TOKYO (Reuters) - Japan Tobacco Inc 2914.T plans to spend $500 million to quadruple its smokeless tobacco production capacity by the end of 2018, as it races against bigger rival Philip Morris PM.N for a larger share of the Japanese vaping products market.

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Global tobacco firms see Japan as a fertile test ground for vaping products since e-cigarettes using nicotine-laced liquid are not allowed under the country’s pharmaceutical regulation. While the Marlboro maker’s heat-not-burn “IQOS” tobacco device is already enjoying strong demand in Japan, Japan Tobacco’s launch of its “Ploom Tech” product has run into delays.

“It’s embarrassing for a tobacco company top to say this, but I did not expect this,” said Japan Tobacco CEO Mitsuomi Koizumi, referring to the popularity of IQOS, which had about a 10 percent market share in April, from 7.6 percent in January.

Japan Tobacco is looking for mergers and acquisitions (M&As)in emerging markets, such as Southeast Asia, Africa and Latin America, as well as opportunities to invest in startups that have patents and technology for alternative tobacco products, the CEO of the world’s No.3 tobacco company said.

With more people shifting to smokeless products such as IQOS due to health concerns, Japan Tobacco’s domestic cigarette sales volume is likely to fall 9.6 percent this year.

“It’s shocking. I am doing this business for more than 35 years but I have never experienced losing 10 percent in volume in one year,” said Koizumi, a career insider who took the top job at the company in 2012.

Demand for traditional cigarettes may come under further pressure given the prospect of tougher regulations as Japan tries to introduce an anti-smoking law ahead of the 2020 Summer Olympic Games in Tokyo.

Koizumi said he expects vaping products, including Ploom Tech and IQOS, to grab as much as 25 percent of Japan’s cigarette market by the end of 2018.

Philip Morris’ IQOS is a battery-powered device that heats cigarette-shaped sticks packed with tobacco leaves. Ploom Tech, also a battery-powered device, generates vapor that goes through a capsule packed with tobacco leaves.

Koizumi said his company was aiming for the top share of Japan’s vaping market in three years.

Japan Tobacco plans to ramp up the annual output capacity of tobacco capsules used for Ploom Tech to the equivalent of 20 billion cigarette sticks in 2018, from 5 billion planned at the end of this year, the CEO said, adding the company was also developing other tobacco vaping products.

The former state monopoly - still a third owned by the government and whose top brands include Winston, Mevius and Camel - last week announced it would start selling Ploom Tech in Tokyo on June 29, later than initially expected.

There has been speculation Japan Tobacco, which has a market capitalization of 8.4 trillion yen ($75.3 billion), is ripe for major M&A, especially after British American Tobacco BATS.L agreed a $49.4 billion takeover of U.S. rival Reynolds American Inc RAI.N, creating the world's biggest listed tobacco firm.

Some analysts speculate Japan Tobacco could even potentially acquire Britain's Imperial Brands IMB.L

But Koizumi said the BAT-Reynolds deal was unlikely to have a direct impact on his company’s business and that Japan Tobacco was not interested in large-scale acquisitions.

“Specific names aside, deals that would be potentially problematic in terms of anti-monopoly regulation are not realistic,” he added.