In a Shifting World, Tobacco Company Vector Group Does the Unexpected

Vector Group faces pressure from Altria Group and other competitors as it struggles in the discount cigarette market. However, Vector's real estate subsidiary could make the stock attractive to adventurous investors.

Jun 8, 2014 at 9:00AM

Vector Group's (NYSE:VGR) prospects as a tobacco company are going downhill after another bad quarter for its discount cigarette volume. Competition from Altria Group (NYSE:MO) and others has put Vector's tobacco business on the ropes. However, the company's real estate investments could save Vector from its apparent demise. Investors bullish on Vector's real estate prospects may find opportunity in the stock's current valuation.

Discount cigarette business getting crunched
Discount cigarettes are Vector's primary business line. The niche accounted for substantially all of Vector's consolidated revenue in 2013. Last year, the discount category accounted for 25.3% of the overall cigarette market, essentially the same share of the declining market as in 2008. However, despite discount cigarettes' relative stability, Vector's market share continues to decline.

Vector's discount share fell from 12.8% in 2011 to 11.6% in 2013. Meanwhile, smaller manufacturers' shares held steady and Altria's discount share increased, despite Vector's cost advantage over its larger rival. Altria's discount share increased from 3.3% in 2011 to 3.8% in 2013, probably due to the tobacco giant's unmatched retail distribution relationships.

Vector's market share will probably continue to decline as Altria accrues modest share gains and as smaller manufacturers exploit their cost advantage over Vector. As a result, its generous dividend could be in trouble. Vector has never missed a quarterly dividend since 1995 and has yielded at least 5% since 1999. However, the company's declining discount market share puts its streak at risk. Vector needs to do something drastic in order to save its high dividend.

Could real estate investments save the company?
Management appears to accept that the tobacco subsidiary's prospects are grim. In December, Vector boosted its stake in residential real estate broker Douglas Elliman Realty from 50% to nearly 70.6%. This caused an accounting change so that Douglas Elliman's revenue is now consolidated on Vector's financial statements. As a result of the change, real estate now accounts for 44% of Vector's overall revenue (excluding excise taxes).

Douglas Elliman is the fourth-largest residential brokerage company in the United States. In 2013, it sold $14 billion in New York metro area real estate, making it the largest broker in that market. The company's fees topped $618 million, $437 million of which would have been attributable to Vector had it owned nearly 70.6% of the company for all of 2013.

Douglas Elliman's scale -- it has 4,401 agents in New York, Long Island, and Westchester County -- and name recognition give it an advantage for winning business in the New York metro area. This advantage enabled the company to grow the dollar-volume of its transactions by 14% from 2012 to 2013. If Douglas Elliman's revenue grows 14% in 2014, it would represent a 10% increase in Vector's overall revenue. This would go a long way toward offsetting the tobacco business' decline.

Does real estate make Vector Group a good buy?
In addition to its stake in Douglas Elliman, Vector owns various real estate investments that are not consolidated in its financial statements. The company's non-consolidated real estate businesses are valued at $130 million, or 6% of its current market capitalization. If you value Vector's tobacco business at 7 times adjusted 2013 operating income, then the tobacco business is worth $1.4 billion. Add in the $130 million unconsolidated real estate figure, and you get a $1.5 billion valuation for everything but the Douglas Elliman stake.

At a $2 billion market capitalization for Vector's stock, the market is valuing the Douglas Elliman stake at $500 million, assuming the company's debt load is sustainable and the tobacco business really is worth $1.4 billion. That's about 11 times Douglas Elliman's 2013 pro forma earnings before interest, taxes, depreciation, and amortization -- a fair price for a growing business.

Foolish takeaway
Vector is quickly becoming more of a real estate company than a tobacco company. Its increased stake in Douglas Elliman will make its 2014 consolidated real estate revenue nearly equal to that of its tobacco revenue. That may be a good thing, as Vector's declining discount cigarette share and a shrinking cigarette market put its tobacco business in a difficult position. Moreover, the market may not have fully factored in the company's real estate growth prospects. If Vector can exploit its scale and name recognition in the New York metro area to sustain its growth, the stock could be a good buy.

Top dividend stocks for the next decade
Altria and Vector are good dividend stocks, but they aren't the best.The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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