Why Investors Should Steer Clear of Vector Group

Vector Group (VGR) is structured as a holding company, but the company's business is selling discount cigarette brands in the United States. Its two largest brands are Grand Prix (29% of volume) and Liggett Select (23%), and the company also sells Pyramid, Eve, and USA. Vector Group also owns a 50% stake in Douglas Elliman, a realtor in the New York metropolitan area, but real estate is such a small contributor to operating earnings that it can basically be ignored for the purposes of analysis here.

Positives

There are few bullish arguments on the stock, but let's address them anyway. First, Vector occupies probably the most attractive niche of the cigarette business: the discount end. Discount cigarettes have been about the only sector of this market to experience volume growth in the last decade, as premium brands are being priced out of the range of lower income smokers. Also, the 1998 litigation settlements with 46 states require only the 3 largest cigarette makers to pay the costs. Vector's Liggett Group is 5th, and as a byproduct has gained a valuable cost advantage against bigger makers like Altria (MO) and RJ Reynolds (RAI). The "big boys" are handcuffed by these costs if they decide to compete in the deep discount cigarette market, a significant competitive advantage for Vector Group.

The second positive is the dividend. Vector Group currently pays a massive 11.4% yield, and it has maintained such a high payout for several years now. It is unlikely that this dividend is sustainable over a long-term period, as last year it represented 122% of free cash flow. Management has been funding it with debt, a bad idea (I'll discuss financial health later).

However, I believe it is more likely than not that a one-year Magic Formula investor would probably be able to collect the full yield, as Vector has been able to sustain operating profits even against some difficult challenges. Dividend investors with a long-term horizon would want to steer clear, though... this is not a yield that is going to hold, and it certainly will not go up over the long term.

Negatives

So that's the case for the stock... now let's get to the negatives, which dwarf the positives, keep Vector Group far out of the MagicDiligence Top Buys portfolio, and in fact should keep MFI investors out of the stock.

First and foremost is the government's shadow war on smoking. Having mostly failed in direct litigation in the 1990's, federal and state governments are now using a more effective stick: Excise taxes. In April of this year, the federal excise tax on a carton of cigarettes was raised from $3.90 to $10.07, a crippling 158% increase. Some states tack on as much as an additional $4/carton. In response, Vector had to increase the wholesale price of its cartons by an average of about $7.50. As a result, revenues have spiked significantly (over 60%), but gross margins have plummeted from the low 40% range to the mid-20's. The net effect has been almost break-even - operating profits have been about flat against pre-increase levels.

The problem, though, is the effect going forward. Higher excise taxes hurt discount brands more than premium ones like Marlboro, as discount customers buy based almost solely on price, while premium brands enjoy customer loyalty and are less price-sensitive. When discount cigarettes get more expensive, it is likely that the low-income buyers they attract will buy fewer packs, or look to alternatives like smokeless tobacco. Vector's volume numbers bear this out: last quarter, Liggett Select suffered a 31% decrease in unit volume, while Grand Prix fell 13%. This is quite the conundrum for Vector, as all of its sales are inside the U.S., and cigarette volume growth (and tax freedom) is almost exclusively overseas.

There are other reasons not to like Vector. The balance sheet is aggressive: About $355 million of debt vs. $300 million in cash, with another $142 million in convertible debt derivatives. Interest is covered by operating earnings just 2 times over, well below the 5 times MagicDiligence likes to see as an absolute minimum. As previously mentioned, free cash flow is not sufficient to service the dividend, yet alone debt obligations. Debt and dividend are being financed with... debt. When you combine shaky financial footing with a very unfavorable regulatory environment, it is a recipe for trouble.

Finally, the company is just ugly to analyze. I count no less then 16 non-operating line items in the income statement (for the past 5 years), with a history of restructuring, unconsolidated side-businesses, and confusing financing. Vector does a bizarre 105:100 stock dividend every year. It engages in the completely unrelated business of residential real estate brokering. In short, it is a difficult business to fully understand, and the ability to understand a business is Warren Buffett's #1 requirement for an investment.

With all of these negatives, MagicDiligence recommends MFI investors steer clear of Vector Group and look elsewhere.


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Earn-out Models for Mergers and Acquisitions

Buyers and sellers often have different views on how much a target is worth and how its value should best be determined. Normally, the valuation of a company is based on both its past performance and its projected future performance. While the seller may be confident of the company's future growth, the buyer may be reluctant to assume the risk of the company failing to perform as expected by paying the seller the whole purchase price upfront. In some cases this problem can be mitigated by the parties agreeing on the introduction of an earn-out provision into the transaction, thus spreading the risk between the seller and buyer.

Earn-out Models and Specific Considerations

An earn-out can be described as a deferred portion of the purchase price which is conditional on the target's achievement of certain predetermined operational or financial goals within a specified timeframe. Earn-outs can be structured according to various models in order to base these goals on different parameters. In most cases financial parameters such as net income, gross revenue, earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA) are used. However, other parameters relating to new customers or other business-specific operating parameters may also be used.

Parameters which are easily measurable are used in order to ensure that earn-out models are simple and transparent. Even so, the buyer and the seller often struggle to agree on how the earn-out is to be calculated. For example, a buyer will often argue that the earn-out should be based on EBITDA, while the seller would prefer it to be based on revenue. From the seller's perspective, using revenue as the basis for an earn-out is often seen as advantageous, since a company's revenue cannot be manipulated by the buyer. On the other hand, the EBITDA could be manipulated - for example, by incurring costs which are not in line with past practice. On the other hand, from the buyer's perspective, using EBITDA or net income is preferable since these parameters say more about the company's performance.

In this light, the buyer and the seller sometimes agree on a code of conduct during the earn-out period. According to such codes, the buyer, although now the legal owner of the company, must adhere to certain provisions when operating the company. Irrespective of how the earn-out is structured, it requires the seller to be involved, to some extent, in the company's business during the earn-out period. This is not always disadvantageous for the buyer and the seller's continued engagement with the company may improve future performance. Often, the valuation of a company is based on the seller's continued engagement or reinvestment, and thus the seller's continued involvement may be prerequisite of an earn-out. In such cases, in order to avoid future disputes, the buyer and the seller must have agreed on a clearly defined role for the seller within the company and on how the seller's work is to affect the earn-out.

In cases where the buyer and seller agree on an earn-out model based solely on financial parameters, the seller will require that the buyer keep it informed of the development of the company. As a consequence, the seller will normally also require that the buyer undertake not to take any measures to manipulate the financial results of the company which would reduce the earn-out. For example, if the earn-out is based on EBITDA, the seller and the buyer can agree that the buyer be prohibited from incurring any extraordinary costs or that such costs are be excluded from the calculation of the earn-out. In addition, the seller and the buyer can agree on a budget during the earn-out period, to which the buyer is obliged to adhere for the purposes of the earn-out calculation, thus preventing the buyer from reducing the earn-out by such means. From a seller's perspective, it may also be important to control an eventual transfer of the company or its business during the earn-out period. For instance, should the buyer decide to sell or merge the company with another company within the buyer's group of companies, such a transfer is likely to make it difficult for the company to reach the EBITDA targets required for the earn-out. However, the seller can prevent this problem and allow, for example, an intra-group transfer, provided that the buyer undertakes to keep the company's accounts separate during the earn-out period so that the earn-out may be calculated accurately.

Following the earn-out period, the buyer must allow the seller to verify the buyer's calculation of the earn-out and let the seller make its own calculation of the earn-out. This is rarely contentious. However, problems may arise when the seller and the buyer cannot agree on the calculation of the earn-out. To prevent such disagreements from escalating into full-blown disputes, both parties can benefit from the inclusion of a settlement provision in the earn-out model. Typically, such settlement provisions stipulate that the earn-out calculations are to be finally determined by an independent auditor appointed by the seller and the buyer. The cost of this auditor can be split between the buyer and the seller or borne by either party, depending on what has been negotiated.

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