Description

Vector Group (VGR) is the sixth largest cigarette manufacturer in the U.S. based on unit sales, and primarily operates in the discount and private label segment of the cigarette market. VGR primarily operates through its two subsidiaries, Vector and Liggett. While Liggett has been a significant player in the discount cigarette market for years, and currently generates almost all of VGR’s current cash flow, Vector has recently developed, and is currently marketing, one cigarette which has significantly reduced carcinogens, and another which has virtually no nicotine. The former is being marketed under the Omni brand name, and the latter as Quest. The thesis is simple: Liggett alone is worth in the low $30s per share on the stock, and any upside from the new cigarettes is simply gravy. This gives a low case upside of 50% on the stock, and possibly significantly more if Vector’s new launches are successful. In the meantime, you get paid to wait as the dividend yield at today’s price is 7.3%. With net cash on the books at March 31 of $156 million, I consider the dividend pretty safe.

Historical numbers seem misleading in looking at VGR as it used to have numerous varied interests ranging from Russian real estate to an ownership interest in U.S. brokerage firm Ladenburg Thalman, among others. Management had disposed of virtually all of these ancillary businesses as of the fourth quarter of 2001, and is now focusing solely on its cigarette business. It still has some real estate interests, however these are not meaningful in size or contribution.

The U.S. cigarette industry is an estimated $35 billion business in the U.S. Despite annual volume declines in the mid-single digits every year as anti-smoking campaigns have taken hold, industry revenues have increased at over a 14% compound annual rate since 1997 due to price increases. Indeed, pricing has doubled since 1997. Although some of this is captured in increased excise taxes and payments under the Master Settlement Agreement signed by the industry in 1998, the 'minors' in the industry are exempt from MSA payments until they reach pre-determined volume caps. This has allowed the ‘minors’ to reap the gains of most of the price increases. The cigarette business has significant barriers to entry due to the fragmented distribution network, the severe limitations on advertising, which therefore favors existing participants, and the brand loyalty exhibited by many smokers. As such, despite gross margins in excess of 80%, existing players have a relatively protected position and generally vie for market share amongst each other.

Vector group operates primarily in the discount segment of the cigarette business. Since 1997, the 'minors' in the industry have grown their market share from 2.3% to 8% currently. Over the same time period, Liggett has grown its market share in domestic tobacco from 1.3% to 2.2%, accounting for a significant percent of the 'minor's' market share gains. This is even more impressive when considering that every market share point is $350 million. While this is likely to continue, many of the smaller players are bumping up against market share caps imposed by the MSA, over which they must start making payments under the agreement. Therefore, market share gains will likely moderate over coming years. That being said, consolidation among the smaller players has now set the stage for accelerated price increases among the discount players. The increased concentration should lead to a narrowing of the gap between the discount and premium pricing in the market.

While VGR continues to reap the cash flow from the discount side of the cigarette business, it is currently marketing two new cigarettes in the premium side of the business under the Omni brand name. One cigarette has reduced carcinogens through a proprietary manufacturing process. The other is a nicotine-free cigarette manufactured using a genetically modified seed. While the jury is out on the market for each of these products, they both have significant potential, which is unquantifiable and, quite frankly, anyone's guess. However in the meantime, Vector is spending close to $50 million on a marketing campaign to launch these new products. In addition, they have to spend money hiring new sales people and educating the distributors. The bottom line is that the new cigarettes will certainly be an earnings drag (no pun intended) until they are either successful or the company shuts down the program. Management has indicated that they are committed to giving the product at least until the end of 2003 before it is declared viable or not.

Due to the discretionary nature of the added expenses of launching the new cigarettes, the most appropriate way to look at Vector’s valuation is to value Ligget on its own to get a base valuation, and treat any value for Omni as upside. On this basis, Liggett should be able to achieve EBITDA of approximately $187 million in 2002, up from $124 million in 2001, driven primarily by price increases, its recent acquisition of Medallion, and, to a lesser extent, organic volume growth. Using a 6.5x EBITDA multiple, the industry average, Vector would be valued at $34.50. Similarly, on a yield basis, the industry trades at approximately 4.4%, which would value vector at $36. Applying a 10% discount to these valuations I arrive at a $31-$33 value for Liggett on its own. I have not attempted to value Omni as it is way too early to gauge the success of the product launch. However, to give a rough estimate of the potential, if Omni can garner 0.2% of industry volumes, this would translate into roughly $30 million of EBITDA. Using the same 6.5 multiple gives upside of $5-6 per share. Once the company is able to pare back advertising expenses for Omni, however, the EBITDA could be significantly higher.

Lastly, I should point out that the two largest holders of the stock are Carl Icahn and Ben Lebow, two people that may be perceived as controversial. I have no insight into what their thinking is regarding the end game for VGR, but I feel good knowing that Icahn owns his stock above today's levels.

Catalyst

Beyond the possible success of Vector's new cigarettes, a catalyst is difficult to pinpoint. However the stock pays you to wait for the significant valuation gap to close with its juicy dividend yield