Can British American Tobacco Beat Philip Morris in E-Cigs?

By Rich Duprey Markets Fool.com

It's not enough that British American Tobacco (NYSEMKT: BTI) is set on becoming the biggest tobacco company with its $50 billion acquisition of Reynolds American (NYSE: RAI), it also wants to steal away the leading global position in cigarette alternatives from rival Philip Morris (NYSE: PM).

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The cigarette giant has grand plans to quadruple the number of markets in which it sells electronic cigarettes by 2018, but competition is fierce and some analysts believe it needs to offer something better than what its rival already has on the market. Moreover, because Philip Morris is present in nearly as many markets as BAT aspires to target, it suggests that in two years time it will be even further ahead.

Image source: Getty Images.

Smoking still on the decline

British American reported a good fourth quarter with traditional, combustible cigarette volumes down significantly less than the industry as a whole. Last month it reported a negligible 0.2% increase in cigarette volumes to 665 billion in 2016, though on an organic basis it was down 0.8%. However, that was still better than the cigarette industry as a whole, which fell 3% last year.

It's the inexorable slide in cigarette usage that has been going on for years now that is leading British American, Philip Morris, Reynolds, and others to invest heavily in cigarette alternatives like e-cigs and vapor products. BAT notes it has invested more than $1 billion in building a completely new division focused solely on next-generation products.

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But it's not the only one that sees smoking alternatives as the future. Philip Morris has even gone so far as to predict a smoke-free future, and committed to investing $100 million last year on such alternatives in the belief it will add as much as $1.2 billion to its earnings by 2020. Indeed, the tobacco giant's iQOS heat-not-burn technology is now the industry leader and is what British American has its eyes set on overtaking.

How vaping differs

The two-part device consists of a miniature cigarette filled with real tobacco and a heating unit. The "cigarette" portion, which is being marketed with Altria (NYSE: MO) under its Marlboro brand as Heatsticks, is inserted into the heating element and is heated to the point where it produces a vapor, but not so hot that it burns the tobacco. The whole device is then removed and "smoked" like a combustible cigarette, and when finished, the HeatStick is discarded.

Image source: Philip Morris.

British American's competing iFuse glo is the next biggest HNB device coming to market. Functioning like the iQOS, BAT's tobacco-filled cigarette will be marketed under its Kent brand as NeoStiks. It has so far been encouraged by the reception the glo has received since being introduced in Japan a little over two months ago, where it reportedly has already gained a better than 5% share of the market. It will be rolled out nationwide there this year.

BAT says it is currently in 10 markets with its alternatives, and outside of the U.S., it actually has the biggest vapor business in the world of any manufacturer. In the U.K. it owns 40% of the market while in Poland it commands half. CEO Nicandro Durante has said, "The rate of growth is exponential. We're in 12 markets now, and I want to double this in 2017, and double it again in 2018."

Smoking alternatives are the future

While HNB products are seen as the future of e-cigs, British American Tobacco has a broad array of cigarette alternative products on the market and if its acquisition of Reynolds is consummated, it will have access to that company's entire portfolio as well.

Image source: British American Tobacco.

In a recent investor presentation BAT pointed to its Vype brand of Vapor products; its iFuse brand of hybrids, that rely upon e-liquids of or a combination of tobacco and e-liquids; and now its glo brand, which is a wholly real tobacco product. The importance of the latter group of products to BAT and other manufacturers is they remain in their wheelhouse of using tobacco as the primary product to deliver the taste consumers seek.

Yet there is some skepticism among analysts as to whether BAT can be successful in surpassing Philip Morris because they say theglois, at best, only as good as the iFuse, and if British American wants to beat it, it needs to be better. It also can't be ignored that Philip Morris is going for a "reduced risk" designation for the iFuse that could give it a substantial competitive advantage.

E-cigs and vapor products are generally seen as healthier alternatives to smoking because it is the burning of the tobacco that produces the vast bulk of toxic chemicals that make smoking so unhealthy. But e-cig manufacturers can't market their products as being safer unless they get FDA approval -- a long, expensive, and labyrinthine process that so far only Philip Morris is pursuing. Gaining that designation could crush all of the iFuse's competitors.

Still, with the amount of money both companies are pouring into R&D, it's likely neither iFuse or glo will be the last we hear about smoking alternative technologies. However, it may take British American Tobacco more than just quadrupling the number of countries in which it sells its electronic cigarettes to be the top dog in this industry.

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Rich Duprey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.