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Vector Group (NYSE:VGR)

Q4 2012 Earnings Call

February 27, 2013 10:00 am ET

Executives

Howard M. Lorber - Chief Executive Officer, President, Director and Member of Executive Committee

Ronald J. Bernstein - Director, Chief Executive Officer of Liggett Group LLC, Chief Executive Officer of Liggett Vector Brands, President of Liggett Group LLC, President of Liggett Vector Brands and Director of VGR Holding

J. Bryant Kirkland - Chief Financial Officer, Principal Accounting Officer, Vice President and Treasurer

Analysts

Kenneth P. Bann - Jefferies & Company, Inc., Research Division

Anton Kawalsky

Operator

Welcome to Vector Group's Fourth Quarter and Full Year 2012 Earnings Conference Call.

Before the call begins, I'd like to read a Safe Harbor statement. The statements made during this conference call that are not historical facts are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those set forth in or implied by forward-looking statements. These risks are described in more detail in the company's Securities and Exchange Commission filing.

Now I'd like to turn the call over to President and Chief Executive Officer of Vector Group, Howard Lorber.

Howard M. Lorber

Good morning, and thank you for joining us on Vector Group's Fourth Quarter and Full Year 2012 Earnings Conference Call. With me today is Ron Bernstein, the President and CEO of Liggett Vector Brands and Liggett; and Bryant Kirkland, Vector Group's Chief Financial Officer.

Today, I will provide an update on our business and review Vector Group's financials for the fourth quarter and full year ending December 31, 2012. Ron will then address Liggett's performance for the period and provide an update on industry developments. After that, we will answer your questions.

As we advised in previous calls, our focus in 2012 was to maintain the strength of our core PYRAMID brand while delivering increased year-over-year operating profit. We are very pleased to have achieved both of those goals for the year despite a challenging industry environment and continuing pressure on the disposable income of consumers. We will discuss our financial results and tobacco performance in more detail in a moment, but first, I want to briefly update you on tobacco litigation and specifically, the Engle progeny cases in Florida.

The Engle progeny cases remain the primary focus of our litigation activity, with 4,516 cases currently pending in both federal and state court, a reduction of 563 cases from the last quarter. Although we and the other industry defendants continue to believe that the Engle process is materially florid and unconstitutional, appellate efforts to overturn the Engle findings have generally not been successful. The intermediate appellate courts have been willing to overturn adverse verdicts on discrete issues of law or where punitive damages exceed constitutional limits but have uniformly upheld the application of the Engle findings in the Engle progeny cases.

However, in September, the Florida Supreme Court heard argument on the Douglas case, a case where Liggett is a defendant. This is the first Engle progeny case to be reviewed by the Florida Supreme Court. A decision is pending. Overall, while we believe we have strong arguments, as evidenced by several defense verdicts in the state cases, there is still considerable risk as these cases go to trial and we remain subject to the ongoing process and periodic negative judgments.

Turning now to Vector's balance sheet. I'm pleased to report that we have recently completed a series of debt financings, which have put in place a capital structure for the company which significantly extend the maturities and the flexibility to permit us to continue to grow our businesses in the coming years. In November 2012, we successfully completed the sale of $230 million of our 7.5% variable interest senior convertible notes due January 15, 2019. The proceeds of the convertible offering will be used for general corporate purposes, including in our tobacco business and in additional investments in real estate projects.

And earlier this month, the company successfully refinanced our senior secured notes to get the benefit of lower interest rates and longer maturities. We sold $450 million of new 7 3/4% senior secured debts due 2021 in a private offering. We'll use the proceeds from the offering to retire the company's 11% senior secured notes, which were scheduled to mature in 2015. Our liquidity remains strong, with cash and cash equivalents of approximately $406 million as of December 31, 2012. Additionally, as of December 30, 2012, the company held investment securities and partnership interests with a fair market value of approximately $94.8 million.

The past several months also have been an active period for New Valley. In August, it was announced that we were moving ahead with partners to develop and convert into luxury residential condominiums. The lease -- recently acquired a 10-story, approximately 122,000 square-foot office building at 11 Beach Street in Tribeca. And in the fourth quarter, we announced that, together with The Witkoff Group and Winthrop Realty Trust, we acquired 701 Seventh Avenue, which is a prime Times Square area site. The property, located on the northeast corner of Seventh Avenue and 47th Street, totals approximately 120,000 gross square feet and is a rectangular corner parcel currently occupied by 2 buildings. We see many attractive redevelopment opportunities for this site, which will include premium space for retail, restaurant and entertainment businesses, as well as a site for potential 30-story hotel.

Additionally, in early January of 2013, New Valley partnered with Property Markets Group and the Hakim Organization to acquire a prime Long Island City property for $37 million. The Long City -- Long Island City location, which is convenient for Manhattan commuters and is in an area that has proved a desirable location for recent commercial development projects, will be redeveloped for residential housing. Moreover, Douglas Elliman will be the marketer for the residential development.

Let me now turn to the key financials for the 3 months and full year ended December 31, 2012, for Vector Group. For the fourth quarter ended December 31, 2012, Vector Group revenues were $277.6 million compared to $292.8 million in the 2011 fourth quarter. The decline in revenues was primarily due to an approximate 8.6% [ph] reduction in cigarette volumes during the period, which was partially offset by higher pricing. The company recorded operating income of $37.4 million in the 2012 fourth quarter compared to operating income of $36 million in the corresponding period in 2011, an increase of 3.9%, primarily due to improved margins. Fourth quarter 2012 net income was $16.5 million or $0.14 per diluted share compared to net income of $7.8 million or $0.09 per diluted share in the 2011 period.

The fourth quarter 2012 results include a pretax gain of $13.5 million from changes in fair value of derivatives embedded within our convertible debt. Adjusting for this item, fourth quarter 2012 net income was $7.8 million or $0.09 per diluted share. Fourth quarter 2011 net income included pretax charges of $5.3 million of changes in fair value of derivatives embedded within our convertible debt. Adjusting for this item, fourth quarter 2011 net income was $11.1 million or $0.13 per diluted share.

For the fourth quarter 2012, adjusted EBITDA was $43.2 million compared to $39.5 million for the fourth quarter 2011. Adjusted EBITDA is a non-GAAP financial measure and should be considered in addition to, but not as a substitute for, other measures of financial performance prepared in accordance with GAAP. A reconciliation of net income to adjusted EBITDA is contained in the company's earnings release.

Vector Group revenues were $1.085 billion for the year ended December 31, 2012, compared to $1.133 billion in 2011. The decline in revenues was primarily due to an approximate 8.1% reduction in cigarette volumes, which was partially offset by higher pricing. The company recorded operating income of $154.9 million in 2012 compared to $143.3 million in 2011, an increase of 8.1%, largely as a result of our improved margins. Net income for the 2012 full year period was $30.6 million or $0.35 per diluted share compared to $75 million or $0.89 per diluted share in the 2011 period.

The results for the full year ended December 31, 2012, included pretax charges of $7.5 million related to changes in the fair value of derivatives embedded within convertible debt and a $15 million pretax charge related to the conversion of the company's convertible debt. Adjusting for these items, net income for the full year ended December 31, 2012, was $43.4 million or $0.50 per diluted share. The results for the full year ended December 31, 2011, included pretax gains from the liquidation of long-term investments of $25.8 million, changes in the fair value of derivatives embedded within convertible debt of $8 million and the sale of townhouses of $3.8 million, offset by $1.2 million charge on the conversion of the company's convertible debt. Adjusting for these items, net income for the full year ended December 31, 2011, was $53.3 million or $0.63 per diluted share. For the 2012 full year period, adjusted EBITDA was $171.1 million compared to $157.1 million for 2011.

I will now turn the call over to Ron Bernstein to discuss our tobacco business. Ron?

Ronald J. Bernstein

Thanks, Howard. Good morning, everyone. As Howard indicated, we're very satisfied with the performance of our tobacco business in 2012. We're particularly pleased to have increased year-over-year operating profit by 7% for the full year and 6% for the fourth quarter. These numbers include a legal judgment expense of $1.4 million in the fourth quarter. While, as expected, the retail shipment rate of our PYRAMID brand slowed during 2012, we were pleased to generate retail growth for both the fourth quarter and full year. PYRAMID's retail market share as of year-end was approximately 2.4%, demonstrating the continued strength of our core brand. Before I elaborate further on performance, let's turn to the financials.

Please note that financial reporting for Vector Tobacco is combined with Liggett. For the 3 months and full year ended December 31, 2012, Liggett revenues were $277.6 million and $1.085 billion compared to $292.8 million and $1.133 billion for the corresponding periods in 2011. The year-over-year revenue decline was primarily caused by anticipated volume declines in our non-PYRAMID brands and the effect of the year-end channel loading by certain competitors.

Operating income for the 3 months and full year ended December 31, 2012, was $45.8 million and $176 million, respectively, compared to $43.1 million and $164.6 million in 2011. We're pleased to have achieved increased operating income in this challenging environment, driven by higher margins on all brands, resulting from price increases that we implemented during the year.

As we've outlined before, our objective is to maintain a balanced approach to pursuing volume and margin opportunities in the market. In essence, we work to maximize short-term opportunities while maintaining focus on brand strength and long-term profit growth. As previously noted, responding to changing market conditions in the second half of 2011, Liggett shifted its short-term emphasis from overall volume growth to pursuing higher margins on our brand portfolio while continuing to build our PYRAMID brand nationally. We continued that focus throughout 2012. We believe that our strong year-over-year earnings performance in 2012 demonstrates the wisdom of that approach.

Entering 2013, we determined that there was an opportunity to further leverage our solid position in the deep discount segment of the market. To that end, in January, we introduced a new national brand, Eagle 20s. While we will discuss Eagle 20s' performance more during the first quarter 2013 conference call, we believe that the addition of the brand will help stabilize our overall volume trends by offsetting losses in our non-core brands. Importantly, Eagle 20s is clearly positioned to be complementary to PYRAMID. The brand is off to a very good start and is clearly benefiting from the robust distribution base we have built with PYRAMID over almost 4 years now.

As we've noted in previous calls, since the excise tax increase in 2009, the cigarette marketplace has changed in some notable ways. There are 2 primary drivers for these changes. The first and most significant driver has been the extraordinary growth of tobacco being sold -- used in cigarettes that is mislabeled as pipe tobacco. This growth has adversely affected the entire legitimate cigarette marketplace, with the most direct impact on the discount segment of the industry.

As a reminder, at the time of the excise tax increase in April 2009, Congress neglected to increase the tax rate on pipe tobacco to the same level as roll-your-own and cigarettes. That opened the door for some companies to game the system by mislabeling roll-your-own tobacco as pipe tobacco, enabling them to evade payment of a substantial portion of excise taxes and other tobacco-related fees. While there has been some progress made by Congress to address this problem, most notably passing legislation that classifies retailers making cigarettes in their stores as manufacturers, the mislabeled pipe category remains strong. Since December 2008, the so-called pipe tobacco category has grown by an estimated 650% from 2.6 billion cigarette equivalents to an estimated 19.5 billion in 2012. While, during the same period, roll-your-own declined from 10.7 billion to 2.2 billion cigarette equivalents.

From various discussions and recent actions, it appears that TTB, the FDA, Government Accountability Office and many members of Congress recognize the issue. However, remedying this problem remains a challenge, especially within the current political environment. As regulators in Congress slowly take action to address mislabeled pipe tobacco, some smokers may switch to filtered cigars, cigarette equivalents that are currently being sold under another unintended tax loophole. While these products are not generally as popular as mislabeled pipe tobacco, we believe that they currently comprise approximately 8 billion cigarette equivalents or almost 3% of the total market, and their appeal, unfortunately, continues to grow.

The GAO has recommended that Congress should consider equalizing tax rates on roll-your-own and pipe tobacco and in consultation with Treasury, consider options for reducing tax avoidance due to tax differentials between small and large cigars. We, of course, support full tax equalization. To that end, Senator Richard Durbin of Illinois recently introduced federal legislation to close the existing tobacco loophole. Importantly, the bill would equalize tax rates on all tobacco products, including pipe tobacco, cigars and smokeless tobacco.

We are also hopeful that FDA and TTB will use the existing enforcement authority that they have to properly regulate this mislabeled products. Some members of Congress are strongly encouraging the agencies to do exactly that, and we have seen some positive guidance from TTB. In addition, a number of states have taken legislative or regulatory actions to address aspects of the mislabeled pipe tobacco problem, a trend that we hope continues and extends to filtered cigars.

The second market change since the 2009 federal excise tax increase has been the significant movement of large domestic and international cigarette manufacturers into the deep discount segment in an attempt to offset declining premium brand volumes. Historically, the deep discount segment has been dominated by smaller legitimate and renegade-type companies, but according to fourth quarter MSAI data, the big 3 companies now comprise a majority, over 50%, of this segment.

Reynolds continues to lead the way with Pall Mall. Altria is building volume with L&M, and Lorillard continues to support Maverick. We have also seen hyperaggressive pricing at times from foreign companies like Japan Tobacco and KT&G on their discount brands.

As noted, despite these industry dynamics and increased pricing, we were pleased to grow retail shipments of our PYRAMID brand in 2012. PYRAMID has a well-established national presence and is currently sold in over 100,000 stores, with a distribution base that grew by almost 5,000 stores in the fourth quarter. PYRAMID remains the seventh largest brand and third largest discount brand in the United States, with a significant opportunity to further expand the brand's national distribution footprint.

According to Management Science Associates, for the full year of 2012, overall industry wholesale shipments declined by just over 2.2%, while retail shipments declined by 2.7%. The discrepancy in the wholesale and retail decline rates is the result of certain companies pushing shipments into wholesale at year-end. All companies experience wholesale and retail declines for the year, with deep-discount-focused companies declining at a greater rate. The lower decline rates from premium-focused companies were largely the result of the significant discounting of their premium products throughout the year. Liggett's 2012 declines in wholesale and retail shipments were 8% and 7.1%, respectively.

For the 2011 year, TTB reported industry taxable shipments declined by 2.6%, which was in line with projections, while declines for 2012 were less than 2%, which was less than industry analysts projected. As you know, the tobacco industry has been subject to the regulatory authority of FDA since June 2009. While the process has developed over the past 3.5 years, there is still uncertainty regarding FDA's regulation and enforcement. In this vein, last December, the U.S. Court of Appeals in Washington rejected the FDA's request to reconsider the court's ruling, blocking the implementation of graphic warning labels on all cigarette packs. It remains to be seen where this issue will ultimately end up, and we continue to watch it closely. In fact, we continue to monitor all FDA developments and remain confident that we'll be able to comply with all aspects of the legislation, if and when they are implemented.

Let me wrap up my comments by again saying that we're pleased with Liggett's performance for 2012. As always, we will continue to adjust to the challenges and opportunities of the marketplace, and I remain confident that Liggett is well positioned to succeed as we go into the future.

Thanks for your attention, and Howard, back to you.

Howard M. Lorber

Thank you, Ron. As you may be aware, during the fourth quarter, Vector management and board members celebrated our 25th anniversary of listing on the New York Stock Exchange. We are proud of the significant annualized returns we have generated since our listing as a public company, and we are determined to continue to produce for our shareholders.

As I noted at the start of the call, we are pleased with our recent performance and continue to believe that Vector Group is well positioned. We have strong cash reserves, have significantly grown our cigarette volumes and market share over the past 3 years, and we'll continue to benefit from our favorable turns under the MSA. Additionally, we are proud of the company's uninterrupted track record of paying a regularly -- regular quarterly cash dividend since 1995 and an annual 5% stock dividend since 1999. The company, once again, reaffirms that our cash dividend policy remains the same.

Now operator, would you please open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Barry Blaine [ph].

Unknown Analyst

Bryant, I have one question. What percentage of the dividend from last year should probably be considered taxable this year? Is there any kind of guidelines?

J. Bryant Kirkland

Yes, we'll be finalizing a preliminary estimate of those numbers in the next 2 weeks, by the March 15 deadline. It will be significantly lower than last year. Last year, the number was 50%.

Operator

Our next question comes from Ken Bann with Jefferies & Company.

Kenneth P. Bann - Jefferies & Company, Inc., Research Division

I just wondered, do you have any assessment of the new appointed head at the FDA or any thoughts on how that might change regulation in the industry.

Ronald J. Bernstein

Yes, I think, first of all, it's always very difficult to assess how FDA is going to operate and what the dynamic for an individual will be once they get into FDA. Many of the people who occupy the tobacco control group at FDA are people who came out of what we might refer to as the anti-tobacco segment of society. But FDA is guided by a commitment to scientific process, and our anticipation is whatever Mr. Zeller's individual perspective is, is that he'll have to operate within the guidelines of FDA and the Tobacco Control Act. So we don't have any particular perspective on what he might do. I've seen a lot of the speculation in -- amongst analysts. And I think that whatever he does, we will comply with things that are legitimately guided by the law, and we'll challenge things that are not.

Kenneth P. Bann - Jefferies & Company, Inc., Research Division

Okay, fair enough. The decline in cases in the fourth quarter, were a lot of those settled? Or -- and can you give us an idea what they were settled for or in what range?

Ronald J. Bernstein

They were inaugural cases that were dismissed.

Howard M. Lorber

Correct.

Kenneth P. Bann - Jefferies & Company, Inc., Research Division

Okay. And then, the $37 million on the Long Island City project, is that your investment? Or what is the total investment by New Valley in that?

Howard M. Lorber

B.K., what was the total investment? I think it was about $7 million.

J. Bryant Kirkland

$7.5 million, yes.

Howard M. Lorber

$7.5 million.

Kenneth P. Bann - Jefferies & Company, Inc., Research Division

$7.5 million, okay. And so do you have -- versus the $37 million, is that your percentage ownership in that project?

Howard M. Lorber

Yes, approximately, yes.

Operator

Our next question comes from Anton Kawalsky with Canyon Capital.

Anton Kawalsky

I think you gave the volumes for 2012 total, but can you give us the volumes for the fourth quarter as well?

Ronald J. Bernstein

Yes, we don't break down by the quarter.

Anton Kawalsky

Okay. Also, what is the total market share? Are you still giving that number?

Ronald J. Bernstein

Yes, our total share is in the 3.6% to 3.7% range.

Operator

[Operator Instructions] Our next question comes from Travis Hogan with Riva Ridge Capital.

Unknown Analyst

Ron, what do you think the prospects are for the Durbin Bill? I think that's a Tobacco Tax Equity Act. Is that correct?

Ronald J. Bernstein

Yes. I think it's hard to say, but we -- what we're optimistic about is that there has been far greater focus given to the issues, and we think that they're being addressed in the right way. In addition to Senator Durbin's bill, Senator Harkin has a bill that also has, I think, a lot of the same parameters. So what we're -- we recognize that there's going to be some budgetary activity this year, and we are hopeful that these types of items will be included or at least the parts that are most egregious.

Operator

There are no further questions at this time. I would like to turn the call back over to Mr. Lorber.

Howard M. Lorber

Well, thank you, all, for attending this call. And as always, B.K. or myself or Ron are available for any questions you may have. Have a nice day, and we'll speak to everyone on the next quarter conference call. Thank you, operator.

Operator

This concludes today's conference call. You may now disconnect.

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