The investment thesis is relatively straightforward - the cigarette business generates significant cash flow and high returns on invested capital.   It has a structural cost advantage (more on this below) that it reinvests in price which has allowed it to continue to grow market share (market share has grown more than 4x over the past 20 years).  Growing market share and regular price increases drive cash flow growth and minimal investment needs allow this to be returned to shareholders in the form of dividends. The business is economically resilient and has tended to be counter-cyclical as market share gains accelerate in a more challenging economy when smokers become more cost conscious and trade down in price to discount cigarettes (which VGR dominates).  The empirical experience is that once customers have traded down they don’t then tend to trade back up (so these market share gains end up being stickier than merely temporary trade downs).  VGR returns free cash flow to shareholders via dividends and will continue to do so (the current dividend yield is >7%).  So in summary, this is a a very stable cash flowing business, which should continue to grow cash flow and then return that cash flow to equity in the form of growing dividends.  The portfolio of real estate and debt/equity investments the company holds in addition to the core tobacco business (approximately 17% of current equity value) provide additional value and margin of safety.  Carrying value of real estate portfolio is $128 million (7% of current equity value) and the carrying value of the debt/equity investment portfolio which is carried at fair value of the underlying investments is $174 million (10% of current equity value).  

 

Permanent Structural Cost Advantage 

VGR is a party to the Master Settlement Agreement between tobacco companies and various states which requires a percentage of sales to be paid into a compensation fund based on the market share of cigarettes sold.  Unlike other tobacco companies VGR is not required to pay any compensation on the first 1.93% market share which gives it a permanent cost advantage.   VGR reinvests this in price which in turn allows it to capture market share.  VGR became a signatory to the MSA in November 1998 and launched a discount brand to take advantage of its permanent advantaged cost position.  

 

VGR has grown market share from 1.2% in 1999 to 5.5% at Q3'23.  EBITDA from tobacco operations has grown from $79 million to $365 million over the same period.  

 

Significant Cash Flow Generation 

VGR generates significant and consistent Free Cash Flow.  LTM FCF was $183 million (10.5% FCF yield vs current market cap).  This is driven by high cash conversion and minimal ongoing capex requirements.  By way of comparison this has increased from $112 million in 2017 and $73 million in 2012 or a 5 year / 10 year CAGR of 10% pa.  The growth in cash flow is from growing market share per above (higher volumes) as well as regular price increases translating into expanding gross margins.    

 

Future Growth Prospects 

Volumes in the tobacco industry overall shrink low single digits per annum.  To offset that tobacco companies raise prices resulting in LSD/MSD top line growth.  Within the industry discount brands have gained market share from premium brands so have outperformed the overall market and VGR has been at the forefront of discount segment.  VGR has the largest discount and deep discount brands and has grown its largest brand to #4 overall in the US.  I expect these trends continue and will drive MSD/HSD top line growth and gross profit growth for VGR.  This translates into similar FCF growth given continued low capex requirements.  

 

VGR currently trades at 7x EBIT and 10.5% free cash flow yield to equity.  This is too cheap given the low risk growth prospects, defensive cash flow profile of the business and the company's intention (and empirical behaviour) of returning capital to shareholders.  Holders are paid to wait via the dividend yield which will grow over time as cash flow grows.