Description

Unfollowed, uncorrelated, catalyst-rich, high-yielding Magic Formula equity with huge hidden prime real estate and brokerage assets ripe for monetization via spin-off or sale.  Core business worth the full TEV, while fast-appreciating Douglas Elliman brokerage and NYC, Palm Springs & Miami real estate assets are ignored by the market and therefore free.  All this in a stock that trades at the same price it did in 2010 and which I believe has the potential to generate a 90% one-year return once the situation is understood and likely catalysts play out.

Company Overview:

Market cap:  $1.6bn

TEV:  $2.2bn (at face, unconverted)

Average daily volume:  0.4mm

Insider ownership:  29.5%

Short interest:  6.7mm (10% of float)

Dividend:  $1.60 (9.6% yield, just raised from $0.38 to $0.40/quarter, raised consistently since 1999)

Vector Group Ltd. (NYSE: VGR), through its subsidiaries, is a leading manufacturer of discount cigarettes in the U.S.  The company operates in Tobacco and Real Estate segments.  The company provides 117 combinations of cigarettes under the PYRAMID, GRAND PRIX, LIGGETT SELECT, EVE, and USA brand names for the military and large grocery, drug, and convenience store chains, as well as for the candy and tobacco distributors.  It also offers residential brokerage services, as well as invests in various real estate properties.  The company, formerly known as Brooke Group Ltd., was founded in 1911 and is based in Miami, Florida.  VGR’s Chairman is Bennett LeBow, who is a well-known investor, having bid for RJR Nabisco in partnership with Carl Icahn and having owned companies including SkyBox trading cards, Western Union, Information Displays and others.

Thesis:

• It is clear why this opportunity exists.
  • Uncovered, entirely off the radar of both the buyside and sellside investment communities.
  • Zero sellside analysts cover the stock.
  • Not written up on VIC in nearly 12 years (far different company back then), never written up on SumZero.
  • Largest non-quant hedge fund owner is Gotham, with a 0.5% stake. (Well, Gotham is not quite like RenTech or Citadel!)
  • Unloved, misunderstood core tobacco industry in slow decline on the surface, yet in reality experiencing very strong profit and FCF growth.
  • Company is purveyor of discount brands completely unknown to overeducated Wall Street types.
  • Key information (e.g. financial information regarding hidden real estate assets) can only be found by parsing public filings “F pages,” conference call transcripts and doing primary research on the properties themselves.

• Massive, highly valuable hidden real estate and brokerage assets ripe for monetization, which the CEO seemed to indicate is likely on Q3 conference call.
• VGR is known by the investment community as a leading manufacturer of discount cigarettes.  However, effective December 16^th, VGR became the majority owner of Douglas Elliman, the leading real estate brokerage firm in the NYC metro area and 4^th largest in the U.S., by increasing its stake from 50% to 70.59% via a contractual buyout of Prudential on highly favorable, pre-ordained terms.  Based on the public comparable Realogy Holdings (NYSE: RLGY), the Douglas Elliman stake is likely worth ~10x its last reported book value of only $78.7mm.  Freed from the Prudential franchise and under the control of VGR, several positive developments result:
  • Douglas Elliman financials will be consolidated into VGR financial statements (likely beginning Q1 2014, possibly Q4 2013), increasing reported EBITDA by 30%+.
  • Douglas Elliman will save ~$7mm/annum in franchise/royalty payments, all of which is incremental EBITDA (included in the $67mm pro forma estimate).
  • Douglas Elliman is expanding into key target markets (e.g. South Florida, which has recently occurred, and Beverly Hills, which was announced last week).
  • I estimate Douglas Elliman’s run-rate revenues and EBITDA at $480mm and $68mm, respectively, based on seasonality and adjustments for Prudential fee and new Beverly Hills market (see spreadsheet link below).
  • Multiple strategic alternatives for VGR to realize tremendous value are created; RLGY trades for 2.1x revenue and 16x EBITDA.
• In addition, VGR owns ~15 non-recourse equity stakes in luxury real estate projects, primarily located in prime Manhattan, Miami Beach and Palm Springs locations (see link above and spreadsheet for details).  These real estate investments are carried at cost and each likely is worth 1-5x last reported book values (most are levered at the project level), depending on vintage, with enormous potential for continued appreciation.  All are luxury/ultra-luxury developments.
• Q3 conference call, CEO Lorber refers directly to Realogy:

• Strong core cigarette operations generating prodigious cash flow.
  • Driven by rising gross margins through consistent price increases, VGR’s discount cigarette business has increased cash flow to a run-rate of nearly $200mm (EBITDA-capex).
  • Rolling 12 month tobacco gross profit has risen every quarter since broken out in reporting, from $248mm in Q2 2012 to $283mm in Q3 2013.
  • Since 2010, gross margin has risen from 19% to 28% (excise tax collection grosses up both sales & COGS in this calculation).
  • Minimal capex typically ranges from $4-11mm annually.

• Cost advantage over other manufacturers driving market share gains.
  • Because it has a relatively small market share (~3.5%) and the Master Settlement Agreement (MSA) calls for payments only on market share exceeding 1.93%, VGR has a significant cost advantage over larger manufacturers.
  • Re-introduction of PYRAMID brand and new Eagle 20s brand are driving market share gains as distribution grows.

• Comprehensive settlement reached in October on Engle Progeny cases substantially removes litigation overhang.
  • >4,900 of the 5,300 individual plaintiffs dismissed claims; company incurred after-tax charge of $53mm in Q3 2013 relating to settlement agreement.
  • “One or two” lawyers control the bulk of the remaining claims, and management is optimistic for their settlement per the Q3 conference call.

• 9.6% dividend yield driven by highly incentivized and aligned management and major shareholders.
  • Quarterly dividend increased from $0.38 to $0.40 on December 2^nd  
  • Dividend has increased consistently from $0.03/qtr in 1995 to $0.40/qtr at present.
  • In addition, the company has paid an annual 5% stock dividend each September since 1999, which while not value-creating in itself, speaks to management’s confidence in paying dividends on modestly rising share counts.
  • While the dividend modestly exceeds current FCF before Douglas Elliman consolidation, the dividend will most certainly be maintained if not increased further as core cash flows grow and real estate assets are monetized.  Large cash balance and liquidity provides buffer.

• Large insider ownership totaling 29.5% (unconverted) in a single common share class, led by Chairman and noted investor Bennett LeBow (75, two daughters) and controversial billionaire Phil Frost(76, no children), both of whom have strong interest in maximizing the value of VGR shares.  Further, a liquidity event for VGR could allow Frost to focus on his core OPK investment, which is 6x the size of his VGR stake.
  • Frost Group:  13.5% (higher including his convert ownership)
  • LeBow Gamma Limited Partnership:  6.0%
  • Bennett LeBow (Chairman):  5.4%
  • Howard Lorber (CEO):  3.8%
  • Other insiders:  0.8%

• Multiple catalysts for value realization.
• Consolidation of Douglas Elliman financials:  Now that VGR owns a controlling interest (70.59%) of Douglas Elliman, the company’s financials will be consolidated in VGR, bringing this asset’s profitability into the light of day.  For Q3 2013, Douglas Elliman generated $128mm of revenue and $18.5mm of EBITDA.  The elimination of Prudential royalties will add $6-7mm/annum to EBITDA per Q3 conf call.  Inclusive of the new Beverly Hills office, ramped up Palm Beach/Miami presence and $7mm of Prudential fee savings, I estimate it is run-rating at ~$480mm of revenue and ~$68mm of EBITDA.
• Spin-off of Douglas Elliman (or the entirety of New Valley LLC) into standalone public company:  Using Realogy as a comparable (2.1x revenue), Douglas Elliman is likely worth at least $900mm, and given the premium NYC location, could be easily worth $1.0-1.5bn.
• From Q3 conference call, a spin-off is clearly being strongly considered, VGR’s CEO himself references RLGY as a comp. 

• Sale of Douglas Elliman:  Simpler than a spin-off, management may choose to sell their prime brokerage asset.  Multiple strategic buyers would be interested, including Berkshire Hathaway, Realogy and CBRE, given the firm’s strong revenue and EBITDA growth and prime footprint.

  • Berkshire Hathaway is making a concerted effort to enter the real estate brokerage business, having acquired Prudential’s network in 2012.  The premier Douglas Elliman brand would likely be highly attractive as Berkshire seeks to build its brand and national scope, and Elliman could bring NYC, South Florida and Beverly Hills in one transaction.
  • Douglas Elliman would likely command a premium to RLGY due to its dominance in prime, luxury markets, but my analysis does not model such a premium.
  • Minority holders of Douglas Elliman (i.e. D.E. management) would be wise to realize a liquidity event for their illiquid stake.
• Sale of Tobacco division:  With MSA and Engle Progeny cases in the rearview mirror, and strong/rising margins and cash flow dynamics of VGR’s discount tobacco business, this unit could readily be sold to strategic buyers.  Comps range from 9-12x EBIT and 3.6-5.1x net sales.  With VGR’s tobacco unit run-rating $600mm of net sales (excluding excise taxes) and $204mm of EBIT, this unit is worth ~$2.3-2.5bn, perhaps more given the strong cash flow growth profile and available synergies.  At a 7% implied unlevered FCF yield, tobacco division would be worth nearly $3.0bn to a strategic buyer, which is in line with the high end of the TEV/sales comps.
• Realization of other real estate investments:  As Manhattan, Palm Springs, Miami and other investment properties are completed and exited, value creation most likely multiples of book value will be realized (most minority investments are leveraged at the project level, non-recourse to VGR).  The Company sold 200 Escena (a Palm Springs development VGR acquired in 2008 by buying the mortgage note in foreclosure) lots for $22.7mm net of selling costs in October 2013, while 667 residential lots, an 18 hole golf course, clubhouse and 7-acre hotel site remain.  At $100k/lot, the remaining lots alone are worth $66.7mm, while the investment is marked at only $13.1mm on the balance sheet.  
• High short interest:  There is a short interest, driven in large part by convert hedging, of 6.7mm shares, representing 10% of the float and 15 days to cover (using 100% of average daily volume) and 75 days to cover (using 20% of average daily volume).  The cost to carry this short is 11.2% per annum given the 9.6% dividend yield and 1.6% cost to borrow.  Once the story is more widely understood, I expect the short interest to fall significantly.

Valuation:

• On a fully diluted, fully converted basis, I believe the shares are worth $30, representing an 81% premium to current value, plus 1 year of dividends achieves a 90% total return. 
• At a $30 valuation, the implied dividend yield would be 5.3%, still at high end of comps.
• See link here for full valuation (tab 1) and segment data (tab 2) spreadsheets:  https://drive.google.com/file/d/0B0xSSQ9VQorNbTdBY2oySWNUMk0/edit?usp=sharing

Links:

• Conference calls:  http://www.investorcalendar.com/CustomEvent/NA012722/index.asp?ID=171442
• Q3 earnings release:  http://finance.yahoo.com/news/vector-group-reports-third-quarter-203300119.html
• New Valley (real estate investment division):  http://www.investorcalendar.com/CustomEvent/NA012722/index.asp?ID=171442  
• Vector Group Acquires Additional 20.59% Interest in Douglas Elliman Realty:  http://finance.yahoo.com/news/vector-group-acquires-additional-20-140000794.html
• The Real Deal:  “Elliman may ditch ‘Prudential’ name”:  http://therealdeal.com/blog/2012/02/09/elliman-may-ditch-prudential-herman-says/
• The Real Deal:  “Douglas Elliman officially drops ‘Prudential’ from brokerage name”:  http://therealdeal.com/blog/2012/11/19/douglas-elliman-officially-drops-prudential-from-name/
• “Elliman Secures First L.A. Office After Six Month Delay”: http://www.elliman.com/news/elliman-secures-first-l-a-office-after-six-month-delay/8671

Primary Risks:

• Reversal of strong profitability trends in core discount cigarette business.
• Reversal of strong ultra-luxury real estate markets, particularly in Manhattan, Palm Beach and Beverly Hills.
• Inability to settle the few remaining Engle Progeny cases on expected terms.
• Ownership concentrated in the hands of LeBow and Frost; related party transactions are numerous but do not impact my investment thesis.
• VGR’s ownership of securities of Morgans Hotel Group (Nasdaq: MHGS) and Frost-controlled LTS and OPK.
• Dividend is not presently fully covered by operating cash flow, but given large cash balance and liquidity coupled with income from property sales and consolidation of Douglas Elliman, the risk of a reduced dividend is de minimis in my view.  Further, the dividend was just raised in this most recent quarter.

Disclaimer:  The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice.  The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.

Catalyst

• Investor awareness.
• Strong growth of core tobacco cash flow.
• Consolidation of Douglas Elliman results into VGR financial statements, causing reported run-rate EBITDA to grow dramatically, and forcing investor recognition.
• Sale or spin-off of Douglas Elliman or entire New Valley LLC real estate division.
• Sale or spin-off of core tobacco division.
• Realization of substantial gains from real estate investment portfolio.
• Reduction of short interest