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Here's Why Vector Group is a Great Investment

By Rupert Hargreaves – Mar 18, 2014 at 9:59AM

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Vector Group is the fourth-largest publicly traded cigarette company in the United States, driving growth in the discount section of the market.

Most investors are well aware of the four main public tobacco companies in the United States: Altria (MO -1.09%), Reynolds American (RAI), Philip Morris International, and Lorillard. Philip Morris International is not active within the United States and Altria, Reynolds, and Lorillard control most of the domestic cigarette market. However, there is a fourth listed domestic cigarette company: Vector Group (VGR -2.17%).

Vector manufactures and sells cigarettes through its Liggett Group and Vector Tobacco subsidiaries under the Pyramid, Grand Prix, Liggett Select, and new Eagle 20s brands. Although Vector is the fourth-largest publicly listed tobacco company within the United States, the company only has a teeny tiny share of the market. Vector reported tobacco revenue of around $1 billion for full-year 2013 and operating income of $188 million, up 7% year-over-year; for comparison, Altria hit $25 billion in sales.

To further highlight Vector's tiny share of the domestic tobacco market, the company recently reached an agreement with the U.S. government which allowed it to postpone making tobacco settlement payments until the company's market share of the domestic cigarette market exceeds 1.65%.

That being said, current trends within the domestic cigarette market indicate that Vector may snatch market share away from its peers faster than expected.

Numbers reveal trends
Data supplied by Reynolds within a shareholder presentation at the end of last year shows that "down-trading" is taking place within the U.S. domestic cigarette market. Reynolds noted that since 2006, the number of premium cigarettes sold as a percentage of the overall volume of cigarettes sold within the United States has declined from just over 70% to 58.6%. Meanwhile, sales of value cigarettes now account for 41.4% of the total market, up from just below 30%.

What's more, Reynolds reports that the markets for pipe and roll-your-own tobacco, products that generally result in lower costs per equivalent cigarette, have exploded over the same period. For example, annual sales of pipe and roll-your-own tobacco rose from 20 million pounds in 2006 to an estimated 41 million pounds for the full year of 2013.

Reflect in results
This trend is actually reflected Altria's full-year 2013 results. Specifically, Altria reported that during 2013 the volume of Marlboro cigarettes shipped by the company declined by 4.3%. Meanwhile, the volume of 'value' cigarettes shipped by Altria during the period pushed higher by 3.1%. Still, discounted cigarettes sold by Altria only accounted for just under 7.9% of the total volume of cigarettes sold by the company during 2013. This was up from a figure of 7.3% during 2012, however. The rising number of value cigarettes sold by Altria has gone some way towards offsetting the falling number of premium-price Marlboro cigarettes sold by the company .

Surprisingly, this trend toward value has not carried through to Reynolds' product offering, which is of some concern considering that the company believes that its Pall Mall brand of cigarette is, and I quote, "a quality cigarette at an affordable price." Despite this belief, sales of Pall Mall declined 2.7% during 2013 and the company's sales of other value branded cigarettes slumped by 7.1%. This was worse than the industry average decline of 3.9 %.

So where does Vector factor into all of this? Well, Vector produces the Pyramid deep-discount brand, which has a strong national following. Vector has decided to leverage this position in the market by introducing a new brand, Eagle 20s, as mentioned above. The key goal of Eagle 20s is to offset the company's declining cigarette sales of non-core brands as well as offering consumers an alternative to Pyramid. Eagle 20s got off to a bad start, but management remains upbeat and the company has been able to leverage its distribution network to get Eagles into around 40,000 retail outlets nationwide.

Like almost all of its peers, Vector has also pushed into the e-cig market with Zoom, a product manufactured within China and developed in Germany using German engineering. So far this product has been accepted in 25,000 retail stores nationwide .

What about that yield?
Vector Group currently offers a 7.8% annualized dividend yield, nearly four times greater than the market average and significantly above that of the company's tobacco sector peers. However, the most important question is whether or not Vector can sustain this payout.

Well, it's hard to tell. Unlike its tobacco sector peers, Vector's business is much more complicated as Vector is not a pure tobacco company. The majority of Vector's income comes from real estate. From looking at SEC filings, though, it would appear that the company has plenty of cash to cover the dividend payout due purchase and sales of investments.

All in all, including the movement of investments and payment of the dividend, Vector saw its cash balance decrease by $171 million to $234 million during 2013. During 2012, however, the company reported an increase in its cash balance of $165 million. So overall, the company is managing to find cash to pay the dividend .

Through property asset sales, retained profits, and debt issuance, Vector has been able to maintain its lofty dividend payout for the past few years. It looks like it will be able to maintain this cash return in the near future as well.

Foolish summary
Vector Group presents an interesting opportunity. The company is a play on the value section of the United States' domestic cigarette market, and its impressive dividend yield looks well covered at more than double the sector's average.

Rupert Hargreaves owns shares of Altria Group. The Motley Fool has no position in any of the stocks mentioned. 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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