Big Tobacco admits defeat, will develop e-cigarettes

November 22, 2013

A couple days ago, the tobacco giant Philip Morris International announced a decision it didn't think it would have to make: It was finally getting into the e-cigarette business, after pooh-poohing the product as recently as July. That is, it would start selling a product that directly competes with the tobacco-stuffed sticks it's always flacked, since nicotine vapor in cigarette form is seen as a decent substitute for the real thing for the 69 percent of American smokers trying to quit.

Why would the world's biggest tobacco company spend $100 million to accelerate the availability of a product that could destroy the business it's been in for 160 years?

The basic answer is, it's already happening. And self-disruption is big tobacco's best chance to survive, even in a different form, for much further down the road. There are three main reasons why.

1. Competitors are already making electronic cigarettes.

Many small companies already have e-cigs on the market, and a few of Philip Morris's competitors — Lorillard and Reynolds American — have either bought e-cig startups or are developing their own. They're still less than 1 percent of the overall market but growing fast, as Philip Morris illustrated at its investor presentation Wednesday:


The e-cigarette market opportunity. (PMI)

What's more, it could be growing faster. In its presentation, Philip Morris outlined e-cigarettes' limitations. "Given high awareness and distribution, lower prices, adult consumer understanding of potential reduced-risk benefits, lack of regulation and significant marketing freedoms, e-cigarette repeat purchases remain surprisingly low," read one slide. "Slower nicotine delivery profile and weak taste explain limited user satisfaction."

With a huge budget available for research, Philip Morris figures it's better positioned to develop a more appealing product than its less well-resourced competitors. That may also be why it's happy to see the Food and Drug Administration regulate e-cigarettes, while the independent producers oppose it; large companies are always better equipped to deal with government oversight than smaller ones.

2. The domestic cigarette market is already disappearing.

Philip Morris USA — the division that Altria kept after spinning off Philip Morris International in 2008 — also dragged its feet on introducing e-cigarettes. But it's facing a pretty cold reality: Fewer Americans are smoking than ever before, according to Gallup, and those who still do are smoking less. Cigarette companies have never diversified into other businesses, like PepsiCo and Coca Cola did with healthier snacks and drinks, because tobacco products have been so lucrative. But with their core product in such a structural, long-term decline, they have little choice.

Philip Morris USA dipped its toe in the e-cig market this summer.

(Gallup)
(Gallup)

3. Even the rest of the world might be slowing down.

Philip Morris International has been thought best positioned for the long term out of the big American tobacco companies, with nearly 30 percent market share in countries outside the United States and China — especially Southeast Asia, where about a third of adults smoke.

But those gigantic markets are also starting to slow down. Philip Morris expects cigarette volume in Russia to decline by as much as 11 percent in 2014, as President Vladimir Putin introduces restrictions. The Philippines slapped a high excise tax on cigarettes earlier this year, which led to a 40 percent drop in Philip Morris's sales in the country, according to the research firm Trefis. Australia recently introduced a plain packaging law that erases the brand loyalty advantage for iconic names like Marlboro and Virginia Slims. The World Health Organization is aggressively pushing restrictions on advertising around the world, which could help do to emerging markets what antismoking campaigns, taxes and surgeon general warnings did in the United States. And meanwhile, counterfeit and discount cigarette makers are stealing market share from Philip Morris's premium products, especially as it raises prices even higher.

Analysts have long loved Philip Morris because of its international exposure, strong name recognition, deep market penetration and the addictive nature of its products — it's a "cash-generating machine," as Morningstar put it. But that love has started to fade, with Goldman Sachs downgrading the stock to neutral in light of the international headwinds, and Nomura Securities rating it a sell because of slowing growth in Asia.

At the moment, e-cigarettes face none of those challenges, and could mitigate the erosion of big tobacco's traditional product. And hey — they're still really addictive.


Philip Morris International's assessment of market shrinkage. (PMI)

4. [UPDATE] It's also possible that people will smoke e-cigarettes in addition to regular ones. 

A reader writes in to point out that Philip Morris is hardly giving up on cigarette manufacturing, having put $200 million into its manufacturing facility in Richmond, Va. Studies on the efficacy of e-cigarettes as smoking cessation tools have been inconclusive; one recent study recently showed that people who tried e-cigarettes as a way to quit smoking were less successful than those who didn't, while another showed the opposite. And whether or not using e-cigarettes as a harm-reduction tool serves public health generally is a matter of considerable debate. But it's quite possible that, if carefully marketed, e-cigarettes could be used as supplements to the real thing, rather than always a substitute.

Lydia DePillis is a reporter focusing on labor, business, and housing. She previously worked at The New Republic and the Washington City Paper. She's from Seattle.
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