Can heat-not-burn products continue to grow at their current pace?
By Stefanie Rossel
All those stunned by the phenomenal development of e-cigarettes in the past decade may soon find themselves at a loss of words to describe the growth of heat-not-burn (HnB) tobacco products. According to some analysts, these products have the potential to dwarf the vapor category. For the time being, it’s the other way around. British American Tobacco (BAT) put the number of vapers worldwide at 55 million in 2017, compared with about 4 million users of HnB products—but the HnB segment is believed to be growing at a rate of 180 percent annually.
“Forecasting growth of the heated-tobacco category is still very much more of an art than a science, but it is relatively clear that in terms of growth rate alone, the category will be much more dynamic than other vapor product categories,” says Shane MacGuill, head of tobacco research at market research provider Euromonitor International.
He cites several factors. For starters, the HnB segment is growing from a smaller base. Also, the unit price of heated tobacco is broadly much higher than that of other vapor product categories, meaning that every new user or additional unit of volume grows value more speedily. “Heated tobacco might appeal to consumers which e-cigarettes do not seem able to reach or retain,” says MacGuill.
In contrast to the vapor industry, the market for HnB products remains highly concentrated. Three years after Philip Morris International (PMI) launched iQOS, though, competition has begun to heat up. Next to PMI, BAT, which has entered the race with Glo, and Japan Tobacco International (JTI), which markets Ploom Tech, are investing heavily to build scale. In November 2017, South Korea’s KT&G joined the multinationals in the category with the launch of Lil. Imperial Brands, too, may introduce a heated-tobacco product, according to analysts, despite that company’s initial skepticism about the segment.
The next generation of next-generation products (NGPs) is already underway. PMI and BAT are both expected to launch carbon-tip HnB products—called Teeps and Neo Core, respectively—this year. And, inevitably, copycats are trying to cash in on the success of the market leaders. There is at least one alternative heating device available that will fit iQOS consumables, wrote Jonathan Leinster, an analyst at Berenberg Bank.
Contrary to previous attempts at marketing heated-tobacco products—think of the hapless Accord and Premier—current efforts appear to be paying off. In terms of profitability, iQOS remains ahead of schedule. The product is expected to break even on a dollar basis in the second quarter of 2018, according to Wells Fargo Securities analyst Bonnie Herzog. At its recent investor day, BAT again increased its estimate for the size of the NGP segment. The company expects the heated-tobacco segment to account for 73 percent of its total NGP sales growth over the next five years, Leinster noted.
Big in Japan
In a recent webinar by Euromonitor on emerging and next-generation nicotine products, MacGuill, too, predicted a bright future for the category. He estimated that, by 2021, the top 10 HnB markets, led by Japan, the U.S. and Turkey, would together be worth $15 billion. Of the overall tobacco alternatives markets, he predicted, the segment would then constitute 45 percent, up from 17 percent in 2016.
By 2021, HnB products are expected to account for an estimated 22 percent of Japan’s conventional cigarette market, in which iQOS alone in October 2017 already held 13.3 percent, up from 11.9 percent in the third quarter of 2017, according to Euromonitor. In terms of market penetration, Japan is expected to continue to lead the global HnB segment by a significant margin.
Japan, of course, is special, not only because of its consumers’ famous appetite for new technologies but also because of its business environment. Due to a ban on vapor devices, there is little competition from other alternative products. Manufacturers in Japan can communicate with consumers comparatively freely, and its tobacco culture remains strong despite growing restrictions. Disposable incomes are high, and, at least for the time being, HnB products enjoy favorable tax treatment.
Decisive year ahead
For Leinster, the next year will be critical for NGPs. “We expect a firm indication in 2018 as to whether the heated-tobacco segment will have a significant presence outside of Japan or South Korea,” he said. Korea currently is the largest HnB market after Japan, with iQOS already accounting for 4.5 percent of domestic combustible cigarette sales. The performance of new products, such as BAT’s Raptor, the nationwide rollout of Ploom Tech in Japan and the national launch of Lil in South Korea, should provide useful indications about the future of the NGPs.
The industry will also be closely watching the outcome of PMI’s modified-risk tobacco product (MRTP) application for iQOS in the U.S., which the company submitted in December 2016. While the Food and Drug Administration is still reviewing the proposal and a determination isn’t expected until the first quarter of 2018, the company’s U.S. branch is said to already be preparing iQOS’ rollout. “If PMI were to be successful, this would be hugely supportive to the category globally,” says MacGuill.
Much of the HnB segment’s future success will depend on taxation. In Germany, for example, the consumables of cigarette-like HnB products, such as iQOS and Glo, are currently taxed as pipe tobacco, since they cannot be smoked directly. That means manufacturers benefit from a considerably lower excise rate—only a quarter of that for combustible cigarettes—and from the lower volume of tobacco needed in the consumables, which are about half the size of a combustible cigarette. As a result, selling HnB products is a lucrative business in Germany. A pack of 20 Heets (the iQOS consumables) retails at €6 ($7.13) in Germany, which corresponds to the price of 20 traditional cigarettes. Speaking to The Wall Street Journal, Michael Lavery, an analyst with Piper Jaffray, estimated iQOS profit margins to be between 30 percent and 50 percent higher than those on regular cigarettes.
Other factors affecting the HnB category include pricing, consumer preferences, regulation and shareholder value. “Many of these factors are bivalent and could work for, or against, the category,” says MacGuill. If regulatory and fiscal authorities recognize that the new products present lower health risks than do traditional cigarettes, he says, this would obviously drive growth.
“Conversely, something close to tax parity between HnB and combustible cigarettes could remove room for maneuver for the industry in future years,” says MacGuill. “With respect to shareholder value, I think the accepted wisdom is that this will slow migration on the part of the companies over to HnB. I think this is true to a point, but it’s hard not to suggest that the emergence of iQOS is supporting PMI’s value currently, and then in the future we may see more and more recognition of the commercial logic in moving to reduced-risk categories and commensurate pressure on companies to do so.”
MacGuill assumes that HnB regulation will differ from that applied to vapor products because of the product’s symbolic content: tobacco. But the impact, he adds, won’t be uniform. “In some countries, the ‘symbolic’ presence of tobacco will lead to prejudice against the category. However, in others it may mean that heated-tobacco products are allowed where e-cigarette products are not, as with Japan currently,” he says. “The key impact will be in increasing the burden of persuasion and evidence building regarding the quantum of reduced risk—this is why the MRTP application could be so important. My sense is that the reduction of risk of liquid nicotine may intuitively be easier to metabolize for regulators and the public simply because ‘it looks different,’ whereas tobacco is assumed a priori to be harmful.”
Technology will also play a major role. “The more open the regulatory environment for HnB—and vapor products as a whole—is, the more incentive there is for innovation in important technical areas,” says MacGuill. “Big technical breakthroughs on vaporization, battery life or size could drive the appeal of HnB—or, conversely, increase the appeal of a competitor e-cigarette product type.”
The impact of next-generation consumers on the future growth of HnB products is still unclear. Members of the currently adolescent Generation Z—the successors to the millennials—are characterized by extreme health consciousness. MacGuill believes that’s a double-edged sword. “A real worry for the industry, I think, is that negative attitudes [among] Generation Z, and those coming beyond, to tobacco use—of any kind—harden so quickly that with or without risk reduction there is little ongoing demand for its products into the mid or longer term. However, if it can persuasively develop reduced-risk products [that] are thoughtfully designed and offer real value to the consumer, then health-consciousness can collide with other emergent consumer behaviors to offer the industry an opportunity.”
While HnB products are increasingly successful in industrial nations, conquering lower-income countries might be more difficult because HnB devices are costly compared to combustible cigarettes. A possible scenario for these markets could be the emergence of a broad spectrum of HnB products, ranging from budget, me-too products to premium devices, such as iQOS—a development similar to that seen in the smartphone market.
MacGuill believes that consumers in low-income markets will be just as interested in reduced-risk products as their compatriots in richer countries. “There will be a demand for similar types of product within what is economically reasonable,” he says. Already, Chinese manufacturers are offering products that allow users to heat traditional cigarettes with the goal to reduce risk.
In the short term, these might be a solution in lower-income countries, as they would facilitate risk reduction while allowing consumers to continue to purchase more “cost-effective” traditional products, says MacGuill.
“In many lower-income countries, snus or other forms of smokeless tobacco could also be a competitor for heated tobacco.”
Can heat-not-burn products continue to grow at their current pace?