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E-Cigarettes, Vapor & E-Cigars EPPS
Vapor, Smoke and Mirrors Key Trends Facing the Industry
February 11, 2015 12:20 – 1:00 PM Bonnie Herzog, Senior Analyst Managing Director Tobacco, Beverage & Convenience Store Research Wells Fargo Securities, LLC 212-214-5051 [email protected]
All estimates/forecasts are as of 2/6/15 unless otherwise stated.
Please see page 39 for rating definitions, important disclosures and required analyst
certifications and to view price charts.
Wells Fargo Securities, LLC does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of the report and investors should consider this report as only a single factor in making their investment decision.
Wells Fargo Securities, LLC 2
Discussion Topics
Total Tobacco Industry Consumption and Distribution Trends
Reynolds’ Acquisition of Lorillard – Value Creating Transaction
Should Be a Favorable Cig Pricing Environment in 2015
Vapor Consumption Could Surpass Combustible Cigs in 10 Years…
…But Near Term, Vapor & E-Cig Growth is Decelerating
Vapors/Tanks/Mods – Key Trend to Watch in Our View
Vape Shops Popping Up All Over
Retailers Divided on Best Way to Merchandise Vapor Category – “Tobacco Talk” Survey Takeaways
Who Will Win the Vapor War?
FDA Regulation Continues to be a Hot Topic
What Is On The Top of Retailers’ Minds?
Wells Fargo Securities, LLC
Tobacco Industry Volume Outlook
Total cigarette volume declining around 3-4% per year – but still
$80 billion in U.S. retail sales.
Premium Brands’ share is declining – now ~70% of total industry volume, down from 91% in 1984.
“Other” tobacco product (OTP) category and e-cigs – provide growth opportunity in our view, though smokeless tobacco growth is slowing.
3
600
700
800
900
1,000
1,100
1,200
1,300
1,400
1,500
1,600
1,700
1,800
1,900
2,000
'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14E
Mil
lio
ns
of
ca
ns
Total Smokeless Volume
CAGR '96-'14E = 4.4%CAGR '08-'14E = 5.5%
-
50
100
150
200
250
300
350
400
450
500
'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14E
Bill
ions o
f S
ticks
Total Tobacco Volume: Premium and Discount
Premium Discount
CAGR '96-'14E = -4.1%CAGR '08-'14E = -5.9%
Source for both graphs: Company data and Wells Fargo Securities, LLC estimates
Wells Fargo Securities, LLC
Source for graphs: Company data and Wells Fargo Securities, LLC estimates
Vapor Revolutionizing Tobacco Industry
4
Vapor Consumption (e-cigs and vapors/tanks/mods or VTMs) could surpass combustible cigs in 10 years
The combined profit pool could grow at a CAGR of 6.6% over the next decade
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E
Eq
uiv
ale
nt
Pa
ck V
olu
me
(in
bil
lio
ns)
E-Cigarettes (in equivalent packs) Combustible Cigarettes (in packs)
2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
Op
era
tin
g P
rofi
t P
oo
l (i
n $
bil
lio
ns)
E-Cigarettes Combustible Cigarettes
Wells Fargo Securities, LLC
Convenience, 65%
Tobacco Shops, 15%
Grocery, 10%
Drug Stores, 5%
Mass & Other, 5%
5
Distribution Channels – Convenience Still Winning
Convenience continues to take tobacco share from other channels
Dollar stores have entered category (Family Dollar and Dollar General)
Leading drug store CVS has stopped selling tobacco products – c-stores
experiencing halo effect on tobacco sales
Vape Shops – a trend to monitor
Retailer Comment – “Dollar Stores will
show continued growth and will be stealing share from
entrenched retailers.” Retailer Comment – “Some pressure from Vape shops
on our e-cig business. However, helping to grow
the product and awareness.”
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
Wells Fargo Securities, LLC
RAI/LO Combination: Value Creating Transaction for LT Shareholders
Reynolds is divesting its Kool, Winston, and Salem brands to Imperial – as well as the blu
e-cig brand - Marty Orlowsky (former Lorillard CEO) is to oversee Imperial’s U.S.
Operations.
Reynolds formalized its strategic partnership with BAT
Probability of BAT acquiring Reynolds now higher in our view (Reynolds has not weighed
in on this)
Vast majority (98%) of retailers believe deal will get approved, albeit with additional
brand divestitures, though market is pricing in only ~65% probability as shown below:
RAI-LO transaction may spark further industry consolidation with
e-cigs/vapor as the catalyst
6
Source: Wells Fargo Securities, LLC estimates
45%52%
58% 58%50% 49%
42% 38% 39% 38% 41% 41% 41% 41% 40% 40% 37% 37%42%
52%47%
53% 50%55% 57% 57% 61% 62% 62% 65%
0%10%20%30%40%50%60%70%
Market Implied Probability of RAI-LO Deal Being Approved
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
RAI/LO Combination: What Does It Mean for Retailers?
Retailers see both pros & cons to RAI-LO combination
Stronger competitor to Altria welcomed
Lower cig margins remain a concern
Vapor expected to flourish - Lower vapor margins from Big 3 remain a concern
Majority of retailers believe no impact to pricing
Impact on retailer gross margin – majority believe retailer gross margins on cigarettes would go down
Retailers generally positive on RAI-LO Combination’s impact on overall vapor category - Many believe this would create higher barriers to entry for smaller brands
BOTTOM LINE:
RAI-LO combination both positive & negative in our opinion – competition should be lower, but Altria could be better kept “in check” and retailers would have one less rep and complexity to deal with
7
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Expect Robust Cigarette Net Price Realization in 2015
Large stockpiles of cash getting larger
Pricing not as critical to drive top line
Manufacturers Realize 2.5x More Earnings Leverage on a Point of Pricing vs. a Point of Volume
Source for graphs: Company data and Wells Fargo Securities, LLC estimates
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
Cigarette Net Price Realization 1997-2015E
Altria Group Reynolds American Lorillard Average
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
2009 2010 2011 2012 2013 2014E 2015E
Cigarette Net Price Realization 2009-2015E
Altria Group Reynolds American Lorillard Long-Term Average
We expect strong cigarette net pricing over the next few years – close to the long-term average of ~6%.
8
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Price Increases Helping Manufacturers More Than Retailers
“Tobacco Talk” survey respondents said price increases do not have much of a positive impact on retailer gross profit margins
Cigarette gross profit margins continue to decline for retailers
Environment expected to remain challenging
Retailer Comment –
“Slight increase for the
retailer but most of the
money is going to the
manufacturer.” Retailer Comment – “Given
small increase, volume
shouldn’t suffer so better
profit potential for
manufacturers.”
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
9
Retailer Penny Profit per pack on Combustible Cigs
$0.72
$0.52
$0.77
$0.68
$0.78 $0.73
$0.54
$0.78
$0.71
$0.76
$0.70
$0.54
$0.77
$0.61
$0.76
$0.00
$0.10
$0.20
$0.30
$0.40
$0.50
$0.60
$0.70
$0.80
$0.90
Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
Current Quarter Year-Ago Quarter Next Quarter
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
C-Store Vapor Growth Remains Robust (>20%) But Slightly Moderating
Vapor taking total tobacco share, currently ~4%,
Total e-cig/vapor retail size likely around $3.5b by end of 2015
Vapor is to tobacco what energy drinks are to beverages –
Profitable and quickly growing in volume and shelf space at retail
Increasingly gaining consumer acceptance
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
10
Overall Growth Trend of the Vapor Category
83.3%
7.1%9.5%
60.6%
15.2%
24.2%
58.1%
22.6%19.4%
65.4%
30.8%
3.8%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Accelerated Stayed the Same Decelerated
Q1 2014 Q2 2014 Q3 2014 Q4 2014
Overall Growth of the Vapor Category
23.1%
20.8%
17.4%
0%
5%
10%
15%
20%
25%
Q2 2014 Q3 2014 Q4 2014
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
2015 Vapor Market Size – $3.5B in the U.S.
Vapor consumption could surpass combustible cigs in 10 years
Source: Nielsen C-Store Database, Wells Fargo Securities, LLC estimates *Other Non-Tracked channels include tobacco-only outlets and other e-cig retail locations.
11
Expected 2015 Vapor Market Size – $3.5B
E-Cigarettes $1.5B
C-Store, Food, Drug and Mass Retail Channels
$700M
Online and Other Retail
Channels
$800M
Online $400M
Other $400M*
Vapors/Tanks/Mods & Personal Vaporizers
$2.0B
Online and Other
Retail
Channels
$400M
Vape Shops $1,200M
C-Store, Food, Drug and Mass
Retail Channels $400M
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
2015 Global Vapor Market Size – Exceeds $7B
Source: Wells Fargo Securities, LLC estimates and Tobacco Talk Surveys
12
According to our Independent Vapor Manufacturer Survey, the global market for vapor products expected by the end of 2015 is ~$7.3B
There are more than 19,000 vape shops globally – about half of which are in the U.S.
Va p e sho p s in the U.S. a nd Glo b a lly
8,459
19,409
0
5,000
10,000
15,000
20,000
25,000
Number of Vape Shops in the U.S. Number of Vape Shops Globally
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Vape Shops Impacting E-Cig Sales: Increasing Awareness and
Consumer Education
Vape shops opening up around the country
62% of retailers say they are impacting e-cig sales
15% expect a negative impact in the future.
Source for data and chart: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
13
Are "Vape Shops" Impacting E-cig Sales?
47.2%
33.3%
19.4%
41.9%34.9%
23.3%
45.5%
33.3%
21.2%
45.2%
38.7%
16.1%
61.5%
23.1%
15.4%
0%
10%
20%
30%
40%
50%
60%
70%
Yes - Negative Impact No impact No Impact Currently - ButExpect Negative Impact in
Future
Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Public Perception of the Vapor Category is Deteriorating
The % of people who believe vapor/e-cigs are just as harmful as combustible cigs doubled in 2014 vs. 2013 to 15%
However, category momentum continues and we expect ~40% growth in 2015
14
Source: Action on Smoking and Health, Wells Fargo Securities, LLC
7%
53%
39%
15%
54%
30%
0%
10%
20%
30%
40%
50%
60%
More/Just As Harmful AsCigarettes
Not Harmful or Less HarmfulThan Cigarettes
Don't Know
% o
f R
esp
on
den
ts
Public Perception of Safety of Vapor/E-Cigs Relative to Combustible Cigs
2013 2014
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Wake Up Call! Action Needed to Keep Vapor Momentum Alive
We’re Increasingly Concerned That Action is Needed For Vapor Momentum to Continue
“Tobacco Talk” Survey –Highlights Key Issues:
1) FDA must take leadership and act soon to improve consumers’ increasingly negative perception of the relative risks of vapor and uncertainty surrounding the category;
2) The industry must align, particularly to push for modified risk claims so that public perception doesn’t deteriorate further; and
3) Vape shops need to be regulated more closely as they are “playing by their own set of rules” potentially harming the industry’s reputation.
We Remain Bullish Long-Term
We still believe consumption of vapor and other non-combustibles (such as heat-not-burn) could surpass consumption of combustible cigs in the next decade (by 2023).
Technological innovation is crucial
Big Tobacco will be pivotal in shaping the non-combustible nicotine industry
15
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Vapors/Tanks/Mods (VTM): Not Your Father’s E-Cig Typical VTM user - former smoker, tried e-cigs, but quickly moved to
tank-style systems and eventually mods
Vaping substantially more affordable than combustible cigs and rechargeable e-cigs
“Open system” VTMs not emulating the razor/blade model since any juice can be used with any VTM –
LOGIC Pro and blu+ are “closed” system – hitting shelves over next few months
VTMs could be a threat OR potential opportunity for Big Tobacco
Source: Wells Fargo Securities, LLC estimates; pictures from Henleycigs.com.
16
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
VTMs Taking E-Cig Share - Growing 3x Faster Than Vapor Category
VTMs overwhelmingly taking e-cig share according to our “Tobacco Talk” surveys
VTM growth expected to continue in 2015
Average VTM consumer's weekly spend about 30% less than e-cig consumer’s weekly spend
VTMs provide: (1) greater consumer satisfaction; (2) an attractive “vaping lifestyle” factor; and (3) better affordability
Source for data and charts: Wells Fargo Securities, LLC estimates and Tobacco Talk Retailer Surveys
17
% growth in U.S. retail sales of the total e-vapor category
150.1%
187.1%
147.1%
57.3% 55.8%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
2012 2013 2014E 2015E
1Q14 1Q15
% growth in U.S. retail sales of JUST the vapors/tanks category
195.1%
282.7%298.4%
128.1%
161.2%
0%
50%
100%
150%
200%
250%
300%
350%
2012 2013 2014 2015E
1Q14 1Q15
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Mix Shift to VTMs Taking Place in the U.S. and Globally
Mix shift of E-Cigs to VTMs Is 45%/55% Currently in the U.S. – From 65%/35% A Year Ago
Global Mix of E-Cigs to VTMs is 50%/50%
Source for data and charts: Wells Fargo Securities, LLC estimates and Tobacco Talk Retailer Surveys
18
% mix o f to ta l U .S. re ta il sa le s - E-c ig s vs . VT Ms
65.0%
35.0%
45.0%
55.0%
0%
10%
20%
30%
40%
50%
60%
70%
E-Cigs and Accessories Vaporizers and Accessories
1Q14 1Q15
% mix o f to ta l Glo b a l re ta il sa le s - E-c ig s vs . VT Ms
49.6%
50.4%
40%
45%
50%
E-Cigs and E-Cig Accessories Vaporizers and VaporizerAccessories
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Do you currently carry E-Cig and/or Vapor-Tank-Mod (VTM) products?
100.0%
85.3%
100.0%
85.2%
100.0%96.3%
14.7% 11.1%
3.7%3.7%
0%
20%
40%
60%
80%
100%
120%
E-Cigs VTMs E-Cigs VTMs E-Cigs VTMs
Q2 2014 Q3 2014 Q4 2014
Yes - Currently Carry No - But Plan to Carry in Next 6 Months No - No Plans to Carry
VTM Traction at Retail Continues
Vast majority of retailers carry or plan to carry E-cigs & VTMs
Increasing prevalence of VTMs could be somewhat marginalizing the “cig-alike” e-cigs but, incrementally growing the overall “Vapor” category
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
Interestingly, nearly
everyone now plans to carry E-Cigs
& VTMs.
19
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
% Vapor Sales - Repeat Sales vs. Trial
40.5%
45.8%
56.8%
41.3%
59.2%
39.9%
0%
10%
20%
30%
40%
50%
60%
70%
Repeat Purchases Trial Purchases
Q2 2014 Q3 2014 Q4 2014
Vapor Repeat Purchases Surpass Trial Purchases
Nearly 60% of total vapor sales are repeat purchases
Significant dual use of cigs and e-cigs
Source: Wells Fargo Securities, LLC Tobacco Talk Surveys
Vapor Repeat Purchases Have Surpassed Trial Purchases
20
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Vapor Displacing >4% of Combustible Cig Volume
Dual Use (~19% of Vapor Consumers) Is More Prevalent Than Full Conversion (~8% of Vapor Consumers)
Conversion is HIGHER for VTM Consumers (8% vs. 7.4% for E-Cig Consumers) – Bodes well for Better Performing Products
Retailers Believe 4.3% of Combustible Cigarette Volume is Being Displaced by the Vapor Category – Speaks to Vapor’s Potential – Still Early Innings
Source for both charts: Wells Fargo Securities, LLC estimates Tobacco Talk Surveys
21
Combustible Cigarette Volume Displaced Into the Vapor Category
3.4%
3.8%
4.2% 4.3%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
Q1 2014 Q2 2014 Q3 2014 Q4 2014
% of Consumers Dual Using and Fully Converting to Vapor Products
14.3%
19.0%
26.9%
22.7%
7.4% 7.9%
18.7% 18.9%
0%
5%
10%
15%
20%
25%
30%
Full Conversion to E-Cigs?
Full Conversion toVTMs?
Dual Usage WithCombustible Cigs?
Dual Usage WithCombustible VTMs?
Q3 2014 Q4 2014
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
0
10
20
30
40
50
60
70
80
1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14E
Billio
ns
of
Cig
are
tte
s
Total Industry Cigarette Volume - Decline Rate ~-3.7%
Combustible Cig Volumes Not Declining As Much As Expected
One key reason is dual use remains high
According to Lorillard, 47% of adult smokers have tried e-cigs with 24% having used in the past 3 months and 15% in past 7 days
Source: Wells Fargo Securities, LLC estimates, company reports
22
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Revenue Mix of E-cigs vs. VTMs in 6 Months Revenue Mix of E-cigs vs. VTMs TODAY?
51.1%
48.9%
53.2%
46.8%
54.4%
45.6%
40%
42%
44%
46%
48%
50%
52%
54%
56%
E-Cigs and Accessories Vaporizers and Accessories
Q2 2014 Q3 2014 Q4 2014
69.4%
30.6%
67.0%
33.0%
65.0%
35.0%
0%
10%
20%
30%
40%
50%
60%
70%
80%
E-Cigs and Accessories Vaporizers and Accessories
Q2 2014 Q3 2014 Q4 2014
Vapors/Tanks Expected to Further Penetrate C-Stores in Next 6 Months
Revenue mix of E-cigs to VTM expected to be ~55/45% in 6 months
compared to ~65/35% today
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
VTM Mix Expected to be ~45% in
6 months
VTM Mix is 35% Today
23
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Change in Shelf Space Allocation Y/Y
0.7%
-1.1% -2.3%-5.4% -4.8%
3.1% 4.8%1.9% 2.9% 3.4%
-4.7%-2.5% -1.7% -1.3%
-1.4%-1.1%
-1.9%
-0.7% 2.0%
1.7%
31%
18%18%
32%
2%0.0%
30.3%
20.6%
31.9%
12.0%
34.3%
12.4%
-25%
0%
25%
50%
Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
Cigarettes Smokeless Snus Cigars E-Cigs VTMs (hardware only) E-liquids
Vapor Gaining Share and Shelf Space From Combustible Cigarettes
E-cigs and VTMs continue to take shelf space
E-cig growth driven by
Increased advertising spend
Greater visibility at retail
Do you believe e-cigarettes are taking share from traditional cigarettes?
67.6%
32.4%
82.0%
18.0%
74%
26%
92%
8%
0%
20%
40%
60%
80%
100%
Yes No
Q1 2013 Q2 2013 Q3 2013 Q4 2013
E-cigs increasingly
thought to be taking
combustible cig share.
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
Vapors Products Incl. E-Liquids Got +1.7-12.4%
More Shelf Space in 4Q14
24
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Vapor Trends at Retail Shifting to VTM from E-Cigs
Mixed feedback on VTM introductions from NJOY and FIN
However if retailers can look beyond the companies' recent e-cig trends,
their new VTM offerings show promise
Source for chart: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
25
Sequential Sales Growth of Key C-Store Vapor Brands
1.5%
6.3%
-7.2%
0.2%3.1%
-13.0%
8.6%
-0.9% -2.5%
-24.4%
-10.4%
41.2%
12.2%10.1%
6.4%4.2%
-13.6%
-25.1%-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Vuse LOGIC Mistic blu MarkTen NJOY FIN
Q1 2014 Q2 2014 Q3 2014 Q4 2014
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
E-Cigs 3x More Profitable to Retailers Than Combustible Cigs
E-cig margin trends vs. Combustible cigs improving for retailers
We expect retailers to continue to embrace vapor – cigarette gross
profit margins for retailers remain on downward trend
Independents offer higher margins than Big Tobacco
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
26
Retailer Penny Profit per pack on Combustible Cigs
$0.72
$0.52
$0.77
$0.68
$0.78 $0.73
$0.54
$0.78
$0.71
$0.76
$0.70
$0.54
$0.77
$0.61
$0.76
$0.00
$0.10
$0.20
$0.30
$0.40
$0.50
$0.60
$0.70
$0.80
$0.90
Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
Current Quarter Year-Ago Quarter Next Quarter
Actual or expected margins (in %) on the following brands
35.4%35.0%
28.0% 26.4%24.7% 25.9%
35.0%31.8% 32.2%
27.8% 28.1%26.3%
25.9%
37.1%
36.0%34.0% 34.0%
30.9%28.7%
26.2%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Haus(Mistic)
Logic FIN NJOY blu(Lorillard)
MarkTen(Altria)
Vuse(Reynolds)
Q2 2014 Q3 2014 Q4 2014
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
E-Cigarette Growth [Q/Q]
54.1%
27.0%
18.9%
50.0%
26.1%23.9%
48.0%
27.0%28.0%
41.9%
25.8%
32.3%
44.4%
18.5%
37.0%
0%
10%
20%
30%
40%
50%
60%
Accelerated Stayed the Same Decelerated
Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
E-Cig Growth Continues to Decelerate
C-stores Reign Supreme in E-Cig Distribution – Retailers Drawn to E-Cigs for Fat Margins and "Low Maintenance" Selling (No Controlling Contracts)
Technology Must Improve for E-Cigarette Growth to Re-Accelerate In Our View
E-Cig Volume Increasing Driven by Vuse and MarkTen - But $ Sales Not Growing as Fast Given Heavy Discounting
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
E-Cig growth is decelerating
27
Annual Growth of E-Cigarettes
19.2%
15.3%
12.0%
6.6%
4.8%
0%
5%
10%
15%
20%
25%
Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Annual Growth Estimated To Be ~10%
Category Growth in Measured Channels Decelerating
However, Category Growth Improved with National Rollouts from Reynolds & Philip Morris USA
Why?
1. The Need for the Next Step Function in Innovation
2. Emerging Vapors/Tanks/Mods Vapor Products Could be Marginalizing the “Cig-alike” E-Cigs but Incrementally Growing the Overall Vapor Category
Source: The Nielsen Company and Wells Fargo Securities, LLC.
28
-25%
-20%
-15%
-10%
-5%
0%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
80%
01/18/14 02/15/14 03/15/14 04/12/14 05/10/14 06/07/14 07/05/14 08/02/14 08/30/14 09/27/14 10/25/14 11/22/14 12/20/14 01/17/15
Pri
cin
g
Vo
lum
e
e-Cigarette Category Volume Vs Pricing Growth
Volume Growth Pricing Growth
E-Cig Growth Continues to Decelerate Per Nielsen Data
Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
0%
10%
20%
30%
40%
50%
60%
70%
Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15
Dolla
r S
ha
re
e-Cigs Category - C-Store and XAOC Combined, Dollar Share By Company
Lorillard Fin Branding Ballantyne DNA Green Smart Living
Njoy CB Distributors Vapor Corp Nicotek Logic
Reynolds American Altria VMR Products All Other
E-Cigarette Category - Dollar Share By Company
Source: The Nielsen Company and Wells Fargo Securities, LLC, last 12 months retail value tracked by Nielsen $551M
“Nationwide” e-cig launches by Altria and Reynolds have taken share from Lorillard
In the recent Nielsen period, Reynolds and Altria took 35% and 5% $ share in c-stores, respectively.
RAI gaining momentum
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Revenue Mix ($ Share) of Vapor Products (E-Cigs and VTM) IN 6 MONTHS
37.8%
10.0%6.0% 8.5%
3.8% 3.1%0.8%
3.7%
26.3%
23.0%
20.0%
5.9%
15.6%
1.4% 1.5% 1.1%2.6%
30.3%
22.1%24.8%
15.9%14.5%
12.3%
8.9% 8.0%
35.6%
0%
10%
20%
30%
40%
50%
blu Vuse Logic MarkTen NJOY Mistic/Haus FIN GS Vapors Others
Q2 2014 Q3 2014 Q4 2014
Revenue Mix ($ Share) of Vapor Products (E-Cigs and VTM) TODAY
48.6%
3.0%
8.1%
3.6% 1.7%
6.4%
1.0% 0.9%
26.7%
31.6%
16.8%
7.4%
11.5%
1.3%
4.7%1.3% 2.4%
23.3%27.7%
24.1%
15.6%
11.1%7.6% 6.0%
4.5%
36.1%
0%
10%
20%
30%
40%
50%
blu Vuse Logic MarkTenMistic/Haus NJOY FIN GS Vapors Others
Q2 2014 Q3 2014 Q4 2014
Lorillard’s blu Ceding Share as Vuse and MarkTen Go Nationwide
Lorillard’s blu has lost share – and expected to fall further as Vuse and
MarkTen expand nationwide
Reynolds and Altria are heavily utilizing coupons, other promos &
consumer engagement strategies to drive trial and awareness of Vuse
and MarkTen
Excited about VTMs blu+ and LOGIC Pro, coming out in next few months
Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys
Vuse and MarkTen expected to take 25% and 15% $ share in 6 months
Vuse and MarkTen currently have 24% and 11% $ share
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Quotes on VTMs From our Recent “Tobacco Talk” Surveys
“Tanks are growing faster than all other categories.”
“Looks like a growth segment we can't ignore.”
“Outpacing all traditional E-Cigs in sales....Higher margins and consumer satisfaction is amazing.”
“Be careful here!! These are likely ‘target one’ of regulation.”
“Looking forward to getting Vaporizers and e-liquids rolled out in test sites to see how they perform.”
“E-Cigs are slowing dramatically now that vapors have hit the streets.”
“As the consumer became more aware of the Vapor devices we are seeing sales move from E-Cigs to the Vapor side.”
“Vapor is what help us to accelerate sales.”
“The liquid vapors are coming on strong.”
Source : Wells Fargo Securities, LLC Tobacco Talk Surveys
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Retailers Divided on Best Way to Merchandise E-cigs
Retailers want a separate E-Cig section to merchandise effectively,
preferably near conventional cigarettes
Lack of counter space remains a challenge
Source : Wells Fargo Securities, LLC Tobacco Talk Surveys
Best Way to Merchandise E-cigarettes
Separate Category, 50%
With Cigarettes,
30%
On the Front Counter, 20%
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Who Will Win The Vapor War?
“Big Tobacco” presents a triple threat in our view – plentiful cash, strong distribution power, superior brand building capabilities
Plenty of room for several other players including: Logic, NJOY, Mistic, Fin, 21st Century and Krave
We expect growth of the combined profit pool for e-cigs & combustible cigs will increase 6.6% in the next decade in our view (above the 4-5% historical growth for cigs)
Big Tobacco incentivized to switch consumers to e-cigs given MSA payments tied only to combustible cigs
Big Tobacco may have no choice but to enter the vapor/tank category either organically or via acquisition. However, we see a few challenges:
1)distribution of vapors/tanks is primarily online and in vape shops, channels over which big tobacco has limited control (this would also be a challenge for c-store retailers)
2)limited branding and commoditization of vapors/tanks
3)potential compression of revenue pool given lower spend per consumer on vapors/tanks
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
FDA Deeming E-Cigs Regulation
Highlights Include:
Companies can keep existing products on the market and can bring
new products to market – this is key in our view since continued
innovation is critical to future growth;
No free samples;
No sale to anyone under age 18;
No health claims in advertising;
Must register ingredients with the FDA; and
Must have a warning label stating nicotine is addictive but this isn’t
required until 2 years after rule is finalized
Proposal Did NOT Include:
Restrictions of flavors (although this could be re-evaluated later);
A ban on internet sales to adults; and
A ban on t.v. advertising
Bottom line, e-cig/vapor regulations should ultimately increase the
barriers to entry. For now, regs don’t seem onerous for retailers which is
positive in our view.
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
E-Cigarette/Vapor Taxation: States Have Started to Pursue
Source for table: Wells Fargo Securities, LLC, National Association of Tobacco Outlets (NATO)
State Rate Status
North Carolina $0.05 per mL of nicotine liquid Passed
Minnesota 95% OTP Passed
Hawaii Actual wholesale cost Failed
Indiana 24% OTP Failed
Kentucky 15% and 20% OTP Failed
New Jersey 75% Sales Tax/$2.70 Failed
Oregon 81.25% OTP Failed
Rhode Island 80% OTP Failed
Vermont 92% OTP Failed
Washington 95% OTP Failed
Michigan $0.15 per 1.5 mL of nicotine liquid Pending
New York 75% OTP Pending
Ohio $1.85 Cigarette Tax Pending
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
What is on the Top of Retailers’ Minds?
Most Excited About:
Growth of vapor/tanks/mods
Altria and Reynolds’ national launches of MarkTen and Vuse
Moist tobacco rebounding
Increasing innovation across the board
Most Concerned About:
Taxes on the category
Profit erosion for retailers
Continued consumption decline for the tobacco category and how the c-store channel should think about merchandising
Manufacturers’ low commodity-style price points for e-cigs
FDA regulations that could ultimately stifle innovation once finalized
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
In Conclusion…
So we wonder:
Is this the beginning of the end of
combustible cigarettes?
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Disclosures LO Basis and Risks: Our valuation range of $69-71 implies a forward EV/EBITDA multiple of 10.4x and a forward P/E multiple of 16.4x, above historical averages, but in-line with RAI's acq. terms. Risks include unfavorable regulation and increased competition in cigarettes. RAI Basis and Risks: Our valuation range of $79-81 assumes an 11.8x forward EV/EBITDA multiple and an 18.4x forward P/E multiple, both above RAI's historical averages. Risks to our valuation include increased competitive pressure within the category and a pullback in consumer spending. MO Basis and Risks: Our valuation range of $59-61 is based on a 12.5x forward EV/EBITDA multiple and a 19.4x forward P/E multiple--both premiums to historical averages, which we believe are justified given MO's total tobacco strategy. Risks include increased price competition and increased downtrading by consumers.
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Disclosures Additional Information Available Upon Request I certify that: 1) All views expressed in this research report accurately reflect my personal views about any and all of the subject securities or issuers discussed; and 2) No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by me in this research report. Wells Fargo Securities, LLC maintains a market in the common stock of Altria Group, Inc., Reynolds American Inc. Wells Fargo Securities, LLC or its affiliates managed or comanaged a public offering of securities for Altria Group, Inc. within the past 12 months. Wells Fargo Securities, LLC or its affiliates intends to seek or expects to receive compensation for investment banking services in the next three months from Altria Group, Inc., Reynolds American Inc. Wells Fargo Securities, LLC or its affiliates received compensation for investment banking services from Altria Group, Inc. in the past 12 months. Altria Group, Inc. currently is, or during the 12-month period preceding the date of distribution of the research report was, a client of Wells Fargo Securities, LLC. Wells Fargo Securities, LLC provided investment banking services to Altria Group, Inc. Altria Group, Inc., Reynolds American Inc. currently is, or during the 12-month period preceding the date of distribution of the research report was, a client of Wells Fargo Securities, LLC. Wells Fargo Securities, LLC provided noninvestment banking securities-related services to Altria Group, Inc., Reynolds American Inc. Wells Fargo Securities, LLC received compensation for products or services other than investment banking services from Reynolds American Inc., Altria Group, Inc. in the past 12 months. Wells Fargo Securities, LLC or its affiliates has a significant financial interest in Altria Group, Inc., Lorillard, Inc., Reynolds American Inc. LO: Risks include unfavorable regulation and increased competition in cigarettes. MO: Risks include increased price competition and increased downtrading by consumers. RAI: Risks to our valuation include increased competitive pressure within the category and a pullback in consumer spending. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC’s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm, which includes, but is not limited to investment banking revenue. STOCK RATING 1=Outperform: The stock appears attractively valued, and we believe the stock's total return will exceed that of the market over the next 12 months. BUY 2=Market Perform: The stock appears appropriately valued, and we believe the stock's total return will be in line with the market over the next 12 months. HOLD 3=Underperform: The stock appears overvalued, and we believe the stock's total return will be below the market over the next 12 months. SELL SECTOR RATING O=Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months. M=Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months. U=Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months. VOLATILITY RATING V = A stock is defined as volatile if the stock price has fluctuated by +/-20% or greater in at least 8 of the past 24 months or if the analyst expects significant volatility. All IPO stocks are automatically rated volatile within the first 24 months of trading. As of: 2/6/2015 44% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Outperform. Wells Fargo Securities, LLC has provided investment banking services for 43% of its Equity Research Outperform-rated companies. 54% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Market Perform. Wells Fargo Securities, LLC has provided investment banking services for 29% of its Equity Research Market Perform-rated companies. 2% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Underperform. Wells Fargo Securities, LLC has provided investment banking services for 37% of its Equity Research Underperform-rated companies. Important Disclosure for International Clients
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Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors
Disclosures
EEA – The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited (“WFSIL”). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. For the purposes of Section 21 of the UK Financial Services and Markets Act 2000 (“the Act”), the content of this report has been approved by WFSIL a regulated person under the Act. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 2007. The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. 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