Vector Group Management Discusses Q3 2012 Results - Earnings Call Transcript

Nov. 1.12 | About: Vector Group (VGR)

Vector Group (NYSE:VGR)

Q3 2012 Earnings Call

November 01, 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 the Vector Group's Third 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 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 filings.

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 third 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.

Today, I will provide an updated our businesses and review Vector Group's financials for the third quarter and first 9 months 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.

As we have indicated in previous calls, our focus in 2012 is to maintain the strength of our core PYRAMID brand, while delivering increased year-over-year operating profit. We are pleased that we have continued to achieve these goals in the third quarter, and we will discuss our financial results and tobacco performance in more detail in a moment.

We are confident that our business continues to head in the right direction despite ongoing industry challenges that Ron will address.

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 5,079 cases pending in both federal and state court, a reduction in 570 cases from last quarter. Although we continue to believe, along with the other industry defendants, that the Engle process is materially florid and unconstitutional, appellate efforts to overturn the Engle findings have not been successful to date. The intermediate appellate courts have been willing to overturn adverse verdicts on discrete issues of law or where punitive damages exceeded constitutional limits but have to uniformly upheld the application of the Engle findings in the Engle progeny cases.

Just recently, however, 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 are 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 $217.3 million as of September 30, 2012. Additionally, as of September 30, 2012, the company held investment securities and partnership interest with a fair market value of approximately $89.1 million.

Let me now turn to the key financials for the 3 months and 9 months ended September 30, 2012, for Vector Group. For the third quarter ended September 30, 2012, Vector Group revenues were $272.8 million compared to $289 million in the 2011 third quarter. The decline in revenues was primarily due to an approximate 10.7% reduction in cigarette volumes during the period, which was partially offset by higher pricing.

The company recorded operating income of $43.2 million in the 2012 third quarter compared to operating income of $37.9 million in the corresponding period in 2011, an increase of 14.1%, principally due to improved margins.

Third quarter 2012 net income was $17.9 million or $0.21 per diluted share compared to net income of $17.5 million or $0.20 per diluted share in the 2011 period. The third quarter 2012 results include a pretax loss of $7.1 million related to the conversion of the company's convertible debt, and a pretax gain of $6 million from changes in fair value of derivatives embedded within our convertible debt. Adjusting for these items, third quarter 2012 net income was $18.6 million or $0.21 per diluted share.

Third quarter 2011 net income included pretax gains of $4.4 million of changes in fair value of derivatives embedded within our convertible debt, and $2.2 million from the liquidation of long-term investments. Adjusting to those items, third quarter 2011 net income was $13.6 million or $0.16 per diluted share.

For the 9 months ended September 30, 2012, Vector Group's revenues were $807 million compared to $840.6 million in 2011. The decline in revenues was primarily due to an approximate 7.9% reduction in cigarette volumes, which was partially offset by higher pricing. The company recorded operating income of $117.6 million in the 2012 9-month period compared to $107.3 million in the prior-year period, an increase of 9.6%, principally due to improved margins.

Net income for the 2012 9-month period was $14.1 million or $0.16 per diluted share compared to $67.2 million or $0.78 per diluted share for the 2011 period. The results for the 9 months ended September 30, 2012, included pretax charges of $21 million related to the 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 9 months ended September 30, 2012, was $35.6 million or $0.42 per diluted share.

The results for the 9 months ended September 30, 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 $13.2 million and the sales of townhouses of $3.7 million, offset by $1.2 million charge on the conversion of the company's convertible debt. Adjusting for these items, net income for the 9 months ended September 30, 2011, was $42.6 million or $0.50 per diluted share.

The first several months have also been active period for New Valley. In August, we announced that we're moving ahead to develop and convert into luxury residential condominiums, the recently acquired 10-story 122,000 square-foot building at 11 Beach Street in Tribeca. And earlier this month, we announced that, together with The Witkoff Group and Winthrop Realty Trust, we have acquired 701 7th Avenue which is a prime Times Square area real estate site. The property located on the northeast corner of 7th Avenue on 47 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 to retail, restaurant and entertainment businesses, as well as a site for a potential 30-story hotel.

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

Ronald J. Bernstein

Thanks, Howard. Good morning, everyone. As Howard indicated, we continue to perform well despite a challenging industry environment. We are pleased to have increased year-over-year operating profit by 12% for the third quarter, and 7% year-to-date. While our third quarter year-over-year retail shipment volume for PYRAMID was essentially flat, we are pleased that we continued to generate retail market share growth during the period on our core brands.

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 and 9 months ended September 30, 2012, Liggett revenues were $272.8 million and $807 million compared to $289 million and $840.6 million for the corresponding periods in 2011. The year-over-year revenue decline was primarily caused by the timing of new business shipments and anticipated volume declines in our non-PYRAMID brands.

Operating income for the 3 and 9 months ended September 30, 2012 was $48.1 million and $130.2 million, respectively compared to $42.9 million and $121.5 million in 2011. We are pleased to achieve increased operating income in this environment, driven by higher margins on all brands resulting from price increases that we have implemented over the past year. As we have 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 we've noted, responding to a changing market environment in the second half of 2011, Liggett subtly shifted its emphasis from overall volume growth to pursuing higher margins on our brand portfolio. We have continued that focus through the first 9 months 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, at the time of the excise tax increase, 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. Shortly thereafter, manufacturing machines that produced a carton of cigarettes in approximately 8 minutes started being sold to retail stores. By using mislabeled pipe tobacco, stores with their own manufacturing machines were able to sell consumers a carton of cigarette at 50% to 75% less than a carton of legitimate manufacturer-made cigarettes.

The result of this was that the so-called pipe tobacco category grew over 570% since December 2008 from 2.6 billion cigarette equivalents to over 17.5 billion in 2011. While during the same period, roll-your-own declined from 10.7 billion to 2.6 billion cigarette equivalents. As a result, based upon Tobacco Tax and Trade Bureau data, the federal government will have failed to collect close to $2 billion in taxes owed to it through 2012.

From various discussions and recent actions, it appears that TTB, the FDA, the Government Accountability Office and many members of Congress recognize the issue. However, remedying this problem remains a challenge, especially within the current political environment. In a positive development, we were very pleased federal legislation was passed requiring in-store manufacturing machine operators to be regulated and taxed as manufacturers. This causes these manufacturers to operate on a more equal footing to legitimate manufacturers and many of them have shut down operations since the legislation took effect. While this legislation is an important and necessary step, it has by no means solved the mislabeled pipe tobacco problem. We believe that cigarettes manufactured in these machines represented 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 using mislabeled pipe tobacco with individual home rolling machine options that are both inexpensive and commonly available.

Alternatively, some may switch to filtered cigars that are 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 9 billion cigarette equivalents or over 3% of the total market. And their appeal unfortunately, is only growing.

The Center for Disease Control and Prevention reported in August that the decline in cigarette consumption over the past several years was largely offset by significant increases in consumption of so-called large cigars and pipe tobacco. Put plainly, cigars consumption grew by 233% between 2001 and 2011 and pipe tobacco increased 482% during that period. It is not surprising that most of the cigar and pipe tobacco growth has taken place since the 2009 excise tax increase. 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. We are also hopeful that FDA and TTB will now follow Congress' lead and use the existing enforcement authority that they have to properly regulate these 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 third quarter MSAI data, the big 3 companies now comprise a majority, over 50% of this segment. Reynolds has led the way with its Pall Mall brand, Altria is building volume with L&M, 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 dynamics and increase pricing, we were pleased to hold retail shipments of our PYRAMID brand essentially flat compared to both the prior year and previous quarter. PYRAMID has a well-established national presence and is currently sold in almost 100,000 stores with a distribution base that grew by over 6,000 stores in the third quarter. PYRAMID is the seventh largest brand and third largest discount brand in the United States, with a significant opportunity to further expand its national footprint.

According to Management Science Associates, during the third quarter of 2012, overall industry wholesale shipments declined by just over 2.7%, while retail shipments declined by 3.7%. With the exception of Altria, which gained over 1%, all other major manufacturers suffered declines in wholesale shipments during the quarter. Additionally, all the manufacturers suffered declines in retail shipments during the period. Liggett's decline in wholesale and retail shipments were 10.7% and 10.9%, respectively. This decline was partly a result of the timing of new business product shipments at the end of the third quarter 2011. In addition, we saw substantial inventory loading at the end of the third quarter of 2012 by a competitor whose fiscal year ends at September 30.

For the 2011 year, industry taxable shipments declined by 3% rate, 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 2009. While the process has developed over the past 3 years, there is still uncertainty regarding FDA's regulation and enforcement. 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, if and when they are implemented.

Let me wrap up my comments by again saying that we're pleased with Liggett's performance for the first 9 months 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

Thanks, Ron. As you may have seen, Vector management and board members recently celebrated our 25th anniversary of listing on the New York Stock Exchange. We are proud of this 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 will 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 of Jefferies & Company.

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

I just wondered on the New Valley investment in the Times Square building. How much is New Valley putting into that transaction?

Howard M. Lorber

B.K., you want to go through the numbers?

J. Bryant Kirkland

Right. We put in $9.2 million through today and then we anticipate that we could put in another $14 million. And that's where 15% -- about a 15% equity interest.

Howard M. Lorber

But, really, we have more than interest because we have a promote on the other investment, the other investors in it. So therefore, we actually financially have a better deal than that. A higher percentage.

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

And that would be the total even for further development if a new hotel goes in on that side also?

J. Bryant Kirkland

That's correct.

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

Okay. And just on the MSA payments this year, given, I guess, the volume declines, would you expect that your MSA payments for this year would be pretty significantly less than what they were last year? And do you have an estimate of what they might be?

Ronald J. Bernstein

I don't have a current estimate, but they certainly will be less than they were last year.

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

Right, okay.

J. Bryant Kirkland

Right. The December payment will be less, Ron, because we ended up paying more in April.

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

Okay, right. And then how you're thinking about pricing in volumes going forward on your brands? Are you considering other price increases? Or are you looking at trying to increase volumes some more in the next few quarters?

Ronald J. Bernstein

Yes, as I said in my remarks, we're always looking at the opportunities that the market provides. And there are times where we believe we have opportunities to increase volume, and when we do, we pursue that. At other times when the market becomes competitive, we sometimes see margin opportunities as we have over the last several months, and we take advantage of that. They don't necessarily happen at the same time, and we are constantly looking at the market and identifying when we have opportunities to continue to build our volume base and also increase our margin base.

Operator

[Operator Instructions] And everyone, there are no questions in the queue currently.

Howard M. Lorber

Okay. If there are no further questions, I'd like to thank everyone for being on this call. And as always, myself, Ron or Bryant Kirkland are available to answer questions you may have. Thank you, all, and speak to you again for the next quarter. Have a good day.

Operator

Thank you. This does conclude our teleconference for the day. You may now disconnect.

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