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Vector Group (NYSE:VGR)

Q2 2012 Earnings Call

July 31, 2012 11:00 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

Operator

Welcome to Vector Group's Second Quarter 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 risk 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 filings.

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

Howard M. Lorber

Thank you. Good morning, and thank you for joining us on Vector Group's Second Quarter 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.

On today's call, I will provide an update on our business and review Vector Group's financials for the second quarter and first half of 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.

Our focus in 2012 continues to be building volume and share growth on our PYRAMID brand while increasing year-over-year profit growth. We are pleased to have achieved those goals for both the second quarter and first half of 2012, and as we look ahead, despite a challenging marketplace, we are confident that our business is heading in the right direction. We will discuss our financial results and tobacco performance in more detail in a moment.

Before turning to the financials, I want to briefly update you on tobacco litigation and specifically, the Engle cases in Florida. The Engle progeny cases remain the primary focus of our litigation activity with 5,649 cases pending in both federal and state court. We, along with the other industry defendants, continue to believe that the Engle process is materially florid and unconstitutional. Having said that, the appellate efforts overturn the Engle findings have not been successful. The intermediate appellate courts have been willing to overturn adverse verdicts on discrete issues of law, where we have punitive damages that exceed constitutional limits but have uniformly upheld the application of the Engle findings in the Engle progeny cases.

Just recently, however, the Florida Supreme Court has agreed to review the Douglas case, a case were Liggett was a defendant. This will be the first Engle progeny case to be reviewed by the Florida Supreme Court. 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. Our liquidity remains strong with cash and cash equivalents of approximately $208.7 million as of June 30, 2012. Additionally, as of June 30, 2012, the company held investment securities and partnership interest with a fair market value of approximately $90.9 million.

Let me now turn to the key financials for the 3 months and 6 months ended June 30, 2012, for Vector Group. For the second quarter ended June 30, 2012, Vector Group revenues were $276.6 million compared to $291.2 million in the 2011 second quarter. The decline in revenues was primarily due to an approximate 8.4% reduction in cigarette volumes, which was partially offset by higher pricing. The company recorded operating income of $40.9 million in the 2012 second quarter compared to operating income of $38 million in the corresponding period in 2011, an increase of 7.6%, principally due to improved margins.

Second quarter 2012 net income was $3.9 million or $0.05 per diluted share compared to net income of $30.3 million or $0.34 per diluted share in the 2011 period. The second quarter 2012 results include a pretax loss of $7.9 million related to the conversion of the company's convertible debt and a pretax charge of $6 million from changes in fair value of derivatives embedded within our convertible debt. Adjusting for these items, second quarter 2012 net income was $12.2 million or $0.15 per diluted share.

Second quarter 2011 net income included pretax gains of $19.5 million from the liquidation of long-term investments, $9.4 million of changes in fair value of derivatives embedded within our convertible debt and $577,000 from the sale of a townhome that were offset by a $1.2 million loss related to the conversion of the company's convertible debt. Adjusting for those items, second quarter 2011 net income was $13.2 million or $0.16 per diluted share.

For the 6 months ended June 30, 2012, Vector Group revenues were $534.2 million compared to $551.6 million in the 2011 6-month period. The decline in revenues was primarily due to an approximate 6.5% reduction in cigarette volumes, which was partially offset by higher pricing. The company recorded operating income of $74.4 million in the 2012 6-month period compared to operating income of $69.4 million in the prior year 6-month period, an increase of 7.1%, principally due to improved margins.

Net loss for the 12-month -- for the 2012 6-month period was $3.8 million or $0.05 per diluted share compared to $49.7 million or $0.61 per diluted share in the 2011 period. The results for the 6 months ended June 30, 2012, included pretax charges of $27.1 million related to changes in the fair market value of derivatives embedded within convertible debt and a $7.9 million pretax charge related to the conversion of the company's convertible debt. Adjusting for these items, net income for the 6 months ended June 30, 2012, was $17.7 million or $0.22 per diluted share.

The results for the 6 months ended June 30, 2011, included pretax gains from the liquidation of long-term investments of $23.6 million, changes in the fair value of derivatives embedded within convertible debt of $8.9 million and the sales of townhomes of $3.7 million, offset by a $1.2 million charge on the conversion of the company's convertible debt. Adjusting for these items, net income for the 6 months ended June 30, 2011, was $28.5 million or $0.35 per diluted share.

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

Ronald J. Bernstein

Thank you, Howard. Good morning, everyone. As Howard indicated, despite a challenging market environment, we're pleased to have increased year-over-year operating profit for both the second quarter and first half of 2012. We were also pleased to continue to generate volume growth on our PYRAMID brand during the first half of the year. The growth strategy we initiated at the time of the 2009 federal excise tax increase is clearly working, and we remain positive about the course we are on.

Before I elaborate more on performance, let's turn to the financials. Please note that financial reporting for Vector Tobacco is combined with Liggett. For the 3 and 6 months ended June 30, 2012, Liggett revenues were $276.6 million and $534.2 million compared to $291.2 million and $551.6 million for the corresponding periods in 2011. The revenue decline year-over-year was the result of unfavorable year-over-year comparisons caused by the timing of price increases and related wholesale buying patterns as well as anticipated volume declines in non-PYRAMID brands.

Operating income for the 3 and 6 months ended June 30, 2012, was $44.6 million and $82.1 million, respectively, compared to $42.2 million and $78.6 million in 2011. Increased operating income was driven by volume increases in PYRAMID and higher margins on all brands resulting from pricing actions that we've taken.

As previously noted, 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 our strategic objectives of key brand expansion and long-term profit growth. Recognizing a changing market environment in the second half of 2011, Liggett suddenly shifted its emphasis from overall volume growth to pursuing higher margins on our brand portfolio. We have continued that emphasis through the first half of 2012.

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 for use 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, there was a substantial increase in the federal excise tax on cigarettes, roll-your-own tobacco and small cigars in April 2009. Unfortunately, Congress neglected to also increase the tax rate on pipe tobacco to the same level as roll-your-own. 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. Shortly thereafter, manufacturing machines that produced a carton of cigarette in approximately 8 minutes started being sold to retail stores. By using mislabeled pipe tobaccos, stores with their manufacturing machines are able to sell consumers a carton of cigarettes at 50% to 75% less than a carton of legitimate manufacturer-made cigarettes.

The result of this is that the so-called pipe tobacco category has grown over 570% since December 2008 from 2.6 billion cigarette equivalents to over 17.5 billion in 2011. During the same period, roll-your-own has declined 76% from 10.7 billion to 2.6 billion cigarette equivalents. As a result, based upon Tobacco Tax and Trade Bureau data, the federal government has failed to collect over $1 billion in taxes owed to it over the course of 3 years. And based upon current trends, that number may exceed $1 billion in 2012 alone. From various discussions, it appears that TTB, the FDA, the Government Accountability Office and many members of Congress recognize this issue. However, government processes are cumbersome by nature, and our political parties seem to disagree on most everything, including the collection of taxes legitimately owed to them.

As I mentioned in the first quarter call, the level of support for addressing this inequitable situation has been growing, and we were quite pleased recently when Congress passed and the President signed legislation that will cause in-store manufacturing machine operators to be regulated and taxed as manufacturers. This will cause these manufacturers to operate on a more equal footing to legitimate manufacturers, and many of them have been shutting down operation since the legislation took effect in early July.

While this legislation is an important and necessary step, it by no means solves the mislabeled pipe tobacco problem. We believe that cigarettes manufactured in these machines represent only approximately 30% of the 17.5 billion cigarette equivalents of mislabeled pipe tobacco being sold. And some of those using in-store machines will simply revert to rolling their own with individual home-rolling machine options that are both inexpensive and commonly available. It is also worth noting that the GAO, in its recent thorough analysis of the issue and its impact on the nation's finances, recommended that Congress go further, stating it 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.

We're also hopeful that FDA and TTB will now follow Congress's lead and utilize the existing enforcement authority that they have to properly regulate these mislabeled products. There are indications that members of Congress are, in fact, strongly encouraging the agencies to do exactly that. In addition, we have recently seen a number of individual states take legislative or regulatory actions to address some or all aspects of the mislabeled pipe tobacco situation, a trend that we hope continues and further encourages the federal agency to take action to finally end this tax evasion.

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. Previously, the deep discount segment was dominated by smaller legitimate and renegade-type companies. But according to second quarter MSAI data, the big 3 companies now comprise a majority, over 53%, of this segment. Reynolds has led the way with its Pall Mall brand. Altria is building volume with its L&M brand, and Lorillard continues to support Maverick. We have also seen hyper aggressive pricing at times from foreign companies, like Japan Tobacco and KT&G, on their discount brands.

Despite these industry changes, we were pleased to be able to grow our PYRAMID brand by almost 10% in the second quarter and over 11% year-to-date compared to the prior year periods. PYRAMID has a clear national presence and is currently sold in over 90,000 stores with a distribution base that grew by over 10,000 stores in the second quarter. While substantial opportunity remains in further building its national footprint, PYRAMID is now the seventh largest brand and third largest discount brand in the United States.

According to Management Science Associates, during second quarter of 2012, overall industry wholesale shipments declined by just under 2%, while retail shipments declined by 2.75%. With the exception of Altria, which posted modest gains, all major manufacturers suffered declines in wholesale and retail shipments during the quarter. In part, this had to do with the unfavorable comparisons caused by timing differences in price increases and related buying patterns year-over-year that I previously mentioned.

Liggett's overall declines were 8.2% and 4.7%, respectively, within the range we expected. Given industry trends, Liggett retail and wholesale share was essentially unchanged compared to the second quarter of 2011. In 2011, industry taxable shipments declined by 3%, which was in line with our projections. Initial indications are that declines for 2012 should be in a similar range.

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 years, there is still a great deal of uncertainty regarding FDA's regulation and enforcement. As an example, in August 2011, Liggett, along with Reynolds, Lorillard, Commonwealth and Santa Fe, filed suit to challenge the legality of the FDA's graphic images in the Federal District Court in Washington. In February of 2012, the District Court granted the industry's motion for summary judgment, indicating that the FDA had violated the industry's constitutional rights. The FDA appealed the District Court's decision, and oral arguments were held in April at the U.S. Court of Appeals for the D.C. circuit. We are waiting for their decision. We continue to work closely with the FDA to seek mutually acceptable solutions to complex issues raised by the statute and regulatory issues. We also continue to monitor FDA developments, and we remain confident that we'll be able to comply with all aspects of the legislation.

Let me wrap up my comments by again saying that we're pleased with Liggett's performance for the first half of 2012. I remain confident that Liggett is well positioned to continue to succeed, and our entire team is committed to meeting the demands of a challenging marketplace while pursuing opportunities that we believe will enhance our long-term strength and profitability.

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

Howard M. Lorber

Thank you, Ron. As I mentioned at the start of this call, we are pleased with our 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 terms under the MSA. Additionally, we are proud of the company's uninterrupted track record of paying a 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 Ken Bann with Jefferies & Company.

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

Ron, I was just wondering, since the President signed that legislation about the change in taxation of the operators of the cigarette machines, have you seen any switch at all to your brands or any change in volumes for discount cigarettes because of that legislation?

Ronald J. Bernstein

Yes, it's too early to be able to see any trends. It's been less than a month since the President signed the legislation and it went into effect. And the process, as you can imagine, is sort of clumsy. The -- many of the machine operators have shut down. Some are trying to pursue angles to allow themselves to continue. We don't see them as having any potential to be successful given the legislation, but there's no trends that are notable yet.

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

Okay. And on a -- I guess on a bigger issue, do you have any thoughts about what's the possibility that we might see some legislation that would increase the taxes on the pipe tobacco?

Ronald J. Bernstein

What we know is that members of Congress have been aggressively pursuing FDA to take action that they already have the authority to take. I think the likelihood of there being tax equalization this year is virtually 0 given the political environment. But FDA, under the existing authority and definitions that they have in the Tobacco Control Act, has authority to identify these products as misbranded products, and that would then compel TTB, we believe, to tax it at the appropriate rate. So while I can't say that I'm optimistic in any particular timeframe, I think there is definitely momentum moving towards that direction.

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

Okay. And then you increased prices on PYRAMID in June of this year, right, and on Grand Prix also in June of this year? Can you tell us have you seen impacts on volumes at all from those price increases? Or is PYRAMID still picking up additional volume due to the increased number of stores that it's being carried in?

Ronald J. Bernstein

Yes. PYRAMID continues to grow, and we have not seen any change in volume trends subsequent to the price increase. So the market has been relatively stable to this point and seems to have accepted increase pretty well.

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

Okay. And so that should hopefully lead to continuing improvement in gross profit margin, I guess, from these -- with these price increases.

J. Bryant Kirkland

One would hope.

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

Okay. Has -- the cost of tobacco, has there been any major changes in that this year along with increases in other crops?

J. Bryant Kirkland

No. We have -- and remember, our pricing tends to be a year out, because we commit to our purchases a year or sometimes more in advance, and we typically have a fair amount of tobacco on hand. So there haven't been any notable fluctuations that will affect us any time soon.

Operator

[Operator Instructions] At this time, I'm showing there are no further questions.

Howard M. Lorber

Okay, operator. Thank you very much, and I'd like to thank everyone to this call. We're always available. Thank you for participating. Please feel free to call B.K. or myself or Ron Bernstein, and we look forward to speaking to everyone next quarter. Thank you very much. We are now complete, operator.

Operator

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

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