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Lorillard Leads E-Cigarettes in the US but Potential Collapse Looms

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Lorillard is dependent on menthol cigarette sales in the US market for its growth and its profits but apocalypse could be imminent in the shape of legislation extending the US flavour ban into menthol cigarettes. The company has acquired the leading US e-cigarette company in blu but sales of e-cigarettes, as yet, represent a very small percentage of cigarette sales. And, should menthol be banned in cigarettes, will menthol smokers give up, switch to non-menthol or take the illicit route?

According to Lorillard in its third quarter results, blu e-cigs, acquired in 2012,  accounted for 49% of the US e-cigarettes market in the third quarter compared with 44% over the 9 month period, with sales to end September 2013 of US$117 million. Meanwhile, the company’s cigarette volumes rose 3.5% in the third quarter due to Newport, second in the market to Marlboro, delivering 4.9% growth.  The company, which operates only in the US market (apart from some sales in Puerto Rico and other US Possessions) in cigarettes, has wider ambitions in e-cigs having acquired SkyCig in the UK in October 2013.

Lorillard is an unusually successful tobacco company, especially given that it is operating in a cigarette market in which volumes are relentlessly contracting. Companies, like the market leader, Altria, and Reynolds American, the second largest US tobacco company, have mitigated the effects of the fall in cigarette volumes by building smokeless tobacco sales but Lorillard is not involved in OTP and has maintained a focus on its brand Newport, which, in the third quarter, increased its share of the US cigarette market by 0.5% to a claimed 14.9%.  Meanwhile, sales in the third quarter, compared with the previous year, increased 10% to US$1.827 billion due to increases in net sales of cigarettes and electronic cigarettes of US$117 million and US$49 million, respectively. Net sales of cigarettes and electronic cigarettes in the first nine months of 2013 increased by US$134 million and US$155 million, respectively, highly impressive numbers from the nascent e-cigarette market, a market now probably worth some US$1.5 bn in the US.

Ongoing Success Story

Newport, the US’s favourite menthol brand, is an ongoing success story, increasing unit volumes 4.9% for the third quarter of 2013 compared to the corresponding period in 2012. Domestic wholesale shipments for Maverick, the company's leading discount brand, decreased 2.5% for the third quarter of 2013 compared to the third quarter of 2012. Gains in market share were primarily attributable to the continued strengthening of Newport Menthol and to the impact of Newport Smooth Select's introduction in the second quarter of 2013.

newport smooth select.jpg

Gross profit was US$654 million, or 37.1% of net sales, in the third quarter of 2013 and $598 million, or 36.3% of net sales, in the third quarter of 2012the increase reflecting higher average net cigarette selling prices and increased cigarette unit sales volume.

Blu Brand Building

Net sales for the e-cigarette business were $63 million and $177 million for the three and nine months ended September 30, 2013, respectively, compared to $14 million and $22 million for the three and nine months ended September 30, 2012, respectively. According to the company, the strong sales of blu e-cigs resulted from significant brand building activities including a national television advertising campaign, expansion of retail distribution into a total of over 127,000 retail outlets, the launch of new, lower priced rechargeable kits and strong repeat purchases.

BLU.jpgAccording to Lorillard, EXCEL which includes electronic cigarettes beginning in the fourth quarter of 2012, blu e-cigs domestic retail market share of the electronic cigarettes market reached approximately 49% for the third quarter 2013 and approximately 44% for the first nine months of 2013.

 Highly Profitable

Although the profit margin for e-cigs is lower than for conventional cigarettes, this is still a highly profitable product: gross profit was US$15 million, or 23.8% of net sales, and US$54 million, or 30.5% of sales, for the three and nine months ended September 30, 2013, respectively. The reason for the difference in profit margin over the two time periods was that the third quarter of 2013 was negatively impacted by the introduction of a new, lower priced rechargeable kit that began shipping to wholesale late in the second quarter.

With its home market threatened by legislation, Lorillard is looking to the global market in e-cigs and announced on October 1st, 2013 that it had acquired SKYCIG, a British-based e-cigarette business for some £30 million (US $49 million) in cash paid (and an additional £30 million to be paid in 2016 based on the achievement of ‘certain financial performance benchmarks’).

Menthol ban in prospect

The tobacco industry has operated for years on the edge of various legislative precipices but apocalypse would appear to be looming more closely for Lorillard. A few weeks ago, the European Parliament voted for a ban on menthol cigarettes, which will come into force in 2022. In 2009 the Food and Drug Administration was given the authority to regulate tobacco products and swiftly banned ‘candy’ flavourings thought to be attractive to children and teenagers. Kreteks – clove flavoured cigarettes, were also banned, much to the chagrin of Indonesia, but the FDA did not ban what was and is the most popular flavouring – menthol.

However the signs appear to point to this anomaly being removed: in July 2013 the FDA stated that it was ‘likely’ that menthol cigarettes posed a greater health risk than normal cigarettes, because they encourage young people to take up smoking. The FDA opened a public consultation on the issue which is due to conclude on November 22nd .

Seismic effect

A menthol ban would have a seismic effect, not only on Newport menthol and Lorillard but on the US tobacco market. Menthol accounts for around 30% of total cigarettes sold in the US, making it by far the largest market in the world for menthol cigarettes. In addition some 80% of Afro-American smokers favour menthol.  Furthermore, capsule cigarettes – generally menthol capsules - are one of the few growth sectors of the US and other cigarette markets

What will menthol smokers do should a ban come into force? The tobacco industry warns that many smokers will switch to illicit products. Early in 2012 Brazil (the sixth-largest menthol market in the world at the time) instituted a ban on cigarette flavouring which encompasses menthol. The problem with assessing the impact of the ban in Brazil is that the country already has the biggest illicit penetration of any major tobacco market.

What is certain is that a menthol ban in the US will be very bad news for Lorillard and a major test of loyalty to the second most popular cigarette brand in the US market. Another problem on the horizon for the company is the potential impact on the fast growing US e-cigarette market once the FDA, as seems likely, takes on the regulation of e-cigarettes, which could well involve a ban on the kind of marketing which has helped the market grow so quickly and enabled Lorillard to build the blu brand. And what about potential bans on the flavouring of e-cigarettes?  Problems do not come singly in the tobacco industry.

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