Long Term We Remain Bullish on Vapor

An email I received:

Equity Research

Tobacco Talk: Independent Vapor Mfr. Survey-- More Bullish Than Retailers-Suggesting Vapor Growth Remains Robust

Hi!

Long Term We Remain Bullish on Vapor but Near Term, We've Become More Cautious Given Increased Uncertainty - We continue to see vast opportunity for vapor long term and continue to believe consumption of vapor and other non-combustibles could surpass consumption of combustible cigs in the next decade (by 2023). While we estimate the industry will continue to grow robustly in 2015 (~40% topline growth), reaching retail sales of $3.5B, we would be remiss if we didn't acknowledge the increased uncertainty we have observed among investors, our retailer/industry contacts, and consumers over the past 6-12 months. We believe this unfortunate trend is being driven by: (1) mixed messages from the media; (2) lack of FDA regulation or leadership; and (3) lack of vapor industry or public health alignment, which are in turn driving worsening public perception of the vapor category. This is exacerbated by the fact that it is difficult for the industry to defend itself or make any modified risk claims (that their products could be less harmful than combustible cigs). Bottom line - we remain bullish long term and continue to believe technological innovation is crucial and that Big Tobacco will be pivotal in shaping the vapor industry.Please see attached our proprietary, interactive vapor industry model.

Sizing the Industry - Our Proprietary Interactive Vapor Model Suggests $3.5B in Vapor Retail Sales by the End of 2015 - Could Eclipse $10B by 2018 - Based on our updated, in-depth analysis of the vapor and combustible cig industries over the next decade, we continue to have conviction in our theses that: (1) Consumption of vapor products and other non-combustible products will surpass consumption of combustible cigs in the next decade; (2) The combined margins of combustible cigs & vapor products will surpass combustible cig margins as early as 2018 driven by lower msa payments as combustible cig volume is displaced to vapor; and (3) The growth of the combined profit pool of combustible cigs & vapor products will accelerate in the next decade (a CAGR of 6.6% - compared to 4-5% growth for combustible cigs historically). Bottom line, the industry is entering its next generation of growth and we continue to believe reduced risk/vapor products will accelerate combined profit pool growth over the next decade.

Tobacco Talk Survey of Independent Vapor Companies - Category Growth Remains Robust, Driven by VTMs - We recently conducted a "Tobacco Talk" survey of independent vapor mfrs. Key takeaways include: (1) The retail vapor market size could reach $7.3B globally and $3.7B in U.S. by the end of 2015; (2) Total U.S. vapor category growth is expected to be 50% in 2015 (our est. is 37%); (3) Sales mix continues to shift to VTMs, which are growing at 3x the rate of the entire category; (4) There are 8,500 vape shops in the U.S. & 19,400 globally; and (5) Net pricing on vapor products is expected to be slightly down (-1.3%) in 2015; despite this, manufacturing capacity is expected to grow 26%.

Regulation Remains a Question Mark- We're Somewhat Concerned by Lack of Clarity Though Industry Contacts Not Letting Uncertainty Dampen Innovation - We have become more concerned that lack of FDA regulations has caused a "paralysis" in the industry as retailers and wholesalers are afraid to get stuck holding product they cannot sell or return. Therefore, they are not necessarily buying new product unless it's "forced" or required (such as Vuse/MarkTen). Despite concerns we're hearing from our retailer contacts, our vapor industry contacts appear less concerned and 83% say they are accelerating their pace of innovation in 2015 with a focus on "consumer-friendly" products.

Please call or email me with any questions.

Thanks!

Bonnie

Bonnie Herzog

Managing Director

Beverage, Tobacco & Convenience Store Research

Wells Fargo Securities, LLC

375 Park Ave

New York, NY 10152

Phone: (212) 214-5051

bonnie.herzog@wellsfargo.com

Additional information available upon request. This information is for your use only and may not be forwarded or distributed. The person transmitting this e-mail is a licensed person of Wells Fargo Securities, LLC. I certify that: (1) All views expressed in this research report accurately reflect my personal views about any and all of the subject securities or issuers discussed, and (2) No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by me in this research report.