Vector Group (VGR -0.10%) will release its quarterly earnings report Monday after having outpaced Altria Group (MO 0.12%) so far this year. The No. 1 U.S. tobacco company lacks the one-two punch that Vector brings to the fight. Even as Vector bleeds share in the discount cigarette market, it has been able to grow tobacco earnings. Moreover, the company's newly consolidated real estate results promise to make reported earnings grow faster than in the past -- putting Vector's stock price on an upward trajectory.
Stable tobacco unit
As the fourth-largest company in the concentrated cigarette market, Vector is 1/45th the size of Altria. Ordinarily, this would make it impossible for Vector to compete since it operates at a scale disadvantage. However, because of its small size, it is largely exempt from payments that Altria must pay under the Master Settlement Agreement. As a result, Vector enjoys a cost advantage over its larger rival.
Even so, Vector's discount cigarette market share has been falling while Altria's has increased. From 2011 to 2013, Vector's discount cigarette share fell from 12.8% to 11.6%. Altria's share increased from 3.3% to 3.8% in the same period. The lost market share has resulted in declining revenue. The trend continued in the first quarter of 2014, when tobacco revenue declined 3% due to a 6% drop in volume.
Fortunately, Vector has demonstrated an ability to make modest price increases in the price-competitive discount category. As a result of a higher gross margin, Vector's tobacco operating income grew 7% in each of the last two years. Tobacco operating income grew by 7% again last quarter compared to Q1 2013.
However, given a price-competitive market and smaller competitors that share the same cost advantages, Vector's tobacco business will not be able to grow earnings forever. Investors should expect similar tobacco earnings growth in the second quarter but should closely monitor the pricing environment to determine whether the tobacco business will become a drag on the overall business or if it still has room to run.
High-growth real estate
While Vector's tobacco business fends off inevitable decline, its real estate business is booming. Douglas Elliman, the real estate broker in which Vector recently upped its stake, will drive Q2 earnings growth. Not only will Douglas Elliman's full financials now flow through to the consolidated income statement, but the real estate broker is growing at a double-digit pace as well.
The consolidation led to a 42% increase in Vector's overall revenue in the first quarter and will lead to a similar increase in the second quarter. Douglas Elliman's earnings before interest, taxes, depreciation, and amortization grew by 50% in 2013 and will likely continue to grow at a double-digit pace for many more years. Combined with growing tobacco earnings, Vector's real estate business will drive significant earnings growth over the next several years.
Meanwhile, Vector's interests in New York real estate properties are also appreciating in value. The company owns an assortment of condominiums, apartments, and office buildings, primarily in the booming New York market. The median price for new condos rose 31% in the first quarter, while Manhattan co-operative apartment prices were also setting records. As a result, investors should expect strong appreciation in the value of Vector's property holdings in the second quarter and throughout the New York real estate boom.
Foolish takeaway
Vector's tobacco business may be shrinking, but its earnings are still growing by a healthy 7% per year. Investors should expect this to continue as long as smokers continue to trade down to discount cigarettes. Moreover, Vector's real estate broker and real estate properties are booming and will drive companywide growth for the foreseeable future. Expect the real estate division to light up Vector's earnings -- and its stock price -- in the second quarter and the years ahead.
