e-Cigarettes, a Business Case Study for our Times

What is the best business to be in?

I’ll define the question a bit more carefully. For the purposes of the question, I don’t mean fun or work-life balance or dinner party bragging rights or fame. I mean as a long-term investor or perhaps as a prospective long-term employee.

You might think of Apple or Google and answer something about technology. True, these companies have grown immensely in value and are still buoyed by huge potential consumer growth. But history tells us that such sectors are tough, because change is ever-present and new competitors are always at the gate. Blackberry would acknowledge that point.

A better answer is Oil and Gas. Exxon has been up there for generations among the leading market cap statistics and as a good employer.

I have another answer. True, you need to swallow a few scruples before working there. But hear me out. Think about tobacco. The competitive landscape is unchanged for years. Returns are predictable and strong, and even somewhat counter-cyclical. If you can accept the fact that you work for a group of serial killers, the benefits are pretty strong.

To understand why tobacco, and Oil and Gas for that matter, have been such strong industries, despite a paucity of growth, you can use one of my favourite business models, that of Porter’s five forces. The model analyses industries according to five forces determining resilience of performance. Internal industry competition lies in the middle, and the other four forces sit to the North, South, East and West.

The first force, to the North, is barriers to entry. Oil and Gas has huge barriers to entry, since to play you need monstrous amounts of capital or access to vast oil reserves. Not many new oil majors appear, and that benefits the incumbents. In IT, barriers to entry are generally limited, unless a player can build a massive scale advantage, for example Google in search. Tobacco has large marries to entry because of the regulatory requirements new players would need to satisfy to become licensed operators.

To the West is the power of customers, or more accurately players further down the supply chain. If customers are few and powerful, they will extract the value rather than you. Companies like Intel struggle to retain leadership mainly because their customers (people like Apple) exert such power. But Apple itself has a great market from this perspective. So does Exxon, except in downstream markets like France where intermediaries have taken the power. In tobacco, the intermediaries are a multitude of small shops and end consumers have even less potential to exert power. Perfect.

To the East are suppliers, or upstream supply chain players. One limiting factor for Exxon are the countries owning the resources. For Apple, rare metals can be a limiting factor. For tobacco, suppliers are plentiful and lacking power. Perfect again.

In the centre is internal competition. Here, growth potential can be a nuisance, because it can lead to lots of firms all competing for so called first mover advantage and little chance to grow margins. “Where there’s much, there’s brass” is a wonderful saying, because it is true that industries with less cachet or visibility often generate good returns. Tobacco fits this category, but there is an even bigger factor in its favour. Government duties make the product expensive, and a consequence is low price elasticity. Reducing the price by 1% to the consumer would not boost sales much, but would destroy margins, so players don’t compete much on price. In the rest of the marketing mix, they are pretty-well banned from competing, such are the restrictions on advertising, promotions, packaging and so on. When you hear tobacco executives bemoaning these restrictions, don’t believe a word of it, they love them, so long as the playing field in any market is level.

So far we have a perfect picture for the tobacco industry. The market is set to generate high margins even without collusion. Marketing budgets can be small, indeed mainly the PR involved in ensuring level playing fields for regulation, and trying to combat smuggling and illegal duty-free sales. Growth is slow, but there are always emerging markets and growth is not everything if capacity can be managed down. But now we come to the fifth box in the model.

Until now, substitutes were another win for big tobacco. Regulation defined the product tightly, so one cigarette became much like another. And the addictive qualities of the product meant that customers were very unwilling to substitute, even to things like nicotine patches. If a class had looked at the five forces and judged which of the five was the strongest fortress for big tobacco, they may well have chosen the southern corner of the model.

But then, a couple of years ago, came electronic cigarettes. Look out for them, you start to see them advertised and displayed more widely. They look like cigarettes, packaged more attractively. You smoke them like cigarettes, and they contain nicotine. But there is no ash, no lingering odour, and few carcinogens. Clever innovators had used chemistry to create a cigarette product that didn’t make you a social pariah or kill you.

To understand the brilliance of this, use another favourite model of mine, blue ocean strategy. In this one, attributes of a product or experience are listed down the side, and the various competitive offers ranked for each attribute. In most industries, everyone offers something similar. In big tobacco, the differences would be narrower than a tobacco paper. The innovator’s trick is to look for the unfilled area, the blue oceans.

For smoking, the attributes might be the shape of the object, how it is smoked, the addictive nicotine, the ash, the health “benefits”, the odour, the social aura (positive and negative), the price, distribution, promotion, packaging and so on.

The main blue ocean would be the health factor, followed by odour, without losing the nicotine. Why then, do smokers are generally not able to switch long term to nicotine patches? The answer has been the smoking act, the comfort of the repetitive hand to mouth action. It may seem strange if you are a non-smoker like myself, but I can relate to it. I am a terrible fidget, chewing biros and fingers and so on. No patch, no social shame, no admonishment from mothers past and present can stop me.

So the inventors have achieved the blue ocean without compromising the key attributes to maintain. Brilliant.

The next elements of this emerging case study are about what happens next. There is little consensus on how to regulate this new sector. All my regular publications have run articles about it, but there is little specificity about any recommendations.

It is a tough challenge. Is this new product a savior or a monster? On the plus side, it can save untold lives, now. Surely anything that can wean smokers from their peril must be a good thing? But will these new objects actually act as a Trojan horse? Perhaps they have their own toxicity, so far undiscovered? Worse, teenagers could become hooked on the newly available and affordable product and then graduate to the “real thing”. What to do?

There is more heat than light in the discussion. Some people, many of them ex-smokers, have developed such a hate for nicotine and cigarettes that they only see evil. The proponents, including shopkeepers eyeing a new income stream, no doubt exaggerate the benefits. And big tobacco itself has fearsome lobbying power, power they have a long track record of misusing. At the same time, all the major cigarette companies are scrambling to develop their own e-cigarette and/or buy out the current suppliers.

It is fascinating, and worth watching over the coming years. If I were a business school teacher, I would be storing up articles and developing an angle for my case study, for it has everything, including emotion. Five forces is a great explanatory model, but Porter would never have denied that change can still emerge, with the blue ocean model a fine way of seeking it. And the dismal modern science of regulation, so necessary but so imperfect and so spoiled by lobbyists and ignorance, has a wonderful new challenge to observe.

Finally, what other heavily regulated sectors, protected by the very regulation they purport to hate, could succumb to a blue ocean substitution? Drugs are an obvious potential case. What about alcohol? What about social things like abuse? Can we somehow tame abusers by giving them what they need without causing the destructive harm? Surely that is a more promising avenue than the current medieval practices of denial, condemnation and retribution.