This Company’s 10% Yield Continues to Be Overlooked

You might not be familiar with the cigarette brands Liggett Select, Grand Prix, Eve, Pyramid or USA. But these brands have helped turn the company that makes them into an income powerhouse.

Investing in cigarette companies isn’t for everyone. Millions die from tobacco-related illnesses each year, and that understandably turns many investors away. I’ve never directly owned shares of any cigarette company, and despite the great returns, I probably never would.

Having said that, cigarette companies in general, and this one in particular, have been solid income performers despite all the problems surrounding their industry. And when I see an opportunity like this — one that makes me reconsider my “no cigarette company” policy — I feel I need to report on it.

Take a look at the five-year total return for the leaders in this space:

Altria Group (NYSE: MO) +108.2%
Reynolds American (NYSE: RAI) +61.3%
British American Tobacco (NYSE: BTI) +146.4%

When compared with the S&P, which has returned just +2.5% in the past five years, those numbers seem almost obscene.

Vector Group (NYSE: VGR) has put up similar gains to its larger, more well known peers. This $1 billion tobacco company has returned +92% during the past five years, and it looks like it will be able to repeat that performance in the next five.

Vector’s brands of cigarettes are priced at about a -25% discount to the Camels and the Marlboros of the world. It’s these discount brands that are the revenue-generating monsters of the company. Discount cigarettes are one of the few areas of tobacco to experience growth during the past several years as premium brands have been priced out of the range of many smokers.

In fiscal year 2008, these brands generated $562 million in revenue, contributing $170 million to operating income, up +7% from 2007. In the most-recent quarter, total revenue was $207 million, up +45% against the same period last year. Net income, however, was negative because of an unusual one-time charge.

The company currently pays a 40-cent quarterly dividend. This gives Vector shares a 10.2% yield at today’s prices ($1.60/$15.76). In the past ten years, the company has raised its dividend by +757%.

Cash flow from operations in the most recent quarter came to $31.5 million, just meeting its $28.2 million dividend. While this coverage margin is a little tighter than I’d like to see, the company also has $232 million in cash, and it fully expects to continue to meet its dividend obligation during the next 12 months.

While discount cigarettes are the major revenue generator for Vector, the company operates in a few other areas. It makes a nicotine-free cigarette called Qwest and two lines of Swedish “snus” — a moist, spitless oral snuff. The company also owns the largest residential real-estate brokerage in the New York City area.

While these business units have interesting potential, this is a value-priced cigarette company. With higher and higher taxes on cigarettes, Vector’s position as a leading discount provider gives it a huge potential to draw customers from the major brands, as smokers look to spend less on their increasingly expensive habit.

Would I break my “no cigarette company” rule for Vector? Probably not, but I want to.