Ep. 45: Totally Lit or Just Hot Air? The Rise of E-Cigarettes in China

Transcript

(Y: Ying-Ying Lu; R: Rui Ma)

[0:00] R: Before we start, just want to thank those TechBuzz fans who came up and introduced yourselves Monday at the SupChina Women’s Conference in New York City. It is always such a pleasure to meet listeners in person! Especially women business leaders.

Y: Congratulations to the team at SupChina for an impressive event, and for all the thoughtful discussions. Of course, the topic of the day was the escalating US-China trade war. And as has been the case for a while, tech is at the forefront.

R: Especially the company Huawei. That made up most of the headlines in China tech this week and last, well that and Baidu’s first quarterly loss since 2005.

Y: We thought about doing an episode on one of those, but it’s already super well covered, and we didn’t think we could provide more insightful analysis than what’s already out there by our excellent journalist friends.

R: So we are going to stick with what we do best, which is to give you unique takeaways on what is relatively less talked about in English but are actually huge topics in the Chinese tech community. And today, we have a perfect example of such a topic.

[1:03] Y: E-cigs!! That’s right. Electronic cigarettes. Did you know that it’s been touted as “the next big trend” 下一个风口 in China tech, ever since last year really, but most especially since the beginning of this year? A lot of investors have either already made their bets or are actively looking for a team to back.

R: It’s also been criticized as the next big money pit of course, a trap for entrepreneurs and investors alike. Not surprising given the relatively low technical barrier and regulatory uncertainty around this product category. And for some people, the ethical considerations.

Y: But that hasn’t stopped a large number of tech entrepreneurs and startup employees in China, including a few famous faces, from jumping in.

R: Nope it hasn’t. An interview of ex-Uber China employees recently, for example, revealed that an alumna’s e-cig startup seems to have attracted the largest number of former colleagues. So that’s where all the startup talent is going! Especially now that Mobike and Ofo have turned out to be failures.

Y: Although China hasn’t yet birthed a decacorn in this sector like US-based Juul, now valued at $38Bn and rumored to be raising even more capital, we’re going to bet that at least one paper unicorn will emerge, with the way the industry is growing.

R: So much opportunity, but also so much risk! Is the Chinese e-cigarette industry totally lit or a bunch of hot air? Continue listening and let us know what you think at the end of the episode!

[3:02] Y: Hi everyone! We are TechBuzz China by Pandaily, powered by the Sinica Podcast Network! We are a biweekly podcast focused on giving you a peek into what’s buzzing within the tech community in China.

R: We uncover and contextualize unique insights, perspectives and takeaways on headline tech news that don’t always make it into English language coverage. So you can be smarter about the world of China tech. TechBuzz China is a part of Pandaily.com, an English language site that tells you “everything about China’s innovation.” I’m one of your two co-hosts, Rui Ma.

Y: And I’m your other co-host, Ying-Ying Lu. We’d like to acknowledge our partners DealStreetAsia and SupChina, creator of the Sinica Podcast Network!

R: In addition to TechBuzz, you can also find Sinica which covers current affairs, NuVoices as well as Ta for Ta on women, the business-oriented ChinaEconTalk, and the Caixin-Sinica Business Brief from China’s leading business magazine.

Y: Speaking of DealStreetAsia, their annual private equity and venture capital conference, Asia PE-VC Summit, is set to take place on the 17th & 18th of September this year. To register, go to their website at dealstreetasia.com!

R: A major thank you, too, to fans Dmitry, SDW, Wilberth, and Collegeguy for your thoughtful reviews on iTunes. Do remember to rate or review us wherever you get your podcast!

Y: And also special thanks to Reuters and Cheung Kong Business School for interviewing us on the 996 work culture and the micro mobility industry in China. You can find links to those articles and everything we use in our research in our transcripts at Pandaily.com.

[4:49] R: Today’s episode is brought to you by the University of San Francisco. USF’s new Masters in Applied Economics combines econ training with practical skills in data analytics — all geared towards helping you understand and analyze today’s new digital economy. Their curriculum covers skills like R and Python, machine learning, and experimental design; plus topics like the economics of platforms, auctions, pricing, and competitive business strategy. To learn about joining the Fall 2019 inaugural class, TechBuzz listeners can visit usfca.edu/techbuzz.

[5:35] Y: Now that smartphone purchases in China are not growing so fast anymore because we’ve basically reached market saturation, a lot of the wealth and entrepreneurial talent that were focused on that product have turned to four new-ish consumer electronics categories. Those are: smart glasses, wireless headphones, translating devices, and of course, the topic of today’s episode: e-cigarettes.

R: With the exception of translating devices, I’d argue that those are some of the same products getting major attention in Silicon Valley, although maybe not the hardware itself, but the relevant technologies. In fact, you can really trace the current e-cig boom in China, and probably globally, to one company and one company only, and that is, of course, Juul.

Y: Most of you have probably heard of this company by now, but if you haven’t, as we said in the introduction, it’s currently valued at $38Bn and was technically founded in 2015 and spun off two years ago from parent company PAX Labs, an electronic vaporizer company that is well known for its cannabis line.

R: Most of the companies we are going to talk about in this episode are very much like Juul in that they use a sort of liquid cartridge to deliver nicotine via sleek looking devices that mostly look like some variation of a USB stick.

Y: These cartridges are often flavored — mango, watermelon, green bean, you name it — and because it’s often marketed as healthier than smoking, or even just straight up harmless, together with youthful marketing and all these cutesy flavors, have been accused of increasing nicotine addiction in young people.

R: One minor technical point before we go further, because it sort of affects how the industry could potentially be regulated, is that strictly speaking, e-cigs are different from the electric smoking systems such as Philip Morris’ iQOS that just got FDA approval in the US last month.

Y: E-cigs, as we’ve already explained heat up liquids while the electric smoking systems heat up — but do not burn — tobacco. So sometimes those are literally referred to as heat-not-burn tobacco products. iQOS, by the way, was originally developed by Ploom, the predecessor to Juul, and first reached mass commercialization in Japan.

R: However, a lot of market studies don’t seem to carefully differentiate between the two, and many Chinese articles include both under the label of 电子烟 or e-cigs, but just know that for most of this episode, unless otherwise noted, we are talking about the liquid cartridge kind.

[8:09] Y: So first, Rui, let’s give our listeners some background on the market opportunity, because it is truly immense, and really the number one driver why so many are bullish on the category. To start off, how many smokers do you think there are in China, Techbuzzers?

R: If you answered over 350 million, you would have been correct. That’s, by the way, more than the entire population of the US. It’s also well over a quarter of the adult population in China. And no one else even comes close. The most number of smokers by country live in China, India and Indonesia respectively, but China has almost three times the number smokers of second place India.

Y: There are so many reasons why this is the case, but one oft-cited rationale is affordability. In China, the price of one box of the best-selling brand of cigarettes is less than $3.00, less than half of that in the US. And many domestic Chinese brands are well below that price, at just $1.50 per box.

R: And it costs that little primarily because of taxes. The World Health Organization recommends 75% of retail price as the minimum tax rate for tobacco — China is only at 40%. From 1996 to 2006, cigarettes, compared with other consumer goods and as benchmarked against other countries, actually became over 70% more affordable in China.

Y: This helped create the singular phenomenon where while everywhere else tobacco use was falling, in China it was actually increasing, to the point that about one-third of the world’s cigarettes are sold in China. If you have ever lived in or traveled to China, this fact would have been obvious.

R: So if we are talking about nicotine addiction — the market is there. It’s been growing, and it’s huge. But what about e-cigarettes?

[10:10] Y: Backing up a second, China’s history with e-cigarettes is a funny one. Believe it or not, it was actually a Chinese person who first successfully commercialized the e-cigarette. In 2003, so the story goes, a pharmacist named 韩力 Han Li who had just lost his own father to lung cancer invented the e-cig after having nightmares that he would succumb to the same disease.

R: It’s true that an American had patented something that resembled the e-cig way back in the 60s, but never made it, so most sources will credit Han with the invention, although it’s still controversial just how much of his design was wholly original. Anyway, the company formed out of Mr. Han Li’s invention, a company called 如烟 Ruyan, saw some impressive initial growth, went IPO in Hong Kong, but ran into some problems, including being criticized by China’s state-owned media CCTV for not being an effective tool for smoking cessation.

Y: CCTV, we’ll learn in a later example, is extremely persuasive in the eyes of the consumer and can really change the fate of your product if you end up on its bad side. So anyway, Ruyan didn’t become a Juul, partly because the technology wasn’t that advanced — the sticks would often become clogged, for example. A few more rounds of innovations would be needed before e-cigs really hit it big.

R: But once those problems, especially the one of getting the same nicotine high as smoking an actual cigarette, were solved, e-cigs really hit their stride. The category went from global revenues of just $20mm in 2008 to over $7Bn by 2014, then $12Bn in 2017. The expectation is that it will exceed $48Bn in another four years. And what’s crazy is that while traditional tobacco products can have profit margins well north of 90% before taxes, e-cigs can be even more profitable. There are very few multi-billion dollar products with such high margins growing at this rate. No wonder so many people are drooling.

[12:20] Y: And where does China come in? Well, for one, it is responsible for over 90% of the world’s current e-cigarette production. There are over 4000 e-cig companies in China, mostly in Shenzhen. But they export over 90% of their goods, generally only earmarking 5% of their inventory to be sold domestically.

R: That’s because despite being such a large producer, as late as 2017, China only accounted for 3% of the global e-cig market, despite having one-third of the world’s smokers, as we mentioned earlier. In first place of the e-cig market was the US, of course, at a market share of 39%, followed by the UK.

Y: And this is what has investors and entrepreneurs alike super excited about the space. The market penetration of e-cigs amongst smokers in China today is less than 1%. China’s Sinolink Securities issued a research report earlier this year that projected the size of China’s domestic e-cigarette market to reach over $4Bn in the next four years. Right now, we aren’t even at Day One … we might be at Day Zero.

[13:32] R: The reason why we say in China at least, we truly might be at Day Zero is because, at least as of now, it’s not really regulated. Oh, don’t get us wrong, there’s plenty of draft legislation and lots of noise from different interested parties on how it should be done, but nothing has been set in stone, just the expectation that rules are coming.

Y: One huge surprise so far is that China Tobacco hasn’t been given the rights to this industry. See, Tobacco in China is a state-owned monopoly. I mean, it’s controlled by two entities, one literally called the State Tobacco Monopoly Administration, the other the China National Tobacco Corporation. Together, they control the production, distribution, marketing and sales of all tobacco products in China.

R: China Tobacco makes 4 out of every 10 of the cigarettes that’s sold in the world, and had profits and tax contributions of over 1 trillion RMB last year, that’s over $160Bn USD, so it’s a major, major player, definitely not someone that can be ignored.

Y: But oddly, back in 2016 when China Tobacco tried to get the monopoly rights to e-cigs as well, they were refused so by the Chinese Supreme Court. And it was only last August that formal regulations came out even banning the sale of e-cigs to minors.

R: Indeed, the Chinese government really hasn’t issued much regulation in response to e-cigs, unlike the 68 countries that have. A dozen countries, such as Norway, Uruguay, etc. have banned e-cigs, including Hong Kong in October of last year, but they are legal in the US and UK to anyone over 18. Unlike in many other countries, the health department doesn’t seem to be as involved, which might account for the slower response. Although it’s important to note that some Chinese cities, including Shenzhen, have banned use of e-cigs in public spaces, although again, that’s not making it illegal.

Y: Neither the e-cig nor heat-not-burn tobacco products have been shown to be safe or effective at reducing nicotine addiction. Not conclusively and incontrovertibly, anyway. As for safety, there’s a lot of conflicting data. The UK’s Department of Health has been most active in recognizing e-cigs as a healthier alternative to smoking, with one government study saying that they are 95% less harmful than traditional tobacco. Others disagree.

[16:08] R: The huge market opportunity, lack of regulation, and controversial benefits are creating a flurry of startup activity in the space though. And in China, we are seeing two main types of entrepreneurs flood into the market. Those who have been making hardware, and those who have a marketing or operating background.

Y: Do you guys remember Luo Yong Hao 罗永浩, the celebrity English teacher turned celebrity entrepreneur, master marketer and founder of the cultishly popular Smartisan smartphone, also backer of Bullet Messenger, the WeChat challenger that we covered way back in Episode 21 in September of last year?

R: You mean the Bullet Messenger that pivoted to Chat Treasure 聊天宝 at the beginning of this year as part of the slew of WeChat competitors, and then has since then basically died? Yeah.

Y: Luo, once super high-flying in the Chinese tech world, and known for doing product announcements at the Bird’s Nest in Beijing, you know, the iconic stadium built for the 2008 Summer Olympics, because he just has legions upon legions of loyal fans, has been seen endorsing not one but two separate e-cig startups.

R: Actually for a while it was not super clear what he was going to do, because he’s been pretty beaten down by the very public failures of his last smartphone launch and the chat app. But it’s been long rumored he’s going into e-cigs.

Y: In January though, we saw the first move, when he endorsed FLOW 福禄, an e-cig brand founded by Smartisan product director 朱萧木 Zhu Xiaomu.

R: Then last month, he announced on his Weibo another brand founded by Smartisan CTO 彭锦州 Peng Jinzhou. It’s called 小野 and vvild in English, and already available for purchase on JD.com. Smartisan, he promises fans, is still alive, but he just needs some more time. Meanwhile, it seems that he’s pretty devoted to the e-cig space for the foreseeable future.

Y: On the other hand of the spectrum we have another celebrity entrepreneur, 蔡跃栋 Cai Yuedong, who founded a media company, and who also announced an e-cig brand called YOOZ, also around January of this year.

R: Cai Yuedong founded 同道大叔, which I am going to translate as Kindred Uncle, but is otherwise simply known as Uncle in China. It is a very popular Western astrology-based brand of comics and books. Aesthetically, it reminds me of LINE friends. By the way, Western astrology is a huge business in China, which you might not have expected. I mean, there are employers and VCs who will reject candidates or founders based on their astrological sign. Not kidding there.

Y: Anyway, the company grew to have 30mm fans and 3mm visitors a day, even opening up its own offline store. It raised money from Sequoia China, and eventually sold to a listed media company, netting Cai Yuedong a neat $25mm.

R: And how did this 31-year-old comic book artist-turned entrepreneur get the idea to go into e-cigs? Apparently on a trip to Silicon Valley when he was taking his new-found wealth to look for angel investment opportunities. Obviously, he saw the success of Juul.

Y: Relying on his existing fan base and digital marketing savvy, YOOZ, that’s spelled YOOZ, the brand he created, sold $700K worth of merchandise on its first day. In addition to individual gift sets at $53, YOOZ was also sold in packs of 18, 60 or 150 at a time.

R: A pack of 150 would have cost you over $5,000, but his strategy was to get you to gift them to your friends and family during the crucial Chinese New Year’s holiday. And now the January launch for all these brands make sense right? It was to capitalize on New Year’s gifting.

[20:11] Y: It may seem weird to our non-Chinese listeners, but gifting tobacco and alcohol is a cultural norm in China. A carton, or pack, of Chunghwa with its signature red packaging is a very popular gift and will set you back almost $100. These millennial entrepreneurs though, turned that into marketing spin where instead of giving your relatives a pack of Chunghwa, you can gift them the supposedly less harmful e-cigarette instead.

R: As of this quarter, Zhenfund, Arena Capital, IDG, and Source Code Capital, all well-regarded, some would even say Tier 1 early stage VC funds in China, have all invested into various e-cig startups. Last May, a company called iJOY raised a $43mm Series A, and in June RELX, founded by a former Uber China executive, raised a $5.5mm angel round. A brand called MOTI received a massive $10mm seed round, and the list goes on and on.

[21:16] Y: But in addition to pending regulations, which many are expecting to drop any day, there’s been a few setbacks to the sector that are unique to China business conditions. I think we should mention them here because the risks they pose really apply to all consumer businesses in China. The first one is, and we’ve already hinted at it, the power of CCTV.

R: Specifically, CCTV’s March 15th Gala, in celebration of International Consumer Rights Day. You see, beginning in 1991, China has made an event out of it, so that now each year on March 15th, hundreds of millions of viewers tune in to understand the latest scams they are facing as consumers and learn how to protect themselves from questionable business practices and products.

Y: As far as quality investigative reporting goes, this is one of the most respected and trusted programs in China. The event has also increasingly focused on tech and cybersecurity in recent years, and trust us, you don’t want to be named as one of the key perpetrators of fraud or unethical behavior. You will feel the impact on your business.

R: For example, Rong360, a publicly listed fintech company in the US, helps people find loans, and was named this year as having shady marketing practices around its interest rates. Its stock dropped 14% on the program’s airing. No joke! A whole slew of other companies were also named and all of them also saw their stock prices dip.
This year, e-cigs was also in the 315 hot seat. The program explained that e-cigs were still harmful to one’s health, and that consumers should be aware of their risks, but stopped short of further criticism.

Y: However, even this relatively minor statement resulted in the major e-commerce platforms, we are talking about JD, Tmall, and Suning here, immediately banning e-cigarettes from their site. That is, searching for “e-cig” would yield no results.

R: Told you 315 is a big deal and generally results in immediate — we are talking about same day — action. But, apparently the e-commerce sites decided that the risks were bearable, and after just one day, most of them had reversed their decision and made e-cigs searchable again. Industry bears though, think that this is just the beginning of further action, and that there is bound to be increased scrutiny on distribution and marketing in the future.

[23:48] Y: Many, for example, are worried about the future of marketing on sites such as short video platforms Douyin and Kuaishou. While those platforms have very strict rules around the presence of tobacco products, e-cigs don’t seem to be under any sort of control. They even show up as fashion accessories in some influencer videos.

R: But after the 315 program, both Weibo and Xiaohongshu, the social ecommerce platform that we covered in Episode 31, seems to have cracked down on advertising related to e-cigs. All related sponsored posts in Xiaohongshu were deleted within the day.

Y: The main reason being that with such a huge proportion of their respective user bases being young people, some who might not yet be of age, it’s difficult to enforce the law of not marketing e-cigs to minors.

[24:37] R: But these are not the largest channels for e-cig customers currently, many of whom are young and tech savvy. Can you guess which channel e-cig entrepreneurs are saying is their lifeblood for online distribution?

Y: If you guessed WeChat mini programs, then you would be correct. And if you think about it, this kind of makes sense. Until proven otherwise, we can safely assume that e-cigs are addictive products, which means that satisfied customers are going to be long-time or even life-time customers.

R: And if you forgot what WeChat mini programs are, well, you’re in luck because we did a deep dive back in Episode 37, but effectively think of them as very light-weight widgets within WeChat suited for simple and fast transactions, like for example, buying a refill for your e-cig.

Y: How did YOOZ, the brand we talked about earlier started by media entrepreneur Cai Yuedong get their first customers? Via their WeChat mini program of course. And how do you leverage the WeChat social network to spread your product? Share the QR code that installs the YOOZ WeChat mini program.

R: But WeChat is not stupid. It’s also well aware of the regulations regarding selling to minors, and it’s repeatedly blocked e-cig mini programs, which is really worrying some startups. What’s confusing is that some brands continue to be able to operate while others have been banned, and at least as of the date of this recording, most of them remain accessible.

Y: It could just be a temporary respite though, until the draft regulations that propose e-cigs be listed as tobacco products are formally adopted. Meanwhile, some industry bears are mocking e-cig entrepreneurs for being so naive that they think their devices will be regulated as electronics instead of tobacco. Better start investing in offline distribution, they said, which still accounts for a good 50% of e-cig sales in China.

R: Not so fast, others say. Remember the facial recognition technology that China is now so famous for? Pay with your face and all that? Some are saying that the next generation e-cigs will come with facial recognition on the device itself. Imagine that!

Y: Or maybe it doesn’t even have to be that extreme, the technology could just be utilized somehow during the purchasing process. And the silver lining for these entrepreneurs is that while the cartridges are most likely definitely going to be considered a tobacco product, the actual device itself and its components probably won’t be, so maybe they can still utilize online channels yet.

[27:15] R: OK, I know this subject is probably distasteful for a lot of Techbuzzers, but we did want to reflect the reality of the Chinese tech market, and the truth is, e-cigs are a big deal at the moment. Of course, please don’t think that aside from fear of regulatory backlash, there isn’t plenty of ethical concerns, because there are.

Y: Xiaomi, for example, has reiterated several times that it won’t get involved in the e-cig business, despite being a sort of natural fit and making every other consumer electronics product out there.

R: And just like I’ve seen people voice their concerns on Twitter, so people have asked on Weibo, what kind of values or 三观 do investors need to have to put money into e-cig companies? Allen Zhu of GSR, one of the top venture investors in China, has stated publicly that he would never support such an industry, for one. But it’s true that plenty of others are actively looking for opportunities, ethical concerns be damned.

Y: Good for Allen, but let’s not necessarily bash all Chinese investors who choose to participate, because the Chinese government has actually been pretty supportive of these technologies, and we don’t know the full data they are working off of. But let’s summarize for our listeners today what we have learned, shall we?

[28:31] R: Well, we learned that much like in the US with the success of Juul, e-cigarettes have been a hot topic in China and the target of venture capital investment. In fact, we can be pretty certain that in at least one case, the trend or 风口 started because people in China saw the success of Juul and were like, why not here?

Y: Indeed, why not in China, home to one-third of the world’s smokers at 350mm people, greater than the population of the United States? In fact, a Chinese person commercialized the first modern e-cig and over 90% of e-cigs today are manufactured in China. Maybe because of the relatively cheap cost of traditional cigarettes in China though, which are only very lightly taxed, market penetration remains less than 1% and global e-cig market share is just 3%.

R: But that means plenty of room for growth, which is why in the last two years a number of high profile hardware entrepreneurs and consumer internet executives have jumped into the fray. The most high profile is celebrity entrepreneur Luo Yonghao but the commonality seems to be that they are all pretty good at marketing.

Y: That’s because almost 40% of e-cigs sales are occuring online in China, and just like in the US, it’s proving to be very popular with youth. Aside from the traditional e-commerce platforms, social networks, short video apps, and WeChat mini programs are major channels for marketing and distribution.

R: However, with regulation looming — with everyone expecting e-cigs to be policed more heavily just like tobacco products — many of these sites have removed e-cig content, although sometimes these bans have been quickly reversed.

Y: The catalyst for much of these actions has been the annual CCTV March 15th Consumer Rights Program that this year talked about the dangers of e-cigs and the cancer-causing ingredients they contain. This program, as we mentioned, is extremely influential and has brought down many a problematic consumer brand, so everyone is terrified to be featured on it.

R: Will we see unicorns from this space, like Juul? I think it’s likely, because of how much interest it’s already gotten from investors and consumers alike. But I also think that the Chinese players are facing the exact same challenges as Juul, which are counterfeiters and unauthorized distribution.

Y: Meanwhile, the problem of age verification is so core to all of these businesses that we will have to see some innovation in either distribution or the verification process itself — like people have mentioned, e-cigs with facial recognition — that maybe it will become a more high-tech business than it currently is, or lose out to State-owned tobacco companies who are not content to sit out the race and already have significant offline distribution built around it.

R: Yeah it’s totally not right now. Some Chinese industry insiders are claiming you can get started with an investment as low as $700K, which is what, a studio apartment in San Francisco. We’ll see how this bubble plays out. Meanwhile, let us know on Twitter what you think! Is this industry totally lit, or just a bunch of hot air? Let us know!

[31:58] Y: OK, that’s all for this week folks! Thanks for listening. As a reminder, episodes will now be available every other Friday instead of Wednesdays. We really enjoyed putting this together, and we are always open to any comments or suggestions. You can find us on twitter @thepandaily, @techbuzzchina, and my personal Twitter account is @GINYGINY.

R: And my Twitter is spelled @RUIMA. TechBuzz China by Pandaily is powered by the Sinica Podcast Network. Pandaily.com is an English language site that tells you “everything about China’s innovation.” Our producers are Shaw Wan and Kaiser Kuo. Our interns are Wang Menglu and Mindy Xu! See you in two weeks!