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Equity Research January 22, 2015 Equity Research "Tobacco Talk" -- Q4 U.S. Vapor Retailer Survey Wake Up Call! Action Needed To Keep Vapor Category Momentum Alive • Vapor Category Remains Promising Long Term But We’re Increasingly Concerned That Action is Needed For Momentum to Continue – We recently conducted a survey of our tobacco retailer and Tobacco wholesaler contacts representing about 20,000 U.S. c-stores. We observed a few “calls to action” from our retailer contacts pertaining to the vapor industry: (1) the FDA must take leadership and act soon to improve consumers’ 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 believe it’s imperative these factors are addressed promptly; if not, we’re concerned that vapor category growth could continue to moderate. Bottom line, we remain bullish long term and 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). We continue to believe that technological innovation is crucial and that Big Tobacco will be pivotal in shaping the non-combustible nicotine industry. • Vapor Category Growth Remains Strong at 17% but Continues to Moderate in C-Stores – Despite continued growth, the vapor category has not yet resulted in a deceleration of combustible cig volume. This has been very perplexing to us but we believe could be due to: (1) high prevalence of dual use; and (2) vapers consuming more (vapers tend to vape more since current vaping technology is a less efficient way to deliver nicotine and it’s easier to vape more places currently). Other key takeaways from our survey include: (1) Vapor category growth in c-stores remains robust (+17% in 4Q14) but decelerating relative to 3Q14’s 21% growth, likely driven by continued heavy promotions on both Vuse and MarkTen which is driving unit momentum but not necessarily accelerating $ sales; (2) Vapor continues to displace about 4% of combustible cig volume; (3) Repeat vapor purchases have accelerated to 60% in 4Q14, up from 57% in 3Q14; (4) E-cig sub category growth continues to decelerate--our contacts estimate about 5% growth in 4Q14--down from 7% last quarter and 19% in 4Q13; (5) blu continues to cede share to Vuse, LOGIC and MarkTen which is expected to continue given heightened activity (particularly on Vuse & MarkTen); and (6) Our retailer contacts are increasingly disenchanted with NJOY, noting issues with product returns and the company generally overpromising and under delivering. • Retailers Have Low Expectations on “Advanced” Devices Coming from NJOY, LOGIC, Mistic and Blu – Retailers seem somewhat underwhelmed by the larger devices that are meant to “bridge the gap” between “traditional” e-cigs and VTMs--such as those from NJOY, LOGIC (Pro), blu (+) and Mistic. Our contacts feel that about 75% of the sales of these products will cannibalize existing sales rather than generate incremental sales. A few retailers noted the higher price points could discourage consumers. One retailer noted, “at a time where Bonnie Herzog, Senior Analyst retail prices are falling on traditional e-cigs, the price point on advanced systems (212) 214-5051 will discourage sales.” However, others noted that the technology improvements [email protected] will benefit the category and are necessary. Bottom line – we remain Jessica Gerberi, CFA, Associate Analyst cautiously optimistic by new e-cig/vapor technological innovation. (212) 214-5029 [email protected] Adam Scott, Associate Analyst (212) 214-8064 Please see page 17 for rating definitions, important disclosures [email protected] and required analyst certifications All estimates/forecasts are as of 01/22/15 unless otherwise stated. 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 Tobacco EQUITY RESEARCH DEPARTMENT Key Takeaways from “Tobacco Talk” Survey We recently reached out to several of our industry trade contacts to get a sense of vapor category trends during 4Q14 including category growth and current brand dynamics. Below are some of the key takeaways from this survey including direct quotes from a number of tobacco retailer and wholesaler contacts, representing approximately 20,000 U.S. retail locations. Vapor Category – Vape ‘Em If You Got ‘Em – Robust Growth Continues but Moderates • Combustible Volume Being Displaced to Vapor Reaches 4.3% – Relatively Flat to Q3 – Repeat Vapor Sales Comprise Nearly 60% of Vapor Sales • Dual Use of Vapor Products (With Combustible Cigs) More Prevalent Than Full Conversion – More Conversion with VTMs • Public Perception Mixed With Regards to the Safety of the Vapor Category • RJR’s Vuse – Nearly 80% of Retailers Carry – Trial Strong – Driven in Part by Heavy Couponing – Though Retailers Note Vuse Has Helped Re-accelerate E-Cig Category Growth • Overall Response Lackluster to Altria’s MarkTen – 100% of Retailers Carry MarkTen – Sales Driven by Coupons and Free Product • Retailers Warming Up to VTMs – Nearly All Either Currently Carry VTMs or Plan to Soon – All Respondents Currently Carry E-Cigarettes • Vapor Category Growth Moderating in C-Stores – Though Annual Growth Still Estimated to be Quite Robust at 17% - Retailers Excited About New Vape Products – Vuse and MarkTen Accelerating Category Growth • “Maturing” E-cigarette Category (Subset of Total Vapor) Continues to Decelerate Despite Heavy Discounting/Couponing From New Entrants • New NJOY and Mistic Vaporizer Products – Feedback Mixed – Some Retailers Seem “Distrustful” of NJOY • “Advanced” E-Cig Offerings Such as blu+ and LOGIC Pro Could Cannibalize Existing Sales According to Most Retailers (76%) • Most Consumers Are “Somewhat Loyal” to Their Preferred Vapor/E-Cig Brand – But Loyalty Is Expected to Increase In Time • Sequential Sales Momentum Continues for Vuse, LOGIC, Mistic and blu – Challenges Mount for NJOY and FIN • E-Liquids Taking the Most Incremental Shelf Space (+12.4%), Followed by VTMs (+12% y/y), Smokeless (+3%), and Cigars (+2%) as Snus (-1%) and Cigarettes (-5%) Lose Incremental Shelf Space • Vape Shops Having Incrementally More Negative Impact on E-Cig Sales According to 62% of Retailers – Consumers Drawn to Vape Shops for A More Robust Assortment That C-Stores Cannot Support – Regulation Needed • As Vapor Category Becomes More Focused at Retail, Retailers Carrying Fewer SKUs – (30 E-Cig SKUs in Q4 – Flat to Q3) – Liquid SKUs Growing Slightly • Big 3 Vapor Margins Expected to be Below Mistic, LOGIC, FIN and NJOY – but Still in the Mid-20s/Low 30s vs. High Teens for Combustible Cigs • Average Penny Profit per bottle of E-Liquid is About 2.50 • Retailers Most Concerned About Vapor Manufacturers Not Taking Back Returns, Too Many SKUS and Traffic Displacement to Vape Shops • VTM Momentum Continues – E-Cig-VTM Mix Expected to be About 55/45 in 6 Months vs. Roughly 65/35 Today 2 WELLS FARGO SECURITIES, LLC "Tobacco Talk" -- Q4 U.S. Vapor Retailer Survey EQUITY RESEARCH DEPARTMENT • Blu & Vuse Represent >50% of Retailers’ Vapor Revenue - Expected to Moderate in 6 Months As LOGIC, MarkTen, NJOY, Mistic and FIN Gain Share • Could Take Longer For Vapor Margin Dollars to Surpass Combustible Cig Margin Dollars - 70% of Retailers Believe Gross Margin from Vapor Products Will Surpass Gross Margin Dollars from Combustibles After 2018 – 26% Believe Vapor Will Never Surpass Combustibles • Vapor Pricing Dynamics Expected to Remain Pressured in 2015 – Though Some Retailers Optimistic On Pricing Environment Due to Pulled Back Promos • Retailers’ Biggest Excitements/Concerns/Predictions – Retailers Remain Excited About Vapor’s Potential for Growth and Profitability, Technology Improvements – Concerns Continue Around Legislation, Regulation, Margin Compression Driven by Big Tobacco Combustible Volume Being Displaced to Vapor Reaches 4.3% – Relatively Flat to Q3 – Repeat Vapor Sales Comprise Nearly 60% of Vapor Sales % of Combustible Cigarette Volume Displaced into Vapor % of Vapor Sales As Repeat Sales Category 5.0% 70% 4.5% 4.3% 59.2% 4.2% 60% 56.8% 4.0% 3.8% 3.4% 50% 3.5% 45.8% 40.5% 41.3% 39.9% 3.0% 40% 2.5% 30% 2.0% 20% 1.5% 1.0% 10% 0.5% 0% 0.0% Repeat Purchases Trial Purchases Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q2 2014 Q3 2014 Q4 2014 Source: Wells Fargo Securities, LLC Dual Use of Vapor Products (With Combustible Cigs) More Prevalent Than Full Conversion – More Conversion with VTMs % of Consumers Displaying Full Conversion and Dual Use with Vapor Products 30% 26.9% 25% 22.7% 20% 18.7% 18.9% 15% 12.2% 10% 8.5% 7.4% 7.9% 5% 0% Full Conversion to E- Full Conversion to Dual Usage With Dual Usage With Cigs? VTMs? Combustible Cigs? Combustible VTMs? Q3 2014 Q4 2014 Source: Wells Fargo Securities, LLC 3 WELLS FARGO SECURITIES, LLC Tobacco EQUITY RESEARCH DEPARTMENT Public Perception Mixed With Regards to the Safety of the Vapor Category Public Perception of the Safety of the Vapor Category 45% 40.7% 40% 35% 33.3% 30% 25.9% 25% 20% 15% 10% 5% 0% Improving Deteriorating Staying About the Same Retailer Comments “New ads on TV sponsored by the state, saying all sorts of negative things about e-cigs, so that may change in the next few months.” “Very little concern about open systems.” “Public needs more awareness of vaping before regulations take hold and restrict use.” “Because of the relatively low numbers of people using e-cigarettes and VTM's, the general public does not realize some of the safety concerns.” “They are starting to get on peoples radar as a local problem.
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