Big Tobacco's Big eCommerce Bet

In business theory, a disruptive innovation is an innovation that creates a new market and value network and eventually disrupts an existing market and value network, displacing established market-leading firms, products, and alliances. Triggered by rapid change in technology or consumer habits, disruption of incumbents is usually beneficial for consumers, as most often then not, they end up with either lower priced products and services or higher share of value and utility. For us as consumers, times of disruption are exciting to live in, interesting to read and even more to write about. For those that are getting disrupted, however, they are much less so.

Boring is beautiful and very profitable. Until it is not.

Disruption brings abrupt changes which often mean sudden ends and new beginnings, and even though none of us like sudden changes, financial markets and long term investors are those who are most made nervous by it. When you're trying to preserve and augment your wealth across long periods of time, it turns out that your best bet isn't gold or diamonds, but tobacco. Or better said tobacco industry stocks. One dollar invested in tobacco stocks in 1900 was worth $6.3 million by 2010. That's 165 times greater than the average industry! Even though you might think that America's most successful stock belongs to a high-tech company, or company that makes a revolutionary product, the industry that somehow changed the world or at least one that is doing something that no other company can do, you are wrong. America's most valuable stock belongs to a member of the tobacco industry, which for a century, basically didn't innovate at all. But they do sell cigarettes and own a brand like Marlboro. America's most valuable stock belongs to a member of the tobacco industry, which for a century, basically didn't innovate at all.

One dollar invested in Altria in 1968 was worth $6,638 in 2015 (including dividends). That's an annual return of 20.6% per year for nearly half a century. No other company comes close to matching its long-term results, according to Wharton professor Jeremy Siegel. It turns out that for preserving and augmenting value in the long term, in face of uncertainty, economic recessions, the tobacco stocks, are your best bet. They proved to be resilient in face of economic downturns, world order changes, even world wars. The ridiculously large gains from compound interest occur at long holding periods.

Tobacco industry basically didn't innovate for a century, simply because it didn't have to. But now that is changing.

The key to building wealth isn't necessarily high returns, but mediocre returns sustained for the longest period of time. In this case boring is beautiful and very profitable, because the companies that make & sell the same product today that they did 50 years ago, will likely be selling it 50 years from now. Tobacco industry basically didn't innovate for a century, simply because it didn't have to, but now that is about to change.

Winds of consumer expectations change fuelling disruption

Winds of consumers' expectation change have swept through many industries. Those who have successfully adapted to changing consumer demands prospered, those who don't risked becoming obsolete. Coca Cola Zero, McDonalds healthy meals and even Adidas record double digit growth in North America ride the same wave of consumers' healthier lifestyle demands. Consumers are increasingly demanding products and services which will be in line with healthy lifestyle choice and whose consumption will either completely remove or significantly reduce any potential negative health impact.

According to Clayton M. Christensen who first defined and analysed the term disruptive innovation, the incumbent firms are usually aware of the innovations, but their business environment does not allow them to pursue them when they first arise, because they are not profitable enough at first and because their development can take scarce resources away from that of sustaining innovations (which are needed to compete against current competition). In Christensen's terms, a firm's existing value networks place insufficient value on the disruptive innovation to allow its pursuit by that firm. Meanwhile, start-up firms inhabit different value networks, at least until the day that their disruptive innovation is able to invade the older value network. At that time, the established firm in that network can at best only fend off the market share attack with a me-too entry, for which survival (not thriving) is the only reward.

In low-end disruption, the disruptor is focused initially on serving the least profitable customer, who is happy with a good enough product. This type of customer is not willing to pay premium for enhancements in product functionality. Once the disruptor has gained a foothold in this customer segment, it seeks to improve its profit margin. To get higher profit margins, the disruptor needs to enter the segment where the customer is willing to pay a little more for higher quality. To ensure this quality in its product, the disruptor needs to innovate. The incumbent will not do much to retain its share in a not-so-profitable segment, and will move up-market and focus on its more attractive customers. After a number of such encounters, the incumbent is squeezed into smaller markets than it was previously serving. And then, finally, the disruptive technology meets the demands of the most profitable segment and drives the established company out of the market.

Tobacco industry feeling the burn of disruption

Established a little over four years ago, Juul has gone from a start-up with three employees to US tobacco giant Altria buying a 35% stake in the company last year for nearly $13 billion. This pre-emptive minor stake buy in was a classical market defence move by Altria, and a pretty good one too. As it was impossible to keep up with much more agile disruptor, Altria made sure it becomes part of its growing market share for now, while creating opportunities for potential complete acquisition in the future.

Pre-emptive minor stake buy in was a classical market defence move by Altria, and a pretty good one too.

This demonstrates just how powerful and profitable disruption can be. Juul was not the first to introduce a vaping product, but it was the first to develop an attractive and easy to use product at a reasonable price. The company has also benefitted by being the first to introduce multiple flavours, which has proved popular with younger consumers, and by aggressively promoting itself on social media.

Global vapor products (e-vapor and heat-not-burn (HnB) devices) market is expected to cross $43 billion by 2023, growing at an impressive CAGR of over 15% over 2017–2023.

In a market context where alternative nicotine delivery systems, such as electronic cigarettes and heated tobacco products, are the first technology leap in the industry for generations, and gaining in popularity as consumers seek healthier alternatives to traditional cigarettes, taking market share and profits away from the traditional tobacco companies in countries such as the US, Japan, South Korea and Germany, Altria's move was actually quite a good one. Although e-cigarettes currently account for just 7% of the US nicotine market, this could rise to 50% within the next five years.

Smoke-free future and disruption from within

Growing global health awareness and technological developments aiding safer smoking is driving the global vapor products (e-vapor and heat-not-burn (HnB) devices) market and is expected to cross $43 billion by 2023, growing at an impressive CAGR of over 15% over 2017–2023. In a rare situation where a sector is being disrupted by a market leader whose ultimate ambition to is to exit the very category that made its name, PMI (Philip Morris International) is leading what it calls a "smoke-free" future. Over the past decade the company behind the world’s biggest cigarette brand Marlboro has invested $4.5bn in R&D as it refocuses on science and technology. The firm has also been busy filing patents, with more than 3,400 granted and in excess of 5,000 pending.

In a rare situation where a sector is being disrupted by a market leader whose ultimate ambition to is to exit the very category that made its name, PMI (Philip Morris International) is leading what it calls a "smoke-free" future.

IQOS began to be commercialised in Japan and Italy in 2014. Today it has more than 6.6 million users globally, spread over the 44 countries where it is available. Philip Morris’s ambition is for at least 30% of its customers who would otherwise continue smoking, the equivalent of 40 million people, to switch to its smoke-free products by 2025. In the case of BAT, there are VYPE and VUSE vapers, GLO tobacco heaters.

Competitive scenario in the global vapor products (e-vapor and heat-not-burn (HnB) Devices) market is currently intensifying with continual innovations and upgrades being the primary characteristics of the market. The vapor products market is highly fragmented with over 300 vendors that operate and sell e-cigarettes under different brand names across the world. The major vendors in the global market are : Altria Group, British American Tobacco, Imperial Brands, Japan Tobacco International, JUUL Labs and Philip Morris International

The IQOS now represents 14% of the company's total reduced-risk product (RRP) revenue, which in turn accounts for about 20% of the company's total net revenue.

The global tobacco giant's 2019 second-quarter earnings report indicates it may not be long before its IQOS heated tobacco electronic cigarette becomes its primary revenue producer. Philip Morris' heated tobacco division saw a 37% increase in volume, shipping 15.1 billion units, with revenue hitting $1.5 billion. The IQOS now represents 14% of the company's total reduced-risk product (RRP) revenue, which in turn accounts for about 20% of the company's total net revenue.

"This changes everything" - indeed it does.

Marketing tagline of IQOS global product launch states "This changes everything" and indeed that is and will be very true - especially for tobacco industry and tobacco companies internally. Even though consumers might be initially the same, HnB devices are completely different product category than cigarettes and that does change everything. From the market itself, go-to-market strategy and execution, market basis of competition as well as consumers expectations from products and companies, as well as the industry as a whole. Unlike in cigarettes markets where competition in mostly based on price, brand storytelling and consumer's self perception, combined with trade / retail market share & presence, with HnB devices, which are technological devices, basis of competition shifts to technology performance and design.

With HnB devices, which are technological devices, basis of competition shifts to technology performance and design.

Unlike cigarettes which are bought, consumed and then disposed, with new product to be re-purchased, HnB devices have a completely different initial purchase price, primary product lifecycle as well as usage context. Different go-to-market strategy & execution entails different sales channels. For the first time in history, tobacco companies are opening their own direct-to-consumer channels, somewhat competing with their long-term established wholesale / retail partnerships. In times of digital consumers, new product category enabled a new economics that fit e-commerce monetisation model proposition. Namely, with higher product price, as well product category entailing a different legal treatment - especially going forward in future, e-commerce becomes a very attractive proposition. New product category will have effects both today and tomorrow, both for competition but also on the internal company economics. As underlying value proposition of HnB devices is technology which is rapidly advancing everyday, we can expect to have future device model versioning expansion. Namely, as technology advances, so will the models of devices. In future we can expect expansion of models of HnB devices, similar to those, say in mobile phones.

As the technology advances, providing better & different solutions, technology expectations of consumers advance as well in relation to their HnB devices performance

As the technology advances, expectations of consumers will advance as well in relation to their HnB devices performance. However, technology expectations are established well outside of tobacco industry - this means that both adjacent and non-connected industries will have an influence of the new tobacco product category competition and consumer expectations.

Different product category, also brings new cost structure. Innovation comes at a cost - a big one. As PMI just announced it will invest an additional $100 million in the IQOS device, bringing the total it intends to spend on RRPs to $400 million, one can imagine that previously non existent R&D costs required a change on the structure of the corporate balance sheet. What's more important, as innovation becomes a basis of competition, R&D expenditures will become a new normal for the industry and its cost structure.

As innovation becomes a basis of competition, R&D expenditures will become a new normal for the industry and its cost structure.

Big Tobacco's Big eCommerce Bet 

Even though initial bulk of sales of HnB devices currently is and will be coming from physical / traditional retail channels, as tobacco companies primarily focus on switching existing cigarette consumers to new HnB products, sustainable future growth will increasingly be dependant on e-commerce capabilities development and e-commerce channel performance. For foreseeable future there will be a shipment volume reduction in the core / traditional product portfolio of combustible cigarette business. Industry level decline in Q1 2019 ranged around 2,5 % while for Phillip Morris International decline was around 3,7%. As price increase tactics reach their natural ceiling in the future, declining core portfolio sales, combined with a dividend levels maintenance requirement, will mean further operations cost optimisations requirement. If one takes into account that, previously non-existing, R&D costs will weigh in on P/L balance sheets in the future more , the cost optimization necessity across the value and supply chain will become more prominent.

Sustainable future growth will increasingly be dependant on e-commerce capabilities development and e-commerce channel performance.

E-commerce growth perspectives for the tobacco industry are obvious if one looks at the general retail trends and rising share of e-commerce. Moreover, "Understanding the Online E-cigarette market" research on the online e-cigarettes market commissioned by the UK's Her Majesty's Revenue and Customs department and done by IFF Research in 2016 points to the fact that "based on the consumer panellist data, the online market is likely to grow further relative to the terrestrial market (many people expected their terrestrial purchases to decrease and their online purchases to increase)"

Consumers' shift & spending increase from offline to online makes sense from two perspective. First, after initial sampling and acquaintance with a new product category, which happens through physical retail, as consumers increasingly become accustomed to it, they will be become confident ordering it online and benefiting from general value propositions of e-commerce - such as increased convenience, greater choice and sometimes better pricing. Second, HnB devices bring a two phased consumption, first - initial device purchase which brings a higher / upfront 'investment' / cost and continuous repurchases of tobacco fillings (HEETS in IQOS case) which act basically as refills. In case of refills one can expect that, once the consumers' flavour is established, he'll be driven by convenience of repurchase which is best done through e-commerce. Even membership / subscription services on continuous orders might spur up in the future. New product category means new perspectives, and for continuous sustainable growth, HnB brands, will increasingly need to turn to post-purchase experience, whose importance has been embedded into the product design itself. Replicating successful cases from other industries, HnB devices are designed to disable cross-brand usage of tobacco sticks. So unlike in buying a pack of cigarettes and switching to another brand, with higher upfront costs, tailored product design that fits only that manufacturers' tobacco sticks, manufacturers are putting high emphasis on post-purchase phase as well "lock-in' of customers to a single (their) device. It wouldn't be surprising to discover that the current pricing of HnB device is subsidised in order to facilitate first usage with hopes of continuous repurchase of tobacco sticks - again which depend on the post-purchase experience of the consumer - whether experience matches his expectations and resulting with (dis)satisfaction.

As product lifecycle extends well beyond the buy button, post-purchase expectations rise and with them the need to align with not only consumer's immediate needs for after-sales services , but also their implicit expectations from an online (post)purchase experience.

Shifting the focus to the post-purchase to ensure the growth bet success

Whether big tobacco will succeed in their big HnB e-commerce bet depends on multiple variables. However, strategic focus to post-purchase phase will be one of the key requirements. As product lifecycle extends well beyond the buy button, post-purchase expectations rise and with them the need to align with not only consumer's immediate needs for after-sales services , but also their implicit expectations from an online shopping experience. New product category aligns the tobacco industry consumers' expectations with a realm of consumer goods / electronics / retail industries which are highly dynamic and highly competitive. HnB consumers will not only compare their experience against tobacco industry standards, but to a more competitive and heterogeneous shopping experiences in retail, electronics and consumer goods. Tobacco companies in their shift to becoming technology companies will need to transform their internal capabilities - something that they've already started to do, but also be aware of the broader e-commerce market context. Namely, tobacco companies are joining the e-commerce market at a time in which steps and rules have already been drafted on what shapes a satisfying shopping experience online.

HnB brands are joining the e-commerce market at a time in which steps and rules have already been drafted on what shapes a satisfying shopping experience online as well as the average consumer expectations from it

Out of three phases (pre-purchase, purchase, and post-purchase) - the post-purchase phase carries most weight and is most influential in defining the total experience. So whether customers will choose to continue to shop with you or competitors depends mostly on post-purchase experience he has and had with your brand. Of course, an evaluation of the experience is always in comparison to your brand promises, but also relative to other retailers' performance in this segment. Namely, it is the collective performance of all retailers customers interact with within a single market that shapes implicit customer expectations and market performance averages.

Namely, it is the collective performance of all retailers customers interact with within a single market that shapes implicit customer expectations and market performance averages.

The post-purchase is an essential, yet often overlooked, stage of the eCommerce customer journey. Given that across the board repeat customers can account for up to 40% of store’s revenue, it’s important to have a strong post-purchase strategy in place in order to provoke repeat engagement, encourage referrals, and drive more revenue. Consumers have made it clear that brand experiences during the post-purchase phase have the greatest overall positive or negative impact on their brand relationship with retailers and their inclination to shop that retailer over competitors. And, so, it’s imperative that you remain ever aware of the fact that after you’ve thanked your customer for her order, you’re just beginning the most influential phase of his brand interaction with you. 

After you’ve thanked your customer for her order, you’re just beginning the most influential phase of his brand interaction with you. 

Tobacco companies need to both determine the implicit customer expectations from an online shopping experience and audit their own to know where they stand in contrast to the market averages and start defining and planning corrective actions. The research and insights into country by country implicit customer expectations from an online shopping experience with particular focus on the post-purchase experience is at the heart of the SO DIGITAL GLOBAL E-COMMERCE BRAND EXCELLENCE PLATFORM. It audits the most influential phase of customer brand relationship by contrasting the customer shopping experience across stages of delivery, tracking, packaging - out of box experience, returns & refunds ( the reality) versus brand set expectations (the promises).

It audits the most influential phase of customer brand relationship by contrasting the customer shopping experience across stages of delivery, tracking, packaging - out of box experience, returns & refunds ( the reality) versus brand set expectations (the promises). Our platform enables competitive cross industry performance benchmarking of best performing e-retailers across dimensions of online (post)purchase experience, including but not limited to, phases of delivery, tracking, packaging - out of box experience, and return & refunds.

To discover more how you can craft an exclusive post-purchase experiences for your e-commerce channel , contact us today for a free no-commitment 1-on-1 live walk through of our solution and client case of Nike (EMEA).

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SO DIGITAL | GLOBAL BRAND EXCELLENCE SOLUTIONS is a technology company based in Amsterdam specialised in serving headquarters of global brands. We are proud partners of leading global digital growth brands like Nike (EMEA) and Uber (EMEA), but also other brands like TomTom (WHQ) and AS Monaco. With offices in Amsterdam, Berlin, Barcelona and Balkans we help global brands reduce complexity cost of global functional execution by delivering speed, scale and efficiency in strategy execution across markets.

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References

"Disruptive innovation" https://en.wikipedia.org/wiki/Disruptive_innovation

Morgan Housel, CNNMoney, "America's most successful stock" https://money.cnn.com/2015/02/19/investing/americas-best-stock-ever/

Alex Tedder, "Up in smoke: tobacco firms feel burn of disruption" https://www.schroders.com/es/ar/simsa/vision-de-mercado/mercados-en-ingles/up-in-smoke-tobacco-firms-feel-burn-of-disruption/

ReportBuyer.com "Market Research Report. " The global vapor products (e-vapor and heat-not-burn (HnB) devices) market and is expected to cross $43 billion by 2023, growing at an impressive CAGR of over 15% over 2017-2023" https://www.prnewswire.com/news-releases/the-global-vapor-products-e-vapor-and-heat-not-burn-hnb-devices-market-and-is-expected-to-cross-43-billion-by-2023-growing-at-an-impressive-cagr-of-over-15-over-20172023-300585952.html

Rich Duprey, "Philip Morris International Gets a Big Boost From IQOS in Q2" https://www.fool.com/investing/2018/04/09/philip-morris-international-gets-a-big-win-down-un.aspx

"The fight for a millionaire business: this is how the tobacco companies prepare the arrival of "4.0" cigarettes in Argentina" https://www.iproup.com/economia-digital/5084-cajero-automatico-e-business-nueva-economia-How-tobacco-companies-prepare-the-arrival-of-4-0-cigarettes-in-Argentina

Charlotte Rogers, MarketingWeek : "Tobacco giant Philip Morris wants to be a ‘disruptive insider’ as it targets the smoke-free market" https://www.marketingweek.com/tobacco-giant-philip-morris-targeting-the-smoke-free-market/

IFF Research, "Understanding the Online E-cigarette market" https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/565928/Understanding_Online_Ecigarette_market_HMRC-research.pdf