Vector Group Ltd (VGR) 2010 Q3 法說會逐字稿

Welcome to Vector Group's third quarter 2010 earning conference call. Before the call begins, I'd like to read a Safe Harbor statement. The statements made during this conference call, which 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 conference over to President and Chief Executive Officer of Vector Group, Howard Lorber.

Good morning and thank you for joining us on Vector Group's third quarter 2010 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 third quarter and nine months ending September 30, 2010. Ron will then discuss the performance of Liggett for the period and provide his views on industry developments and a competitive environment. After that, we will take your questions.

Let me begin by saying that we remain very pleased with our Company's performance and volume growth trends through the third quarter of 2010. As we have noted, we made the decision to strategically invest in the growth of our tobacco business in advance of the April 2009 legislation that increased the federal excise tax on cigarettes by $6.17 per carton, and legislation that ultimately granted the Food and Drug Administration regulatory authority over tobacco products.

The success of this strategy that we put into place is reflected in Liggett Vector Brand's third quarter 2010 wholesale shipment growth in excess of 25% compared to the year-ago quarter. And year to date we have achieved wholesale shipment growth of almost 28%.

Looking beyond the short term, we are committed to a program of sustainable growth in our tobacco business, and Ron will provide more detail on that in a moment.

With respect to real estate, we continue to see positive signs in a challenging market environment. We are very pleased with Douglas Elliman's reported net income of $34.1 million for the nine-month period ended September 30, 2010, which is the highest in its history for the first nine months of a year.

We still believe that there are good investment opportunities in this market, and we are pursuing appropriate opportunities that meet our criteria.

At this point, I want to briefly address the tobacco litigation environment, and specifically developments with respect to the Engle cases. As previously noted, the primary focus of our current litigation activity is the Engle progeny cases in Florida. There are approximately 17,000 cases pending, with more than half of them in federal court, and the balance in Florida State Court.

We, along with the other industry defendants, continue to believe that the Engle process is materially flawed and unconstitutional. While we believe we have very strong arguments and have recently received a potentially significant favorable ruling in federal court that we referenced on the last quarter's call, there is still considerable risk, and we remain subject to the ongoing process and periodic negative judgments.

As previously reported, in June 2010 we paid $14.4 million to resolve a judgment in the Lukacs case, which was the first Engle progeny case tried. Although the verdict was rendered years in advance of the Florida Supreme Court's ruling on the Engle case, which overturned certain findings that the jury in Lukacs relied upon in assisting liability-- assessing liability, the appellate court chose not to review this case. This is the largest judgment against Liggett to date, and it was a result of what we believe to be unique circumstances.

The federal court ruling from the 11th Circuit Court of Appeals, impacts approximately 3,900 Engle progeny cases pending federal court. We believe the court's rulings will likely result in significant restrictions on the ability of plaintiffs in federal court to use Phase I findings determined by the prior Engle jury to meet their burden of proof at trial.

We agree with the industry leader that this ruling should also provide persuasive authority for Florida State Courts that have been allowing plaintiffs to rely on the Engle filings without satisfying the requirements of Florida law or due process. We are encouraged by this development and believe it could have a positive impact on the future direction of the Engle cases.

In addition, while the industry has had adverse jury verdicts in 19 Engle cases, the industry has prevailed either through mistrial or defense verdict in 11 cases, including defense verdicts in the five most recent cases that have gone to trial. The adverse verdicts are all expected to be appealed.

Before discussing the financial results, I'm also pleased to remind you that in April 2010, we enhanced our strong financial position by completing a private placement of an additional $75 million of our 11% senior secured notes due 2015.

Our liquidity remains strong with cash and cash equivalents of approximately $258.6 million as of September 30, 2010. Additionally, as of September 30, 2010, we held investment securities and partnership interests with a fair-market value of approximately $151.6 million.

Now, let's turn to the key financials for the three months and nine months ended September 30, 2010 for Vector Group.

For the third quarter, ended September 30, 2010, Vector Group revenues were $295.1 million, compared to $236.7 million in the 2009 third quarter. The increase in revenues in 2010 was primarily due to increased cigarette unit volumes.

The Company recorded operating income of $29.9 million in the 2010 third quarter, compared to operating income of $37 million in the 2009 third quarter.

Third quarter 2010 net income was $10.9 million or $0.14 per diluted share, compared to $16.2 million or $0.21 per diluted share in the corresponding 2009 period.

Excluding a $3 million pretax nonrecurring settlement charge and $1.7 million of pretax gains from changes in fair value of derivatives embedded within our convertible debt, third quarter 2010 net income was $11.7 million or $0.15 per diluted share.

Excluding $6.1 million of pretax charges from changes in fair value of derivatives embedded within our convertible debt and the recognition of a one-time income tax benefit of $6.2 million, third quarter [2010] income was $13.6 million or $0.18 per diluted share.

For the nine months ended September 30, 2010, Vector Group revenues were $785.7 million compared to $564.7 million in the first nine months of 2009. The increase in revenues in 2010 was primarily due to increased volumes and higher prices related to the federal excise tax increase, which became effective on April 1, 2009.

The Company recorded operating income of $82 million during the first nine months of 2010, compared to operating income of $107 million for the 2009 nine-month period.

Excluding a $14.4 million pretax charge related to the litigation judgment and a $3 million pretax nonrecurring settlement charge, operating income was $99.3 million for the nine-month period. This performance is consistent with our expectations, given the substantial investments we have made in the growth of our Pyramid brand, which Ron will elaborate on in a moment.

Net income was $42.1 million for the first nine months of 2010 or $0.55 per diluted share, compared to $11.4 million in the 2009 period or $0.15 per diluted share.

Excluding the litigation judgment, settlement charges and $12.7 million of pretax gains from changes in fair value of derivatives embedded within our convertible debt, net income for the nine-month period in 2010 was $44.8 million or $0.59 per diluted share.

Our financial results for the nine months ended September 30, 2009 include a pretax gain of $5 million related to the 1999 trademark transaction with Philip Morris, pretax charges of $18.4 million on extinguishment of debt and pretax expenses of $25.8 million from changes in fair value of derivatives embedded within our convertible debt, pretax impairment charges of $8.5 million on real estate and pretax restructuring charges of $1 million.

Adjusting for these items, our net income for 2009 nine-month period would have been $34.2 million or $0.45 per diluted common share.

Now we'll turn the call over to Ron Bernstein for our review of our tobacco subsidiaries. Ron?

Thanks, Howard, and good morning, everybody. As Howard mentioned, we continue to be very pleased with the performance and growth of our tobacco operations. Over the past 18 months, we've seen substantial increases in product shipments and market share, and we feel very positive about the track we're on.

I'll elaborate more on our performance in a moment, but first let me turn to the financials.

As discussed on prior calls, in 2009, we restructured operations at Vector Tobacco and ceased most of Vector Tobacco's research activities. Accordingly, beginning in 2010, we are combining financial reporting for Vector Tobacco into Liggett. As a result, comparisons to 2009 performance are adjusted to reflect the combination of Vector Tobacco and Liggett.

For the three and nine months ended September 30, 2010, Liggett revenues were $295.1 million and $785.7 million compared to $236.7 and $564.7 million for the corresponding periods in 2009. As Howard mentioned, the revenue increase during the nine-month period was due to increased unit volumes and the higher federal excise tax rate.

Operating income for the three and nine-months ended September 30, 2010 was $35.5 million and $96.5 million, compared to $41.6 and $119.2 million for the corresponding periods in 2009. Adding back the $14.4 million Lukacs litigation judgment paid in the second quarter and the $3 million settlement charge in the third quarter, operating income for the three-month period of 2010 was $38.5 million, and operating for the nine-month period of 2010 was $113.9 million.

Included in the year-ago nine-month period's operating income is the one-time gain of $5 million related to the 1999 trademark transaction with Philip Morris and restructuring charges of $1 million.

On our last call, I mentioned that in the second quarter, our Company had increased wholesale shipment share to 3.4% of the market, and I'm pleased to report that we have continued to grow our share through the third quarter of 2010.

According to Management Science Associates, the quarter ending September 30, 2010, Liggett's wholesale market share was almost 3.8%, an increase of over three quarters of a share point, versus the third quarter of 2009.

At the same time, Liggett's retail share increased to approximately 4%, an increase of 80 basis points over the prior-year period. This markets the highest industry share held by Liggett since 1985.

Overall, third quarter retail shipments for the industry declined by 3.7%, while Liggett's retail shipments increased by almost 20%. All major competitors suffered declines in retail shipments for the quarter, except for Lorillard, which data indicates had an increase of 3.9%.

As you may recall, following the April 1, 2009 federal excise tax increase, there was a reloading of industry inventory at both wholesale and retail. By far, the greater impact was at wholesale where higher inventory levels are maintained. Under any circumstances, retail shipments tend to be more stable, and we believe serve as a better indicator of Company performance.

Having said that, overall industry wholesale shipments declined by less than 1% in the third quarter of 2010 compared to the 2009 period. Liggett significantly outperformed the market during the third quarter, with wholesale shipments growing by more than 25% over the prior-year period.

The primary driver for Liggett's volume growth at both retail and wholesale continues to be the strong performance of our Pyramid brand, which was redesigned, repackaged and reintroduced to the market in April 2009. Pyramid's new box styles are offered at a highly competitive but sustainable low price point. As indicated in prior calls, we made the strategic decision to price at a level that makes economic sense for us. And we believe that Pyramid box continues to offer the trade and consumers the best value proposition available in the market.

As previously reported, effect January 1, 2010, Pyramid was made available nationwide, following the regional rollout we implemented last year. We continue to provide Pyramid-focused promotional programs to the trade that also provide support to our other core brands.

We remain very pleased with the growth of Pyramid box and are progressing well with other initiatives that we are undertaking to continue to succeed in the changing tobacco marketplace.

Since 2005, we have carefully balanced our approach to pursuing volume and margin opportunities in the market. That continues to be the case. As we have invested in the growth of Pyramid box, we have also improved profit margins on our other core brands-- Liggett Select, Grand Prix and EVE. The margin increases we achieved in other brands have helped to mitigate the impact of our investment in the growth of Pyramid during the first nine months of 2010.

This has allowed us to keep operating income close to flat year over year when adjusting for the second quarter litigation judgment third quarter settlement charge and last year's Philip Morris transaction. However, it is important to note that as the year progresses and we continue to invest in the growth of Pyramid, we will see additional earnings contraction compared to 2009. We are managing the situation carefully, and we'll make adjustments to assure that we stay in an acceptable range of profitability while continuing to grow Pyramid.

As we've previously explained, Liggett and all companies with an MSA-grandfathered market share exemption determine the value of that exemption by multiplying their respective share exemption percentage by taxable industry shipments. These companies, including us, also increase the value of the exemption by an inflation factor of a minimum of 3%.

As a result, the historical 2.5% to 3% annual industry decline typically balances with the inflation factor, keeping the value of the MSA exemption relatively stable. However, for each percent that industry shipments declined above 3%, we estimate that we lose approximately $1.8 million of our exemption value. Given the extraordinary industry shipment decline of $8.6 percent in 2009, Liggett suffered a decline of $10.7 million in its MSA exemption, which was reflected in 2009 earnings.

As previously noted, this decline was within the range we anticipated. At this point, estimates for 2010 industry volumes project shipment declines in the range of 4% to 5%, which would be closer to historical norms. But as mentioned, any decline above 3% will result in further declines in the value of Liggett's MSA exemption.

As you know, in June 2009, the president signed legislation granting the FDA authority to regulate tobacco products. There continues to be a great deal of uncertainty regarding the FDA bill, and many open issues remain. However, we remain confident that we will be able to fully comply with the legislation.

We have been bearing costs associated with the implementation of the FDA requirements and will continue to do so in the future. Based on our current estimates, which are subject to change as regulations are issued over the next two years, we expect the costs to remain in a manageable range and to be absorbed over an extended period of time.

We had been hopeful that based upon our expertise and experience in the fields of biology and chemistry, as well as in smoking cessation, that we would have had the opportunity to provide meaningful input to the FDA as the process developed. Regrettably, to this point, that has not been the case, and the tobacco products scientific advisory committee, or TPSAC, appears to have been largely dominated by anti-industry zealots, while knowledgeable industry experts have been shut out for the most part.

It is unclear if the FDA will blindly accept what we fear will be inevitably biased recommendations from TPSAC, or if they will open the discussion to objective scientific data. Regardless, we are closely monitoring the activities of FDA and its committees, and along with other industry participants, we'll pursue such remedies as necessary to assure that the process is as fair as possible.

In other industry news, we were heartened to learn a few weeks ago that the US Treasury's Alcohol and Tobacco Tax and Trade Bureau has ruled that retailers that sell cigarettes produced by roll-your-own machines in their stores must obtain manufacturing permits and pay applicable federal taxes. We believe this is a significant development that should slow the alarming growth of these machines that typically use so-called pipe tobacco to avoid paying proper excise taxes and fees to federal and state entities.

The ruling deems stores using such RYO machines as cigarette manufacturers, meaning they must obtain permits from the Tobacco Tax Bureau, comply with recordkeeping rules and pay $10.07 for each carton of cigarettes they make. We believe this ruling, if properly enforced, will help level the playing field as many of these retailers may now find it cost prohibitive to deploy these machines.

In conclusion, we're very pleased with Liggett's performance through the first nine months of 2010. Through a concerted, companywide team effort, we continue to meet the challenges of a difficult marketplace, while pursuing opportunities that we believe will enhance the long-term strength and profitability of Liggett.

There is no doubt that new challenges will continue to arise, but I am confident that Liggett is well positioned to meet them and to succeed. Thanks for your attention. And back to you, Howard.

Thank you, Ron. Before I finish the prepared remarks, the Company once again reaffirms that our cash dividend policy remains the same.

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

Yes, sir. At this time we'll open the lines for questions. (OPERATOR INSTRUCTIONS) Okay. We'll take our first question from Mitch Pindus with Wells Fargo.

Good morning, gentlemen.

Good morning.

Good morning.

I have to say I was very heartened when I saw that nice jump in revenue's top-line growth, but, you know, obviously as we drill down into it and we see it, it didn't really help your bottom line. The question becomes-- and I think, Ron, you did a great job of explaining how you're investing in the new brands-- at what point do you slow down the investments in that new brand and we start to see that inured to the bottom line?

Our expectation is that-- what we're trying to do, Mitch, is to build a broad and substantial footprint for the Pyramid brand, and we're doing that. And we made a commitment to following that through. However, our expectation is that we will start to re-- see an improvement in bottom line earnings as we move forward, certainly beyond this calendar year.

I don't remember seeing this. Did you break out the numbers for the different brands, Pyramid, for example, on a quarterly basis?

In terms of volumes?

Yes.

No.

Okay. Can you?

Well, I mean, we can. The-- in essence, at this point, Pyramid is reflecting close to half of our volume.

That's a nice jump in such a short period of time. And you rolled this out at the beginning of the year, correct?

No, we rolled Pyramid out in April of 2009, just following the federal excise tax increase. It was a brand that was designed to be able to capitalize on what we believed we were going to be changing trends in consumer purchasing habits because of the excise tax increases. And what we've been able to do to this point is pick up substantial volume as a result.

Okay. Well, in looking at the revenue jump of about $58 million and the cost of goods sold jump of about $61 million, it looks like obviously the cost of goods sold increased more than the gross revenues increased. Is that directly related to the Pyramid?

Well, remember, the bulk of the excise tax-- of the revenue increase relates to excise taxes and the increased sale of Pyramid. Since we are investing in growth that obviously that we're hitting a bit of a decline relative to the cost of goods sold. So we also, as we're increasing volume, are needing to make strategic investments into the factor in order to be able to meet the volume requirements.

I see. Okay. Switching gears for a moment, this is probably for Howard, the investment partnerships dropped in value on the balance sheet from $68 million to $45 million. Was something sold?

[BK], do you have those numbers?

Yes, I do. No, they did not drop, Mitch. At 12-- at December 31, 2009, long-term investments were recorded on one line on the balance sheet, and that was a-- they were recorded at about $50.3 million. Their fair value was around $70 million.

At September 30, 2010, we recorded those same investments on two lines on the balance sheet, and the two lines total $56.4 million. The reason for the difference is we now report one of these investments under our separate line item because we own more than 5% of it, and we account for it under the equity method of accounting. And the fair value of the two line items at September 30, 2010 is $79.5 million.

Year to date, the investments were up in value about $5.7 million, which is about 11-- an 11% return, and that's pretty good, compared to the S&P was up 4% through September 30.

And what type of investments are these?

These are primarily hedge funds.

Okay.

Thank you for your question. We'll take our next question from Ken Bann with Jefferies & Co.

Good morning. I was just wondering, again, on the cigarette brands. As Pyramid continued to grow during the quarter, did you see a decline in volumes in your other brands?

Yes, in general, what the marketplace is doing right now is that declines are really running not just with our brands but with everybody brands in all price points pretty much above the deep discount level. So we're seeing declines in premium brands, such as Marlboro and Camel, as well as in mid-priced brands like Liggett Select or USA Gold, or, you know, at slightly deeper discount levels with brands like Grand Prix.

So there's been sort of an effort, I think, you know, in terms of the industry. It's a question of taking margin through pricing, which we have done with our other brands. So in-- rather than trying to fight to maintain volume with brands that are inherently going to decline at this point, we've opted to take margin opportunities with those brands.

Okay. Has the volume declines been similar to the rest of the industry in those brands?

Yes, in those categories.

Right. Okay. And you mentioned that stores are-- that are installing cigarette machines will now have to pay, I guess an extra tax. Do you have any analysis as to how much, in terms of volume, those machines and those stores have taken in the industry?

No, because the-- what we've seen over the course of the last year and a half, because of the significant increase in growth in pipe tobacco and little cigars, but pipe tobacco in this case in particular, that the machines became something that would have created a very big growth opportunity if it wasn't, in fact, shutdown.

So there-- it hadn't gotten to the point where there was substantial volume, but these machines were proliferating like mad. And so what this does is cuts off a tremendous avenue for growth through avoidance of excise tax payments.

Okay. And then, finally, are you still looking at investments in various real estate? You've been talking about real estate in Florida. Is anything pending in terms of acquisitions in that area?

Yes, we have been. We are still looking and bidding on a number of opportunities. We see now the banks are finally loosening up and starting to take back properties from the developers or sell their notes. And, you know, we have made one acquisition of a defaulted note, which if we end up getting the property, we'd be very happy. So, but we are working on a couple of opportunities at this point.

Can you comment on potential size of any of these transactions?

No, we don't-- you know, we're not-- there's nothing that big that we're disclosing at this point.

Okay. So it's not-- it wouldn't be-- there--

About $100 million.

Okay. All right. Thank you.

All right.

Thank you for your question. Our next question will come from [AJ Guido] with Golden Tree.

Hey, thanks for taking my question. Most of my questions have been answered, but regarding the profitability of the cigarette business, you talk about an acceptable range of profitability. Is there any way you can define what you would view as acceptable (inaudible)?

We-- you know, we don't provide guidance, but, you know, what we're trying to do is to stay within a range that's comfortable to where we were last year. And I think that if you look at where our numbers are through the first three quarters, you can sort of get a measure for the type of deviation year over year.

You know--

Go ahead. Sorry.

No, obviously our investment into Pyramid, we're expecting good returns in that, so, you know, the whole program of spending money and getting the volume up is to ultimately make a lot more money on the brand. So that's the direction we're heading into, and hopefully we'll be able to accomplish it.

Okay. Thank you.

Okay. Thank you for your question. (OPERATOR INSTRUCTIONS) Okay. Our next question will come from [Jim McMiller] with (inaudible).

Yes. I was wondering if you could tell me a little bit more about the timing or the anticipated timing on some of these Engle cases. I think you said there-- in the queue that there were 38 pending for 2010 and '11. Any sense for how those breakout throughout that time period?

I-- in terms of what? I guess the anticipation is, is that these cases are moving very slowly, and the patterns change as the courts have to make adjustments. But the-- there's-- you know, there's-- in terms of we expect the cases to continue to move through the way kind of at the pace they have been.

I mean, we also-- I'm not so sure that that number are all cases that include Liggett, the number you're talking about. Are they all Liggett cases, Ron, the 38 that are scheduled?

No, I don't think so.

Yes, I don't either. So, first of all, you know, a lot of times we really don't know the Liggett history until it's very close to trial. And I think it's also good to comment on, you know, these last five defense verdicts, you know, in discussing it with our attorneys, I mean, what they basically feel is that the defense lawyers have gotten better, okay, as the cases have gone along, in trying the cases.

And also what may have happened is that the plaintiff lawyers may have tried their best cases first. And, you know, after the best cases go, then they go into cases which aren't so clear cut. So we're sort of, you know, cautiously optimistic right now the way things are going.

And, in fact, since we-- just yesterday there was another positive defense verdict, so it's now six in a row.

That's helpful. Thank you very much.

Okay. At this time we'd like to turn the conference call back over to Howard Lorber.

Well, thank you, everyone, for being on this call. And, as always, Ron Bernstein, Bryant Kirkland and myself are always available to answer any questions you may have.

So thank you again, and have a good day.

This concludes our teleconference. You may now disconnect your lines.