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The Vector Group (NYSE:VGR) is a holding company consisting of 3 main businesses:

Liggett Group – manufactures and sells cigarettes.
Vector Tobacco Inc. – specializes in developing low-risk cigarettes like nicotine-free QUEST.
New Valley LLC – real estate business.

The Liggett Group primarily specializes in discount cigarettes. During 2005 and 2006 all of its sales were of the discount variety. According to the Management Science Associates, its market share of the overall discount cigarette industry has grown from 7.4% in 2004, 7.5% in 2005 to 8.7% in 2006. Its best seller is the Liggett Select brand. All of its sales are in the United States, and it has no foreign operations.

It also has a cost advantage compared to its bigger competitors like the Altria Group (NYSE:MO) and Reynolds American Inc. (NYSE:RAI) due to the Master Settlement Agreement, which states that the three biggest cigarette manufacturers must make payments to states based on how many cigarettes it sells annually. Liggett only has to pay if its market share is above 1.65% of the U.S. cigarette market. In the past 3 years, its market share of the overall U.S. cigarette market has averaged 2.3%.

It is the fifth largest manufacturer of cigarettes in the United States based on sales volume and there are roughly 135 litigation cases pending where the Liggett Group is named as the defendant or as one of the defendants.

Vector Tobacco is a small part of the Vector Group holding company. Its goal is to continue developing low-nicotine and nicotine free cigarettes, and to continue its work on the development of low-risk cigarettes. Its sales as a percentage of total sales in the holding company in 2004, 2005, and 2006 has been 2.8%, 2.0%, and 1.3% respectively. Vector Tobacco has not been profitable over the past 3 years. It also benefits from the Master Settlement Agreement, as it will only have to pay if its market share is above a .28% share of the U.S. cigarette market.

New Valley LLC consists of real estate operations all across the United States. It owns a 50% interest in the biggest residential brokerage in metropolitan New York City, the Douglas Elliman Realty, LLC. It also holds interest in properties in Hawaii, Washington D.C., and Florida.

The Vector Group has been very aggressive in cutting costs in its two tobacco operations. It is constantly eliminating jobs and trying to improve operating efficiency. This has been a big staple of Altria’s success over the years and has greatly contributed to Vector’s success as well.

The Cigarette Industry

The total domestic cigarette industry has been declining, and this downswing will continue. According to the Management Science Associates, in 2006 it declined 2.4%. Based on sales volume in the domestic market, the three largest cigarette manufacturers accounted for 86.8% of the market. The Liggett Group faces competition on two fronts. The three major distributors and other small manufacturers similar to Liggett in size do not have to pay in the Master Settlement Agreement since its market share is so small. In the past, there have been considerable barriers to entry in the industry, but recently, the smaller companies have been able to enter the market since it is not influenced by the Master Settlement Agreement and due to the surplus manufacturing capacity in the industry. Litigation has been a constant in the industry since 1954.

Valuation

It is trading at a trailing twelve month price/earnings ratio of 25.7, which is not great, but when you look at Joel Greenblatt’s pre-tax earnings yield, which removes the effect of the financing and taxes, it is at 10%. It also has a high Pre-Tax Return on Capital and 24.5% of the outstanding shares are owned by insiders. There is a little over $103 million of long-term debt on the books with almost $147 million in cash and cash equivalents. There is also approximately $57 million in long-term investments with Icahn Partners LP (NYSE:ACP) and in the Jeffries Buckeye Fund LLC. It also owns about $29 million worth of Ladenburg Thalmann Financial Services Inc. (NYSEMKT:LTS) stock.

Two investment gurus, Carl Icahn and David Dremanthat are invested in the Vector Group. It also pays a dividend of $1.60 a year which, at today's prices equates to a dividend yield of 8.7%. It has a strong dividend history, raising it from $.213204 a share in 1998 to the current dividend of $1.60 a share. Its gross margin in 2004, 2005, and 2006 has been 34.7%, 40.3%, and 37.7% respectively. This stock appeared on Joel Greenblatt’s Top 25 Magic Formula stocks over the $100 million market cap on May 6, 2007 which is based on the Pre-Tax Earnings Yield and the Pre-Tax Return on Capital.

Technicals

Like most tobacco stocks, VGR has been on a tear this past year. It is currently trading near its high of the year. The uptrend is still in tact, the 20DMA is greater than the 50DMA which is greater than the 200DMA, but the 20DMA is moving dangerously close to the 50DMA, and if it crosses it could be a big shift in momentum. Momentum has been slowing already though as MACD and RSI are both diverging with the stock trend. It seems like there will be support along the 17 area, followed by the 15 area.

VCR 1-yr chart

Conclusion

The tobacco industry is obviously in decline, but that still has not stopped tobacco stocks from outperforming the market. There is a lot to like about the Vector Group besides the 8.7% yield. It uses its capital wisely, has a high earnings yield, is owned by Carl Icahn and David Dreman, and 24.5% of its ownership is by insiders. Also, its performance will not suffer in an economic slowdown due to the nature of its product.

One issue with the company that I have encountered is the lawsuits that are currently pending against them, but this is the nature of the business. All of the other cigarette producers are experiencing the same issue. I will be looking to add this to my portfolio once the stock pulls back to the $15-$17 a share range.

Disclosure: The author has no position in VRG.

Source: The Vector Group: Is The Cigarette Industry Burning Out?