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Big Tobacco Has Caught Startup Fever

Big Tobacco Has Caught Startup Fever

It’s not smoking. It’s platform-agnostic nicotine delivery solutions.

In January, Philip Morris International Inc., the largest publicly traded tobacco company in the world, relaunched its website. Front and center on the home page, a freshly fashioned statement of purpose now greets visitors: “Designing a smoke-free future.” It’s a curious ambition to claim for a company that last year sold more than $26 billion in tobacco products. On the home page, there are no images of its familiar top sellers, no Marlboros or Virginia Slims. Instead, the page displays a provocative, open-ended question: “How long will the world’s leading cigarette company be in the cigarette business?”

Members of the press who’d been invited last fall to the Philip Morris International headquarters in Lausanne, Switzerland, for a special briefing already knew the question was top of mind at the company, even if the answer was hazy. After Chief Executive Officer André Calantzopoulos walked into the airy meeting room and introduced himself, he pulled out something called an IQOS (pronounced “I-kose”), a tobacco gizmo that’s responsible, in part, for Philip Morris’s open flirtation with a life after cigarettes. Would the assembled reporters mind, he asked, if he partook in their presence? “There is no impact to the environment,” he assured them. “There is no danger for any of you.” Assent was granted, and for the next hour, as he spoke, Calantzopoulos intermittently raised the IQOS to his lips and inhaled deeply.

To use an IQOS, you push a flavored packet of tobacco called a heatstick into the mouth of a tubular, pipelike holder, which is a bit smaller than a kazoo. When you press a button on the holder, it heats up a metal blade inside, which cooks the tobacco to roughly a third of the temperature of a traditional cigarette. Then you puff away. The tobacco is warmed without combusting, so it doesn’t release any fire, smoke, or ash. This, in theory, makes it healthier to inhale when using heat-not-burn gadgets than when smoking, for instance, a run-of-the-mill Parliament. On the internet, various users have theorized that IQOS is an acronym for “I Quit Ordinary Smoking.” Calantzopoulos says this “was obviously not the intention.” Through a spokeswoman, the company later clarified that the name, which started with a lowercase “i,” then morphed into a combination of “IQ” with “OS,” “has no meaning in particular—it’s meant to represent quality, technology, electronics, intelligent systems—because this is not a tobacco category.”

In between heatsticks, you holster the cyberpipe in a mobile charger, a smooth, palm-size contraption that calls to mind a cigarette pack mated with a smartphone and designed by Apple’s Jony Ive. “I was a smoker before,” Calantzopoulos said as he handled a charger. “I switched to this completely, and I cannot smoke cigarettes anymore.” Somewhere in flavor country the Marlboro Man is turning over in his grave.

Calantzopoulos was named CEO of Philip Morris International in 2013. Five years earlier the company had been spun off from its U.S. counterpart, Philip Morris, which, amid a sustained public health backlash, had rebranded as Altria Group Inc. At the time of Calantzopoulos’s ascension, profits at Philip Morris International were strong. In the fiscal year ended December 2012, the company made $8.8 billion of net income on $31.3 billion of revenue. Even so, an uneasiness permeated the industry. Smoking rates were in decline among well-educated consumers in developed economies; to make up for slipping sales, the companies were raising prices, which they could do for only so long. Meanwhile, a growing number of customers were switching to e-cigarettes in the hope of escaping their addiction or preserving their health. The devices, which use battery-powered coils to vaporize nicotine-infused solutions, had leapt on the scene seemingly out of nowhere. One of the first commercially available e-cigarettes had been created circa 2003 as a smoking cessation device by a Chinese pharmacist whose father had died of lung cancer. By 2013 the e-cigarette market had $3.7 billion in annual sales, according to Euromonitor International, and was expanding rapidly.

Philip Morris International scrambled to fashion newfangled nicotine-delivering devices that would catch the wandering eye of the restless tobacco consumer. In 2014 the company unveiled IQOS in Japan, where it quickly gained a passionate following, and in Italy. The gadget has since expanded to 20 markets, including Canada, Germany, Romania, and Russia. According to a company spokesman, IQOS now has more than 1.4 million regular users. Executives say current smokers may be more likely to switch to an IQOS rather than to an e-cigarette, because they believe the heat-not-burn experience more closely resembles the taste and buzz of cigarettes. It’s a key selling point. Some packs of IQOS refills are marked with the slogan “The pleasure of heated tobacco.” The heatsticks, branded as Heets, look like stumpy cigarettes with a filter on one end and the hyperprocessed golden-brown tobacco neatly packed in cigarette paper. Right now the tobaccomagineers are getting ready to field-test a disposable heat-not-burn product called Teeps, which looks like a standard cigarette. Tobacco-based inventions give the cigarette industry a considerable advantage over the fragmented, e-cig startup world, because the companies are already well-positioned to manufacture rolled leaf on a massive scale. Calantzopoulos notes that his company has a handful of other “platforms” also coming to market. Altogether, it’s spent more than $3 billion on these developments.

This commitment to next-generation nicotine delivery has manifested itself in a $111 million, environmentally progressive research center called the Cube, which hugs the shoreline of Lake Neuchâtel in western Switzerland, a 45-minute train ride from headquarters. The Cube features a translucent glass facade, passive solar heating, and extensive gardens. It has three wings, named Earth, Wind, and Air. Pointedly, there is no Fire. It is the heat-not-burn of contemporary European architecture.

Philip Morris executives say they’re firmly committed to the sunsetting of cigarettes. When asked for specifics, however, they shy away from a hard deadline. “I hope it’s not going to take that long,” Calantzopoulos says. “At a certain stage, once people see everybody around them using these new products, I think that constantly accelerates the process. It becomes a self-fulfilling prophecy.”

Healthy advertising and marketing budgets will help the prophecy fulfill itself more quickly. Over the past two years, to nurture its community of IQOS users, Philip Morris has opened a series of retail stores throughout Europe and Asia. The IQOS store in London sits on a hip commercial stretch in Soho. A modish sculpture, vaguely celestial, hangs in the storefront window. Inside, IQOS devices are perched atop rugged pine shelving, beckoning to visitors. “Product experts,” dressed in neutral-toned uniforms, circulate offering “guided trials.” On the store’s lower level, there’s a communal workspace where IQOS devotees can get together to inhale on heatsticks while indulging in free beverages and Wi-Fi. The overall effect is one part Nespresso Boutique, one part Apple Store, one part Pret A Manger.

A 20-pack of heatsticks goes for about £8 ($10), and the device itself costs about £45. An IQOS comes in a white box, adorned with an image of the brand’s spirit animal: a vivid, blue-green hummingbird in midflight. A company spokesperson says the hummingbird—nimble, aesthetically fetching, and disruptive (of stinging insects)—is an ancient symbol of tobacco and one that’s meant to convey a sense of movement and transformation. Opening an IQOS’s packaging, with its various glossy parts nestled in thin plastic liners set in molded compartments, beneath which lies the requisite nest of cords, is like unboxing an iPhone.

Philip Morris isn’t the only multinational tobacco company to catch innovation fever. Mature industries typically have a hard time disrupting themselves, but, flush with cigarette profits, the big competitors have decided to try. Since the rise of e-cigarettes, it’s no longer such a stretch to imagine a messianic engineer in a garage somewhere inventing a nicotine-delivery gadget capable of doing to cigarettes what Uber did to taxicabs or Napster did to the compact disc. If your profits hinge on nicotine addicts, you might want that visionary in your employ. Everywhere you look in the industry, companies are pouring money into product development while borrowing liberally from the style of Silicon Valley. They’re funding tech incubators, running venture funds, hosting TED-style talks, and developing apps. The new dogma has spread. Cigarettes are the industry’s past. Reduced-risk tobacco platforms are the user interface of the future.

Tobacco executives often sound like media owners talking about content. That is, they’re open to delivering their drug via whatever pipe the consumer chooses—be it e-cigarettes, heat-not-burn devices, gum, lozenges, dip, or some medium that hasn’t been invented yet. They are, as the media gurus would say, “platform-agnostic.”

“Consumer behavior is changing, competitors are taking action, the environment keeps changing so quickly,” says Yasuhiro Nakajima, vice president for emerging products at Japan Tobacco Inc. “Unless we are quick, we can’t be part of the game.”

In 2014, Reynolds American Inc., the second-largest tobacco company in America, rolled out Vuse, its first e-cigarette brand, nationwide. Sales grew fast. In January 2016, Reynolds stepped up its commitment, announcing the creation of a subsidiary called RAI Innovations Co. devoted to the development of cutting-edge nicotine and vaping products. The company named Carolyn Hanigan as its first president. Hanigan, who’s 45, had never worked in tobacco before. But she had marketing experience at big consumer-facing companies such as Mars and Nestlé and most recently was a vice president at Swander Pace Capital, a Bay Area-based private equity firm with holdings in consumer-products companies. She drove an electric car. When juice cleanses became all the rage, she leaned in. Moving forward, she would lead Reynolds’s quest to invent the next great nicotine product—ideally, some sort of killer tobacco app that doesn’t kill.

1400x-1Hanigan relocated to Winston-Salem, N.C., and got to work setting up Reynolds’s tobacco-tech skunk works. The company carved out a space in its existing research and development center and gave it a sleek retrofitting that included concrete floors, exposed piping, a workshop, a 3D printer, midcentury modern furniture designed by Eero Saarinen and Hans Wegner, and a vapor lounge. (Not marijuana-compatible. Big Tobacco’s devices have the vaping material locked in, as the iPhone locks a SIM card, so users can’t change the liquid inside. At least, until someone figures out how to jailbreak them.) On one wall, spelled out in white lettering against a dark background, is the phrase “The future begins now.” Hanigan recalls that one time last year, Reynolds CEO Susan Cameron walked into the emerging innovation zone and reacted favorably. “She said, ‘I feel like I’m in New York,’ ” Hanigan says. “And I said, ‘Good. I feel like I’m in San Francisco!’ ”

It didn’t take long for Reynolds to receive a major vote of confidence. On Jan. 17, Nicandro Durante, the CEO of British American Tobacco, announced that the company had reached an agreement to pay $49.4 billion for the 57.8 percent of Reynolds American that it didn’t already own. If approved by shareholders, the acquisition would make British American Tobacco even bigger than Philip Morris. On a conference call with analysts, Durante said he was delighted. The combined company would control a rich portfolio of cigarette brands—Pall Mall, Lucky Strike, Camel, Newport, Dunhill, Natural American Spirits—with a “unique geographic footprint,” spanning the globe from Asia to Africa to the Middle East to the U.S. “By combining these two companies,” Durante said, “we’ll be creating a stronger, truly global tobacco and next-generation products company.”

The deal, Durante explained, wasn’t only about scale. It was also about the future of smokeless nicotine. In 2013, British American Tobacco introduced its first e-cig, Vype, which has since grown into one of the most popular vaping brands in Europe. In December 2016, the company started selling a silvery heat-not-burn device in Japan called Glo. BAT now sells “next-gen” products in 12 countries and plans to quadruple that figure over the next two years. The combination with Reynolds’s next-gen device shop, Durante said, would create a powerful vortex of tobacco innovation—one giant R&D tornado that could blow away the competition and achieve global tobacco-tech supremacy.

Global domination requires conquering America, the largest source of smoke revenue next to China, which has its own state-run megaplayer, China Tobacco International Inc. At the moment a little more than half of all electronic smoking devices in the U.S. are sold by either Reynolds American (42.2 percent) or Altria (12.6 percent), according to data from Bloomberg Intelligence. Last year the Food and Drug Administration decided to try to regulate the wild west of vaping and e-cigs. Ironically, this makes it a good time for Altria/Philip Morris and BAT to push hard into the market since they have the capital to wend through a regulatory maze. All tobacco products released after 2007—including e-cigarettes—must now seek the regulatory agency’s permission to remain on store shelves. Companies have 24 months to file premarket applications for items already on the market, and the FDA has a year to review the submissions.

Jan Verleur, co-founder and CEO of VMR Products LLC, owner of V2, the largest independent e-cigarette brand in the U.S., accuses the FDA of becoming “the handmaiden of Big Tobacco.” He estimates that going through the approval process will cost his company from $300,000 to $1 million per product. That’s more, he says, than most independent vaping companies can afford. He says he hopes that at the least Congress will tweak the FDA regulations to grandfather in all tobacco products released prior to August 2016. “A higher barrier to entry to bring new technology to market in the sector is a very, very good thing for Big Tobacco,” Verleur says. In other words, big tobacco companies are embracing the trappings of startup culture at a time when the new regulations have genuinely independent, lean vaping startups on the run. “It’s going to be an arms race,” says Nik Modi, an analyst with RBC Capital Markets. “Who has the best technology, the best science? Who can get their applications through the FDA the quickest? We’re not in a pricing war. We’re in an innovation war.”

Altria is working with Philip Morris International to bring IQOS to the U.S. under a licensing agreement. Philip Morris is planning to have its application in to the FDA by the end of March for the basic approval now required to be on shelves. The FDA promises to address such applications within a year. Back in December, Philip Morris submitted almost 2 million pages in support of a separate application that could designate the IQOS as a “modified risk” tobacco product. (The FDA offers no time frame for processing this one.) If the effort passes muster, the device could become the first tobacco product to receive this determination. The aura of (relative) healthiness would give IQOS a market edge, but Altria plans to begin selling IQOS in the U.S., with or without it, in late 2017 or early 2018.

On Feb. 22, during a speech at an investor conference in Boca Raton, Fla., Altria CEO Marty Barrington noted that the company is developing its U.S. marketing strategy. The plan, he said, will include “flexible retail concepts” offering “guided trials.” He proceeded to show the audience glam shots of the sumptuous IQOS stores in Japan and Italy.

In a conference room at Altria’s Center for Research and Technology in Richmond, Va., Jose Murillo, an Altria executive who oversees FDA-related regulatory strategies, discusses how the agency’s involvement plays into the company’s goals for post-smoke America. Murillo reaches across the table and grabs a pack of Verve, a flavored nicotine lozenge, which Altria began testing in Richmond-area stores a few years ago. He pops one in his mouth. It’s one of several smoking alternatives he’s excited about. “There’s a lot of opportunity to move smokers along—subject to FDA review—something we call the continuum of risks,” Murillo says. “You have to know what the consumer is looking for. You have to match technology to product. And you have to have a regulatory path to get to market.”

Murillo says that whichever direction consumers zag, Altria will follow. He points out that the company has long been adept at coming up with better ways of syncing nicotine with the human bloodstream. The breakthroughs have included machine-rolled cigarettes, filters, flip-top boxes, and dip in a can. “We’ve been through any number of disruptions,” he says. The industry, after all, was an early supporter of disruption, having created the smoke break. “We have a track record of being able to evolve with the changing times.”

The company operates a fund called Altria Ventures, which, according to its website, invests in startups focusing on “mobile coupons, augmented reality, digital Point-of-Sale, beacon technology, battery technology, data security, age and identification verification, inventory and product intelligence.” Altria also hunts for strategic acquisitions. In 2014, Nu Mark—an Altria subsidiary focused on smokeless tobacco alternatives—acquired e-cigarette maker Green Smoke for approximately $110 million. “Green Smoke had a lot of supply chain expertise that we were looking for and an excellent online customer interface,” Murillo says. “Their headquarters are located in Israel, right there in the high-tech area between Tel Aviv and Jerusalem, which gave us access to a lot of leading engineers and electronic experts.”

Antismoking groups are watching all of this warily. In general, they support efforts by the industry to get smokers to transition to reduced-risk tobacco products. Although the medical community doesn’t have a comprehensive understanding of the health effects of the various new tools, a study in the February 2017 Annals of Internal Medicinefound that former smokers who switched to e-cigarettes “substantially reduced” their levels of carcinogens and toxins. Around the same time, several studies came out that indicated teenagers’ vaping increased their likelihood of becoming cigarette smokers. Under pressure from antismoking advocacy groups, the FDA last year included in its regulatory changes a rule banning e-cigarette sales to minors.

Critics also don’t see much change in how the industry is promoting its legacy product. “Philip Morris, for example, has talked about envisioning a society someday without cigarettes,” says Matthew Myers, the president of the Campaign for Tobacco-Free Kids. “But they have never marketed traditional cigarettes more aggressively than we’re seeing them do in low- and middle-income countries across the globe.” Executives at BAT, more subdued on the topic of a smoke-free future, said recently that they were also willing to keep selling cigarettes, forever and ever, if that’s the will of the people.

Almost 80 percent of the world’s 1 billion smokers now live in low- and middle-income countries, according to the World Health Organization. In the U.S., the Centers for Disease Control and Prevention’s 2015 numbers showed that almost twice as many adults living below the poverty line than those above it smoked. Only 3.6 percent of adults with a graduate degree smoked cigarettes compared with 34.1 percent of GED-certificate holders. And for now, cigarettes continue to be the lifeblood of the industry. According to estimates from Euromonitor International, the global market for cigarettes in 2017 will be $717 billion vs. a mere $11.2 billion for all vapor and heated tobacco products combined.

Robin Koval, the president and CEO of the nonprofit Truth Initiative, says the arrival of extravagant nicotine-delivering gadgets could be an attempt to win back the kind of wealthier, upscale consumers who are no longer reliably using tobacco. The stylish devices could seduce a new fan base among white-collar, cosmopolitan types by differentiating the tobacco experience from déclassé, overtly unhealthy cigarettes. The move into tech, she points out, is also likely to help cigarette makers overcome some of the stigma of working in a field whose core product remains the leading cause of preventable disease and death in the U.S., according to the CDC, killing almost 500,000 people a year.

Promoting a job with Big Tobacco as a job at the tech frontier has been effective, at least according to David O’Reilly, the head of science and R&D at BAT, who says youngsters are now lining up to join the revolution. The company’s 2017 “graduate entry program” in England (positions usually held by twentysomethings just out of university), he says, saw applications double from last year. “It used to be very difficult to recruit for this sector, but now the quality of the talent we can get is world-class,” he says. “For a scientist who starts working with us today, they’re told, ‘The world is your oyster. History is yours to write.’ It’s about inventing the future.”

Altria’s Murillo also says his company has created an environment where code jockeys and art school grads alike feel at home inventing this future. “When I started Nu Mark, we visited people who were working for us—potential acquisition targets, venture accelerators, startups, and so forth—and I stole shamelessly,” he says. “Look at what they do for the lunchroom! And look at these chairs! The idea was to make sure that people realize that we are a startup, we are an innovation company.” Altria’s nicotine ninjas are offered a range of activities to stay stimulated. In Richmond the company hosts art shows, throws live music performances, and sponsors an in-house robotics competition. “We have a lot of left-brain, right-brain activities,” Murillo says. “It’s an amazing time.”

Quitting cigarettes is never easy, though. The cigarette manufacturers are still mostly novices when it comes to electronics. There have already been some slip-ups. In March 2016, Japan Tobacco failed to meet deliveries of its futuristic vaporizer, called Ploom Tech, when the company couldn’t keep pace with demand. When Philip Morris introduced IQOS in Japan, the company set up a call center designed to handle as many as 30,000 calls. Instead, it received about 1 million, overwhelming the system. Earlier this year, BAT abandoned development of a nicotine inhaler called Voke, because it proved to be too complex for the company to produce on a large scale.

Despite the early coughing fits, the industry keeps huffing forward. In February, Jacek Olczak, Philip Morris International’s chief financial officer, told investors that an IQOS update was in the works for the second quarter of 2017. “New features of the device will include an improved user interface and a significant reduction in the holder’s charging time,” he said. “The new version will also provide connectivity and access to an IQOS app.”

Not to be outdone, Reynolds has integrated Bluetooth wireless technology into two of its e-cigarette products. From a free smartphone app, users can track battery life or how many puffs they’ve taken that day. “VUSE is the most advanced e-cigarette and the first e-cigarette designed with Smart Technology,” the brand explains on its website. “The Vuse digital Vapor Cigarette contains a vapor delivery processor that uses algorithms in the same way a computer does, therefore it is ‘digital.’ ”

But in cigarettes, as in music and news, the shift away from analog is more of a process than a pivot. Murillo points out that Altria has been developing heat-not-burn technology for several decades, but only recently have the consumer and regulatory conditions grown favorable for widespread adoption. In 1998, Philip Morris started selling a heat-not-burn device called Accord. Despite the company’s high hopes, the Accord flopped. “It was very cutting-edge for its time,” Murillo says. “But consumers were like, what do I do with it? What does it do for me? Is this less harmful? We couldn’t talk about any of that.”

Also, the Accord looked, somewhat distressingly, like an old-school car phone choking on a half-swallowed cigarette. Every cutting-edge company has its fail-fast experience, but Murillo suggests that Altria doesn’t intend to make that kind of mistake again. “Design is essential. I’m a big fan of what Apple has done. We try and bring that to all of our product development,” he says.

“We’ve had to bring in talent in terms of design,” echoes Hanigan over at Reynolds. “These need to look like an everyday product, like an iPhone or a Fitbit or a pair of Ray-Bans.”

Source: bloomberg