VGR - Vector Group Seems Promising Despite Regulatory Risks

2023-09-03 23:19:55 ET

Summary

• Vector Group manufactures and sells cigarettes and also invests in real estate through apartment buildings, hotels, and commercial properties on the side.
• The company has a strong growth history and high profit margins, making it an attractive investment option.
• Despite regulatory risks in the tobacco industry, my discounted cash flow model suggests a moderate upside for VGR, supporting a buy rating for the stock.

Vector Group ( VGR ) manufactures and sells cigarettes. As an odd addition, the company also invests into real estate through apartment buildings, hotels, and commercial real estate. With a historically quite stable growth and incredibly high margins, the company seems like a good quality pick. Even though the tobacco industry has significant regulatory risks, I have a buy-rating for the stock as my DCF model estimates a moderate upside.

The Company

Vector owns a tobacco manufacturer and seller called Liggett Vector Brands. The company holds brands such as Montego, Eagle 20's, Pyramid, and Grand Prix, positioned in the discount brands. The company has grown the brands through tobacco outlets, mass merchandisers, and variety stores at a large scale compared to competitors - 36.6% of Liggett's sales come from the mentioned sources, as opposed to the industry's 13.4%:

Other than tobacco, Vector owns a real estate firm called New Valley Realty:

Of Vector's adjusted EBITDA of $352 million in 2022, only around $8 million came from the real estate segment according to the company's August presentation - with a real estate portfolio worth approximately $176 million, New Valley represents a very small portion of Vector. New Valley holds assets mostly in New York, as seen on the company's website .

In addition to real estate acquisitions, Vector Group seems to spend cash flows on dividends - the company has a dividend yield of 7.27%, making the payout ratio around 73%. Vector's dividends have a history of mostly growth, but the quarterly dividend seems to have been cut in half in 2020 from quarterly payments of $0.26 to $0.13:

Financials

Vector has had a good growth history, as from 2002 to 2022 the company's compounded annual growth has been around 5.6%:

From 2014 to 2018 the company had significantly higher revenues, as the company consolidated Douglas Elliman's real estate revenues into the company's revenues; the figures seem disturbed for the five years. Vector has since done a spinoff of Douglas Elliman into its own company.

The achieved growth has mostly organically and through real estate acquisitions - the company has a solid growth track record. The company has faced some slowdown in the most recent quarter, though, as in Q2 Vector's revenues fell by 4.2% . The company's COO, Nick Anson, attributes the decline to a slowdown in the industry in Vector's Q2 earnings call :

According to data from Management Science Associates, Liggett's second quarter wholesale and retail shipments both outperformed the industry. Liggett's second quarter wholesale shipments declined by 7.9%, whereas industry wholesale shipments declined 8.9%."

Vector has achieved a very high EBIT margin throughout its history - from 2002 to 2022, the company has had a margin well above 20% on most years:

The margin has reached even higher numbers in the recent history - currently the company's trailing EBIT margin stands at 37.4% despite the claims of a slowdown in the industry. I believe that the achieved margin could be sustained, as Liggett has grown its brands. Also, I don't see a reason as to why the current trailing figure would be significantly boosted by macroeconomic or other factors.

Vector currently has a cash holding of around $330 million and short-term investments of $116 million, securing the company's operations in case of a cash flow downturn. On the other side, Vector seems to leverage debt to its advantage - the company has long-term debts of $1384 million, of which only $0.03 million is in current portions. I believe the debt amount is reasonable, as Vector has earnings very well above interest expenses.

Valuation

On a price-to-earnings basis, Vector seems to be trading below its long-term average - the company's trailing P/E stands at 10.85, below the 5-year mean of 17.64:

As tobacco companies usually have quite cheap valuations due to ESG-related issues, the price-to-earnings ratio seems to be justified. To have a more thorough understanding of the valuation, I constructed a discounted cash flow model in my usual manner.

In the model I estimate Vector to have a growth of 3% for 2023, as the industry is facing a cooldown. For 2024, I estimate a growth of 5.0%, more in line with Vector's history. After the year, I estimate Vector's growth to slowly ramp down into a perpetual growth rate of 2.0%; although the company could prove to grow for more years to come, the tobacco industry has regulatory risks that I believe should be slightly accounted for in the model.

For the EBIT margin, I expect Vector to have a slight decrease in 2023 due to the industry's rough period - I estimate a decrease of 1.7 percentage points from 36.9% to 35.2%. In the following years, I estimate Vector to slightly grow the margin back, as in 2032 the company has a margin of 35.8%. It is important to note that the estimated margin is above Vector's average - there's a possibility that my DCF model estimates too high of a margin, although I don't see it as likely.

These expectations along with a weighted average cost of capital of 10.86% crafts the following DCF model scenario, with an estimated upside of 27% from the current price of $11.00:

The used cost of capital is derived from a capital asset pricing model:

In Q2, Vector had around $27.1 million in interest expenses. With the company's current amount of long-term debt, this comes up to an annualized interest rate of 7.83% - the rate seems quite high, but as Vector operates on a low-ESG tobacco industry, I believe the rate is caused by ethical issues. As the company does have a good amount of debt for its real estate, I believe the long-term debt-to-equity should be somewhere around 25%.

For the risk-free rate on the cost of equity side, I use the United States' 10-year bond yield of 4.18% . The used equity risk premium of 5.91% is Professor Aswath Damodaran's latest estimate for the United States. Although tobacco companies are usually really recession-proof and have low betas, Tikr estimates Vector's beta to be 1.03 - I believe this is caused by the company's more cyclical real estate segment. Finally, I add a small liquidity premium of 0.5% and an ESG-addon of 1.75% into the cost of equity to address the aspects, crafting a cost of equity of 12.52% and a WACC of 10.86%.

Takeaway

As my DCF model estimates an upside for the stock, Vector Group seems like a good investment. The company seems quite cheap even with growth estimates that are slightly below Vector's history - although the regulatory environment poses a significant risk for Vector Group, I see the stock as a good opportunity. As such, I have a buy-rating for the stock.

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