Coffee Sipping Big Board Stocks

[EZ2]

Vector: Undervalued, Growing Fast, Yields 7%

MARKETWATCH 6:17 PM ET 08/14/14

Symbol Last Price Change
VGR 21.99up 0 (0%)
RAI 57.7up 0 (0%)
LO 60.63up 0 (0%)
BRK/A 202850up 0 (0%)
QUOTES AS OF 04:02:36 PM ET 08/14/2014

Cigarettes are bad for your health. And for some investors, that's enough of a reason to stay away. But for those who do not object to tobacco stocks on moral grounds, they have been beneficial to portfolios, in no small part because of their generous dividends.

Take Vector Group(VGR) ), a holding company that owns Liggett Group, the fourth-largest tobacco manufacturer in the nation, among other cigarette brands. With market capitalization just over $2 billion, Vector is often in the shadow of its larger rivals, but it produces steady, high-quality cash flow and has a diversified revenue stream thanks to an unusual asset: It owns 70% of Douglas Elliman, the fourth-largest real-estate company in the U.S.

The market, however, is underappreciating these holdings--as well as the chance Vector could be snapped up in ongoing consolidation in the tobacco sector.

"Vector is a largely underfollowed company with a highly competent management team and numerous ways to unlock value," says Oppenheimer analyst Ian Zaffino, who recently initiated coverage of the stock with a Buy rating. He notes that the company has been able to consistently increase Ebitda (earnings before interest, taxes, depreciation and amortization)-- at a 29% compound annual growth rate in the past half decade--and has been aggressively expanding its real-estate presence.

Yet despite this growth, the stock doesn't get much attention from analysts or investors, leading to a valuation gap.

Investors may be put off by Vector's nose-bleed price/earnings ratio: It trades at 27.8 times forward earnings estimates. But P/E is misleading as it doesn't account for the company's nonconsolidated real-estate holdings and equity in joint ventures. On an enterprise value to Ebitda basis--a widely used metric given the company's asset mix--Vector trades at 11 times, compared to an average of 14 for the tobacco group. Its dividend yield, 7.3%, is meaningfully above its peers, whose payouts average 4%.

"Vector is trading well below its intrinsic value," says David Bechtel, principal at Barrow Street Advisors, who notes that the company has increased its dividend by a factor of 10 in the past 20 years. "Management has clearly shown its dedication to sharing corporate cash flows...and given the cash that this company kicks off, that dividend is secure." To wit: At the end of the second quarter, Vector had more than $740 million in cash and equivalents on hand--nearly double its total at the start of the year--thanks to strong operational income and refinancing.

Tobacco (including e-cigarettes) accounts for nearly two-thirds of Vector's sales, with the remainder coming from real estate. While tobacco use is on the wane in the U.S., Vector has an advantage: A number of its brands are exempt from making payments under the 1998 Master Settlement Agreement between tobacco firms and state governments, as long as Vector's brands remain below a certain percentage of the market.

This alone gives Vector as much as 65 cents of price advantage on each pack of cigarettes it sells, Bechtel estimates- -before factoring in manufacturing efficiencies and lower advertising costs--a major advantage in the discount cigarette space where it competes.

Even if a bigger tobacco company doesn't snap up Vector for its brands, it could benefit from any disruptions in the market stemming from Reynolds American's(RAI) ) purchase of Lorillard(LO) (LO(LO)).

Given recent Senate hearings, some market observers expect the government to reclassify pipe tobacco, subjecting it to higher taxes, which could be another potential catalyst. Without a tax advantage, many pipe tobacco users would switch to low-cost cigarettes, Oppenheimer's Zaffino believes, playing right into Vector's core market.

Its real-estate prospects are bright, too. Douglas Elliman has been rapidly expanding in highly populated areas including New York, Florida and Southern California. Vector also has stakes in many nonconsolidated real-estate projects that won't show up on the books until they are finished, but are quite valuable. Zaffino estimates that the sale of these projects could bring in close to half a billion dollars.

Vector isn't without risks. Although cigarette litigation is largely behind the sector, a big settlement would eat into its robust cash hoard. E-cigarettes are a wild card at this point, as that nascent industry is in flux, and while Vector's Zoom brand is a very small part of its business, the stock could suffer headline risk from negative e-cigarette news.

Yet Vector's future looks bright, given its strong balance sheet and efficient tobacco operations. Insiders own close to 30% of Vector's stock, suggesting that management is aligned with shareholders.

Nor could its tobacco operations be the only takeover target. As Bechtel notes, "Berkshire Hathaway(BRK/A) ) is snapping up real estate brokerages across the country." Even on its own, as the largest real-estate brokerage in New York City, Douglas Elliman--and by extension Vector--enjoy "a large percentage [of the business] in all five boroughs. That's like owning a piece of the city."

E-mail: [e-mail]

-Teresa Rivas; 415-439-6400; [e-mail]

Subscribe to WSJ: http://online.wsj.com?mod=djnwires


(END) Dow Jones Newswires
08-14-141817ET
Copyright (c) 2014 Dow Jones & Company, Inc.