DOUG - Revisiting Our Vector Group Ltd. Trade

Summary

• The tobacco business has gained market share and as of last quarter was at its highest market share within the industry since 1984.
• Management has held the dividend steady at $0.20/share.
• With shares up strongly, we think dividend investors and income investors who were using VGR as a bond proxy might now have diverging strategies.

Last July we wrote about Vector Group Ltd. ( VGR ) and why we were bullish the stock . As it turns out, we were a few months early to the trade, but for those who liked the trade and acted upon it there are still some really solid unrealized gains. While the S&P 500 is up 3.44% since that article was published, Vector Group shares have moved higher by 15.60% and with the dividend factored into the returns, the total return for Vector Group is 20.28% since publication. Sure, it would have been better to be buyers in late September or in October at prices in the single digits, but it is very difficult to get upset with a holding that has a total return multiples higher than the general market.

This brings us to our predicament today. Back when we initially covered Vector Group, we laid out the case for why the market was overreacting to the company's ability to continue to pay the dividend after spinning off its real estate brokerage business, Douglas Elliman ( DOUG ), and argued that with management now focused on building up another discount brand that the dividend was probably safer than many realized. In fact, we argued that over time not only would the dividend be getting "safer" as management built up the new brand, but could also increase moving forward.

Today we still believe this to be true, especially after last quarter's results showed the deep-discount Montego brand growing very strongly and the company succeeding in grabbing vacated market share. Revenues from continuing operations were up sharply in the quarter and so too were earnings - although we would point out that adjusted net income was up a less impressive 10% (although that is still very strong!).

Management Is Delivering

When we last discussed Vector Group, it was a company in transition. Management was reinvigorated to be launching a brand to grab market share from a competitor who had pulled out of the market after having just spun off its real estate brokerage business. The story then was that they were going to work to grab market share with this amazing opportunity and EBITDA would follow (which would replace revenues and earnings lost from the loss of the brokerage).

Management, in our eyes, has delivered so far. Market share has been gained, and as was discussed on the conference call back in November , the company achieved its highest market share total since 1984. The Montego brand rollout has been successful and we suspect that profitability will ramp up in the quarters ahead as management adjusts pricing across all of their brands to optimize prices for the consumer and the company's realized profits.

Stronger Balance Sheet

In our last article we highlighted three ways that management could keep the dividend at its current level. They were as follows:

1. Deliver on growth strategy with the Montego brand

2. Begin paying down debt when possible

3. Buy back company stock with the cash on hand (which reduces outflows via dividend expense)

Management is succeeding on our first point, and we think that the story there will continue to play out over the next few quarters as well, as growth will eventually shift from market share to growing revenues and profits via price adjustments and cost management.

On the second point, we highlighted how the company had bonds outstanding with a 10.5% coupon which were trading at a discount. Simply using cash on the balance sheet to buy these bonds on the open market would create significant interest expense savings and the net of interest income lost and interest expense saved would help shore up the dividend.

On this point, management saw what we saw and was active in the market in Q3. On the last conference call, Vector Group's President and CEO Howard Lorber, stated that the company "repurchased and retired $12.9 million in aggregate principal" of those bonds which had a coupon of 10.5% - with the added benefit of lowering annual interest expense by $1.4 million. Not a lot of money to be sure, but roughly equivalent to about 1% of what the company spends annually on dividends.

How We Trade This Moving Forward

Depending on what type of investor you are, and what kind of portfolio these shares were purchased for, there are two ways to trade this. For dividend investors the stock is still a 'Hold' at current levels. There is still a little upside for those willing to hold for another year or two as the overall story plays out and management is able to adjust the balance sheet and optimize the debt size. We suspect that management could use 2023 and 2024 to not only boost the bottom line via growth in the operating business but also by paying down debt.

For investors who utilized this name as a bond proxy, which was our recommendation at the time, we think that it might be time to rotate out and pocket gains which we were not expecting this quickly. Yes, the dividend yield is still north of 6%, but we would point to the 15.60% capital gain that was delivered in only about 6 months' time. It is a strong return, an even stronger annualized return, and the size of the gains on a bond proxy trade forces one to take them. We would also note that interest rates are up sharply since our article and that rotating back into them now, having not only missed the capital gains destruction that occurred there but also now being able to get exposure to higher rates (although bond yields are still lower than Vector Group's yield within the investment grade arena, it is a way to de-risk one's fixed income portfolio), makes a lot of sense for those who may need to protect their downside.

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