Why Vector Group Stock Is Up 26% in 2014

Vector Group's (VGR -0.10%) stock price has climbed 26% since the start of the year, giving investors a 31% year-to-date return including the dividend. Vector's performance crushed the S&P 500 index, which returned 7% year to date including dividends. In order to properly analyze Vector, investors should understand why the market is rerating the stock and whether the stock's strong performance will continue or if it has reached its peak.

Source: Vector Group

Changing expectations
For the last few years, Vector has been viewed as a discount cigarette manufacturer on the decline. As a small cigarette manufacturer, Vector qualifies for a special provision in the Master Settlement Agreement that exempts the first 1.63% of its cigarette market share from payments owed under the settlement. This gives Vector a cost advantage over larger rivals on about half of its cigarette production.

However, Vector's market share is shrinking as competitors boost their presence in the growing discount segment; the company's market share declined from 3.8% in 2011 to 3.5% in 2012 to 3.3% in 2013. Vector shipped 1 billion fewer cigarettes in 2013 than in 2012 -- a huge drop-off for a company that shipped only 9.1 billion cigarettes last year. Given that discount cigarettes accounted for 96% of Vector's 2013 consolidated revenue, investors had reason to be skeptical of the company's ability to pay its dividend.

At year-end 2013, Vector's stock changed hands at $16.37 per share and yielded 9.5%, reflecting a poor outlook for the company and its dividend. However, the market has reset expectations for the stock since Vector announced it would increase its stake in real estate subsidiary Douglas Elliman Realty. The move called attention to Douglas Elliman's strong performance, which had escaped investors' attention while it was an unconsolidated entity. Now that Vector owns more than 70% of the company, Douglas Elliman's earnings will be reflected in Vector's consolidated earnings, making the stock appear cheaper.

Source: Douglas Elliman

Compelling growth
The stock is up 26% after the market revised its expectations for Vector. Apparently, the market noticed Douglas Elliman and liked what it saw. Douglas Elliman's earnings before interest, taxes, depreciation, and amortization grew 50% in 2013 to $46.6 million. In the first quarter of 2014, it generated $7.4 million in EBITDA compared to $681,000 in the first quarter of 2013. If it performs the same in the rest of 2014 as it did in 2013, it will generate $53 million in EBITDA. According to Morningstar, Vector's consolidated financials reported $112 million in EBITDA over the last four quarters, meaning Douglas Elliman's consolidation will boost EBITDA by nearly 47% before growth.

If Douglas Elliman grows EBITDA by 15% over 2013 in quarters two through four, it will generate a 54% increase in Vector's reported EBITDA, assuming tobacco's contribution remains the same. If earnings per share grow by the same amount, Vector will generate more than $0.72 in earnings per share over the next four quarters.

At the beginning of the year, Vector traded at 23 times the $0.72 earnings-per- share estimate . It has since zoomed up to 29 times that estimate. Having grown EBITDA by more than 37% in the fourth quarter of 2013, Douglas Elliman is clearly growing at a high rate. Continued growth could justify the higher price.

Catalysts could unlock additional value
Simply waiting for Vector's real estate results to filter through to full-year earnings and become a meaningful growth engine in the years ahead may be enough to boost the stock price, but there are a number of things that Vector could do to unlock shareholder value even faster.

For example, the company could sell or spin off Douglas Elliman, allowing an acquirer or the market to value the subsidiary as a stand-alone entity without having to pay for the tobacco business. Vector could also liquidate the real estate properties it owns outside of Douglas Elliman, which are valued at nearly $130 million on the latest balance sheet and are not consolidated in earnings.

Any one of these actions would serve to unlock shareholder value sooner rather than later. Given that Vector's CEO owns 4% of currently outstanding shares, investors have reason to believe that management will act in shareholders' best interest. As a result, further value-unlocking actions could be taken within the next year or two.

Foolish takeaway
Vector's stock price has crushed the S&P 500 since the beginning of the year. The market's sudden realization of Douglas Elliman's value caused a sharp rerating of the stock. Although the stock is no longer an obvious bargain, the CEO has several options at his disposal to unlock additional value. Given the CEO's significant stock ownership, Vector's stock price may still have room to run.