A Post-Spinoff Look At Douglas Elliman And Vector Group
On December 30, 2021 Vector Group spun off Douglas Elliman. Vector Group was a combination of Liggett, a discount cigarette company, and Douglas Elliman, a luxury real estate brokerage. The spinoff made sense because the two businesses operate in completely separate industries with completely separate growth opportunities. They should have different shareholder bases.
The spinoff allows Douglas Elliman to pursue a more aggressive growth strategy. Post-spin, Douglas Elliman has $200 million of net cash and its own stock that it can use as currency for signing bonuses, discounted equity programs, acquisitions, and “acqui-hires.” The stigma around tobacco companies probably made Vector Group shares unappealing to luxury real estate agents. The spinoff should help Douglas Elliman acquire new agents and retain existing ones.
The spinoff may also unleash some pent up entrepreneurial forces at both companies. Douglas Elliman wasn’t profitable until the pandemic induced 2021’s housing boom. That doesn’t make much sense to me, since it is a capital-light business with scale. The most likely explanation is that Douglas Elliman’s management wasn’t under the gun to maximize profits when Vector Group has tobacco cash flows pouring in to cover costs. That may change now that they’re a stand-alone company.
Douglas Elliman
Founded in 1911, Douglas Elliman is the sixth largest real estate brokerage in the U.S. and one of the largest in the New York City metropolitan area. The company’s markets are “international finance and technology hubs that are densely populated and offer housing inventory at premium price points.” Douglas Elliman is well established in New York, LA, Miami, and Aspen. It entered Dallas and Houston last year. The New York metro area is Douglas Elliman’s most important, accounting for about half of sales.
Douglas Elliman’s upscale focus sets it apart from its competitors. The company has an industry-leading average transaction value of $1.6 million in the nine months ended September 30, 2021. Million Dollar Listing LA’s Josh Altman and Josh Flagg are both agents. The company thinks the luxury market is more recession-proof than the broad real estate market, though it’s surely still cyclical.
Douglas Elliman makes money when its agents make money. So, I analyze it like I would a franchisor. The more value Douglas Elliman provides its agents, the more agents it will garner and the more it will make.
Douglas Elliman’s average commission has trended down from 5.3% in 2017 to 4.9% in 2020. That’s below the national average of 5.8% because the company’s mix is skewed towards higher-priced homes.
The company pays 75% of gross commissions to agents, which is in-line with industry standards. The remaining 25% is the company’s gross profit. The company’s operating costs are marketing, G&A, and investments in technology. Overall, the company operates with slim margins of 1-3%.
Douglas Elliman has a few levers to pull for growth. The company benefits from rising home prices and lots of transactions. Low for-sale housing inventory is currently a headwind, but higher housing prices are a tailwind. However, neither of these factors are directly under the company’s control.
What Douglas Elliman can control is whether it is attracting productive (i.e. high volume) agents. One way Douglas Elliman plans to grow is by entering new geographies by leveraging the company’s new development sales and marketing business (“DEDM”). DEDM helps condo developers sell new units. Often the buyers are also selling their old place so they make for good leads. Douglas Elliman can partner with a developer in a new geography and use the leads it generates to begin scaling a real estate brokerage there.
Douglas Elliman’s forward returns are difficult to estimate given the company’s cyclicality and operating leverage. For example, look at what last-years housing boom did to the business. EBITDA margins of 1-3% ballooned to over 8%!
Normally, I’m not a fan of discussing EBITDA, let alone adjusted EBITDA. However, here I think it makes sense. Douglas Elliman is extremely capital light (minimal capex) and also has several one-off costs and non-cash impairments that won’t reoccur.
Besides the housing boom, Douglas Elliman’s margins expanded because they aggressively cut costs in 2020. They reduced headcount by 25%, reduced G&A, and exited some leases. Operating expenses, excluding excluding activity-driven items such as advertising and discretionary compensation, have declined by about $25 million or 12% since 2019. Douglas Elliman also has a lot of fixed costs it was able to lever in the 2021 boom.
On a trailing basis, Douglass Elliman looks cheap. It has $200 million of net cash, $100 million of adj. EBITDA, and a $575 million market cap. Ex-cash, the stock trades for less than three times EV/EBITDA.
The key question is whether 2021’s earnings are the new normal or a cyclical peak. I’d guess normalized EBITDA is somewhere between 2020’s pandemic-depressed $20 million and 2021’s stellar $100 million. Admittedly, that’s an absurdly wide range.
I invest in simple, predictable, and profitable businesses. While Douglas Elliman is simple and profitable (at least currently), its cyclically and operating leverage make it too unpredictable for me.
At best, I like Douglas Elliman as a trade betting that it will re-rate as forced selling abates. The stock has gone virtually straight down since the spinoff. Part of that is broad market weakness. The other reason is forced selling as Vector Group’s tobacco-focused shareholders sell the shares they received.
Realogy trades for 7x EV/EBITDA which implies a $11.50 price for Douglas Elliman, 65% upside.
Vector Group
The Vector Group remainCo consists of Liggett, a discount U.S. cigarette company, and some real estate investments carried at $97 million.
While I don’t think Vector Group is a particularly interesting investment, Liggett is an interesting company with a storied history that offers insights into the modern tobacco market.
In the 1990s, Liggett made history as the first tobacco company to cooperate with the state attorneys generals that were trying to prove cigarettes caused cancer. Liggett was the fifth largest U.S. tobacco company at the time (now the fourth) and was much smaller than Philip Morris (now Altria). Philip Morris pressured Liggett to hold the line and deny any knowledge that cigarettes are harmful. Philip Morris was even reimbursing some of Liggett’s legal fees.
In 1996, Liggett decided to double cross Philip Morris and entered into secret negotiations with the state attorneys general. They offered to turn over damning internal documents and testify about the dangers of smoking in exchange for immunity from most penalties.
On March 20, 1997, Liggett became the first tobacco company to admit cigarette smoking is addictive and causes cancer. They said:
We at Liggett know and acknowledge that, as the Surgeon General and respected medical researchers have found, cigarette smoking causes health problems, including lung cancer, heart and vascular disease and emphysema. We at Liggett also know and acknowledge that…nicotine is addictive.
It’s wild to think that as recently as 1997 cigarette companies denied that nicotine was addictive!
In 1998 Liggett was the first to sign the Master Settlement Agreement (MSA) with the states. According to a 2003 Wired article:
Vector gained an advantage when its competitors were forced to settle with the states and pay heavy penalties for each pack of cigarettes sold. When the other companies raised their prices to accommodate the penalties, Vector jacked up what it charged and pocketed the money. In 1999 - the first year the price increase showed up on the bottom line - Vector's profits rose by a factor of 10.
In 1999 the company sold its L&M, Lark and Chesterfield brands to what is now Altria to narrow its focus on the discount end of the market. Shortly afterward, it began to contemplate a world without smoking.
Liggett’s idea was to genetically modify tobacco plants to contain no nicotine. The company sold cigarettes in three nicotine strengths so that consumers could ween themselves off of nicotine and quit smoking. Liggett began selling Quest cigarettes in 2002 but admitted failure and shut down the business in 2010.
The entire Wired article is worth a read because it explains how Philip Morris refused to work with tobacco leaf dealers who dealt in genetically modified tobacco in an attempt to shut down Liggett’s project. Liggett eventually turned to Amish farmers in Pennsylvania to grow their nicotine-free tobacco.
Today reduced risk products (RRPs) are all the rage and powering Philip Morris’s growth. Oh the irony. While Liggett was ahead of its time, it got the philosophy behind Quest wrong.
Quest cigarettes were full-carcinogen, low nicotine. Philip Morris’s IQOS, by contrast, is full nicotine and low carcinogen. People want nicotine, flavor, and oral fixation from cigarettes. They don’t want carcinogens. It no surprise then why Philip Morris’s IQOS is selling well while Quest failed.
Liggett never did develop a successful RRP but continues to sell discount cigarettes in the US under brand names: Eagle 20’s, Pyramid, Montego, Grand Prix, Liggett Select and Eve.
Discount cigarettes represent about 29% of the US market, of which Liggett has a 14% share. Discount segment cigarettes are more commoditized than premium cigarettes like Marlboro. Discount consumers are less brand loyal and more price sensitive.
Altria and BAT (British American Tobacco) together control 74% of the US cigarette market and use their scale to set prices at each pricing tier in the market. Competitive market forces compel smaller manufacturers to fall in line.
The MSA granted Liggett a granted a grandfathered market share of 1.65%. It only has to make MSA payments on cigarettes sold beyond that. Today Liggett has a 4.1% share, so 40% of its sales are except.
Liggett’s low MSA payments give it a cost advantage over its rivals that results in higher gross margins. However, Liggett lacks the scale of Altria and BTI, so it ultimately has lower operating margins than its larger rivals.
Since Liggett’s cost advantage is tied to its market share, the company doesn’t have a big economic incentive to attempt grow volumes and take share. That’s one reason I think Vector Group has historically invested in real estate and Douglas Elliman. I’ll be curious to see if management signal a change in capital allocation post-spin, like buybacks.
Today Vector Group trades for $11.25 per share and has 154 million shares outstanding for a market cap of $1.7 billion. Last year the company’s tobacco segment produced $320 million of operating income, implying a 6x P/OI. However, Liggett has $1.4 billion of debt, some of which carries a 10.5% interest rate. It looks Vector Group borrowed at 10.5% in 2018, which seems crazy and makes me question management’s capital allocation skills.
Liggett’s annual interest expense is $110 million, so pre-tax earnings are about $220 million and P/EBT is about 8x. That’s a cheap absolute valuation but not super compelling considering Altria trades for 9x pre-tax earnings.