Vector Group Ltd. (VGR)

The Vector Group is a holding company consisting of 3 main businesses:

Liggett Group – manufacture and sell cigarettes
Vector Tobacco Inc – specialize in developing low-risk cigarettes like nicotine-free QUEST
New Valley LLC. – real estate business

Liggett Group primarily specializes in discount cigarettes, in 2005 and 2006 all of their sales were of the discount variety. Their market share of the overall discount cigarette industry has been growing, 7.4% in 2004, 7.5% in 2005 and 8.7% in 2006 according to the Management Science Associates. Their best seller is the Liggett Select brand. All of their sales are in the United States, they have no foreign operations. They also have a cost advantage compared to their bigger competitors like the Altria Group and Reynolds American Inc. due to the Master Settlement Agreement, which states that the three biggest cigarette manufacturers must make payments to states based on how much many cigarettes they sell annually, Liggett only has to pay if their market share is above 1.65% of the U.S. cigarette market. In the past 3 years, their market share of the overall U.S. cigarette market has averaged 2.3%. They are the fifth largest manufacturer of cigarettes in the United States based on sales volume. There are roughly 135 litigation cases pending where the Liggett Group is named the defendant or one of the defendants.

Vector Tobacco is a small part of the Vector Group holding company. Their goal is to continue developing low-nicotine and nicotine free cigarettes and to continue working on the development of low-risk cigarettes. Their sales as a percentage of total sales in the holding company in 2004, 2005, 2006 have been 2.8%, 2.0%, and 1.3% respectively. Vector Tobacco has not been profitable in the past 3 years. They also benefit from the Master Settlement Agreement, they will only have to pay if their market shares is above .28% of the U.S. cigarette market.

New Valley LLC consists of real estate operations all across the United States. They own a 50% interest in the biggest residential brokerage in metropolitan New York City, the Douglas Elliman Realty, LLC. They also hold interest in properties in Hawaii, Washington D.C., and in Florida.

The Vector Group has been very aggressive in cutting costs in its two tobacco operations, they are constantly eliminating jobs and trying to improve operating efficiency. This has been a big staple of Altria’s success over the years and this has greatly contributed to Vector’s success as well.

Cigarette Industry

The total domestic cigarette industry has been declining and will continue to decline. In 2006 it declined 2.4% according to the Management Science Associates. In the domestic market, the three largest cigarette manufacturers based on sales volume accounted for a total of 86.8%. Liggett Group faces competition on two fronts, the three major distributors and other small manufacturers similar to Liggett in size that do not have to pay in the Master Settlement Agreement since their market share is so small. In the past, there have been considerable barriers to entry in the industry, but recently the smaller companies have been able to enter the market since they are not influenced by the Master Settlement Agreement and due to the surplus manufacturing capacity in the industry. Litigation has been a constant in the industry since 1954.

Valuation

They are trading at a trailing twelve month price/earnings ratio of 25.7, that’s not great, but when you look at Joel Greenblatt’s pre-tax earnings yield, which removes the effect of the financing and taxes, they are at 10%. They also have a high Pre-Tax Return on Capital. 24.5% of the outstanding shares are owned by insiders. There is a bit over $103 million of long-term debt on the books with almost $147 million in cash and cash equivalents. There is also approximately $57 million in long-term investments Icahn Partners LP and in the Jeffries Buckeye Fund LLC. They also own about $29 million worth of LTS stock. Two investment gurus that are invested in the Vector Group are Carl Icahn and David Dreman. They also pay a dividend of $1.60 a year which equates to a dividend yield of 8.7% at today’s prices. They have a strong dividend history, raising it from $.213204 a share in 1998 to the current dividend of $1.60 a share. Their gross margin in the year 2004, 2005, and 2006 has been 34.7%, 40.3%, and 37.7% respectively. This stock appeared on the top 25 Joel Greenblatt’s Magic Formula stocks over $100 million market cap on 5/6/2007 which is based on Pre-Tax Earnings Yield and Pre-Tax Return on Capital.

Technicals

VGR has been on a tear this past year, like most tobacco stocks. It is currently trading near its high of the year. The uptrend is still in tact, the 20DMA is greater than the 50DMA which is greater than the 200DMA, but the 20DMA is moving dangerously close to the 50DMA, and if it cross it could be a big momentum shift. Momentum has been slowing already though; MACD and RSI are both diverging with the stock trend. There seems like there will be support along the 17 area, followed by the 15 area.



Conclusion

The tobacco industry is obviously in decline, but that still has not stopped tobacco stocks from outperforming the market. There is a lot to like about the Vector Group besides the 8.7% yield, they use their capital wisely, have a high earnings yield, are owned by Carl Icahn and David Dreman, and 24.5% is owned by insiders. Also, their performance will not suffer in an economic slowdown due to the nature of their product. One issue with the company that I have encountered is that the lawsuits that are currently pending against them, but this is the nature of the business. All the other cigarette producers are experiencing the same issue. I will be looking to add this to my portfolio once the stock pulls back to the $15-$17 a share range.

Disclosure: I don’t have a position in VRG.