cigarette in nicotine delivery – look at NRT for example. It will depend to some extent on the costs and impact of regulation and how this affects the pace and nature of innovation, and what it does to the appeal of the products.  That suggests key to a pro-health e-cig market capable of challenging the dominance of cigarettes is:

• to keep regulatory burdens proportional to risk and to a minimum consistent with health, safety and consumer protection public policy objectives and mindful of unintended consequences of excessive regulation;
• to encourage innovation by allowing or encouraging frequent changes to products and responsiveness to revealed consumer preferences;
• to allow consumer-focussed advertising and creation of ‘buzz’ among adults;
• to make it easy and attractive to smokers to switch by not banning vaping in public places and by vapers and venue managers finding mutually respectful accommodation.

That is all counter-cultural for tobacco control and public health organisations, but it is integral to a credible harm reduction strategy – and what they should support if they want to reduce harm.

Disclaimer: investment analysts are not omniscient or always right. Not all reports are publicly available on the internet so there are some cases where there is no link provided to the original and therefore no context, disclaimers, disclosures and some discuss the US market only. So please take these limitations into account and don’t invest any money on the back of these quotes! Having said that, I think a general sense of how they see this emerges.

PS. if you are an analyst or otherwise involved and have access to other quotes or reports (or you think I’m misreading them) please get in touch – I am keen to access more of this sort of information if people are willing and able to share it.