Big Tobacco Seeks Its Savior in Asia

 | Aug 01, 2017 | 9:00 AM EDT
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Will Asia save the cigarette? The industry will have to "electrify" for that to work.

Electronic cigarettes -- the devices that release vapor rather than smoke -- are catching on fast in pockets of Asia. Japan in particular is proving a key market; the world's third-largest economy is catching on to cigarette alternatives fast in a way that is already goosing the numbers of Philip Morris (PM) .

First-time visitors to Asia may be surprised by how many people smoke. Just about every adult male in Southeast Asia does, by my eyes. Developed East Asia isn't far behind.

Officially, Indonesia does in fact lead the world in smokers, according to the World Health Organization nation-by-nation data, with three out of every four adult men smoking. At least two-in-five men smoke basically throughout the rest of the region.

China alone is both the world's biggest producer and consumer of cigarettes. China (where 48% of men smoke) was also home to the first e-cigarette. And that's where the future lies.

Big Tobacco, though, doesn't have a stranglehold on the industry. Local brands of cigarette are popular, nation by nation, often because they're a lot cheaper and easier to find.

The development of e-cigarettes may change that -- the devices require a lot more technology behind them than rolling your own. Companies that capitalize on Asia as a market and succeed in rolling out electronic products can capture huge gains. 

Japan and its rapid adoption of electric-powered tobacco burners is already saving Philip Morris and its figures.

The company missed its forecasts when it reported earnings last month, thanks to plummeting demand for traditional cigarettes. Shipments of regular cigarettes fell more than 7% in the second quarter and 11.5% in the first, as the Financial Times explains

Cigarette volumes fell particularly precipitously in Japan, with 8.3 billion individual cigarettes sold in the second quarter, down a remarkable 25% compared with the same time last year.

But revenues rose 4%, with the sale of e-cigarettes making up the gap. Sales of "heated units" soared to 6.4 billion, up from 1.2 billion the same quarter last year. And the company sold more than five times as many of its Marlboro tobacco sticks, the tally of units for its burners rising to 5.7 billion, making up for the drop in individual cigarettes. 

The legalese makes tracking "cigarette alternatives" tricky. The term e-cigarette is often used interchangeably for two different types of device.

The "heated units" are devices that take actual tobacco in the form of sticks and heat it to the point where it emits a vapor, but does not burn. This in theory doesn't generate the harmful smoke that normal cigarettes produce.

"Vaping" involves devices that don't use tobacco at all. Instead, they vaporize a liquid that often contains nicotine, alongside propylene glycol and glycerin, into steam. Those are normally called e-cigarettes, although it's a bit of a misnomer -- vaping devices or vapes would be better terms. 

Legislation is, frankly, is all over the place on how to handle the new products. The liquid-based products are illegal in Japan, but the "heat and burn" devices are OK. In my hometown, Hong Kong, it is illegal to possess an e-device that contains nicotine, a crime punishable by up to two years in jail and a fine of HK$100,000 ($12,800), and there's a move to ban e-devices altogether.

The tobacco companies have also been all over the place on e-products, and have acted basically just like the big car companies with electronic vehicles.

There's a half-hearted approach to latch on to the new technology, with a test model or two that isn't marketed particularly well or widely. The companies hope that place-holder will do the job while they sell as many of their traditional products as possible. And there's plenty of lobbying behind the scenes to make sure the new-fangled devices encounter as many regulatory and tax hurdles as possible.

Philip Morris has taken the lead, however, among big tobacco makers. Both its U.K. and Japan heads say they want to stop selling cigarettes (eventually, of course).

"Our goal for Japan is to switch every consumer we have to this," Japan president Paul Riley told the Japan Times. "For me, it's like a no-brainer. The biggest thing is we know that smoking kills. If we've got an alternative to that, that's a pretty good reason to switch."

Its success in Japan with its iQos device means it is well on the way there, and it hopes to repeat the trick in South Korea. Half of men smoke in Korea (50% exactly), and in Japan, one in three men (34%) puff away.

Philip Morris has been aided in its advances in Japan by a slow-moving domestic behemoth. The Japanese government itself owns a 33.3% stake in Japan Tobacco (JAPAY) , making it by far the largest shareholder, so the government has historically been loath to bring in laws that would much affect sales.

Don't look to its stock to make a quick buck -- shareholders are looking at an 11.3% gain over the price a decade ago, at the close of 2007.

Japan Tobacco has let its rivals steal a head start on its own turf. It has been slow to introduce heat-and-burn products at home and has a small e-cigarette imprint overseas.

It has been doing its vaping through acquisition. It bought the British e-liquid brand E-Lites in 2014 and the U.S. maker Logic in 2015. It markets its products in Britain under the brand Logic LQD.

Of course, since it is the only alternative in its home market, the company is also in on the "heat, not burn" act. It bought the technology of the U.S. producer Ploom in 2015 and started selling devices and sticks under the Ploom Tech brand.

It only started rolling out Ploom Tech in Tokyo last month, via its own Ploom Shops and tobacco stores, after a pilot 2016 launch online and in the southern city of Fukuoka.

Investors should watch how that product rollout goes to gauge if "JT" really buys into the e-trend. If, like some of the big U.S. carmakers, it sees its electric machine as a placeholder, it's destined to fail.

The same applies equally to South Korea's tobacco giant, Korea Tobacco & Ginseng, better known as KT&G KR:033780.

In South Korea, vapor products tripled in popularity after the country increased the tax on normal cigarettes by 120%.

But there was a raft of bad publicity surrounding vaping products in 2016, according to the trade publication Tobacco Asia. The government has also said it believes vapor devices are at least as harmful as regular cigarettes. By contrast, in the U.K. the government said in 2015 that "the current best estimate is that e-cigarettes are round 95% less harmful than smoking."

Vaping sales have dropped off, and now "heets" as the heat sticks are known are catching on fast. Philip Morris introduced the iQoS in Korea this May. The government taxes heets at a lower level than regular cigarettes, and a pack of 20 sticks sells at around 5% cheaper than a pack of cigarettes.

Investors worry, correctly, that KT&G will lose its market share in Korea to e-cigarette makers. It trades at a discount to other tobacco producers. However, there's also a tax bill in the works which, if it comes into effect, would tax e-cigarettes at the same rate as cigarettes.

The investment bank Nomura is predicting that the discount on KT&G will narrow, with the prospect of higher e-cig taxes and only a 7% take-up in market share nationwide.

I wouldn't bet, though, on such a slow rate of adoption. What's more, hoping that regulation and legislation will prop up an ailing company isn't much of a long-term investment play.

KT&G, like the other tobacco companies looking to Asia as a market, would be better off getting on board.

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