However, with massive consolidation in the tobacco industry, courtesy of the secular decline in world smoking rates, the number of quality tobacco blue chips continues to decline.
Vector Group (VGR) is now the highest-yielding tobacco stock trading in U.S. markets with a 7.6% dividend yield, and the company has even raised its dividend for 19 consecutive years.
Is the stock’s high yield a signal that this relatively tiny ($2.7 billion market cap) cigarette provider is a hidden gem that investors living off dividend income should consider owning?
Or is the market providing an important warning sign that Vector Group is a value trap that needs to be avoided at all costs?
Let’s take a closer look at the business.
With roots dating back to 1873, Vector Group operates two major business segments.
Tobacco Products (60% of sales, 90% of adjusted EBITDA): 117 total cigarette brands sold through its Liggett and Vector Tobacco subsidiaries. These include mostly discount cigarette brands such as: Eagle 20’s, Pyramid, Grand Prix, Liggett Select, Eve, Bronson, USA, and Tourney. In total, Vector is America’s 4th largest tobacco company.
Real Estate (40% of sales, 10% of adjusted EBITDA): Vector’s New Valley subsidiary owns 70.6% of Douglas Elliman Realty LLC, one of the largest real estate brokers in New York City. Through Douglas Elliman, Vector owns properties in some of the fastest growing regions of the country such as California, Florida, New York City, and Texas, as well as international holdings in Bermuda and St. Bart’s. In total, Vector’s real estate ventures own 23 properties, consisting of land, condos, apartments, hotels, minority stakes in commercial properties.
Vector Group’s total sales and operating profits are very diversified, with Real Estate providing over 40% of both. That certainly is good news for investors concerned about the secular decline of the tobacco industry.
At first glance, there is a lot to like about Vector. Unlike most tobacco stocks, the company has a very fast growth rate, especially in terms of free cash flow, which is ultimately what secures, and provides for a growing dividend.
This faster growth rate is courtesy of the company’s fast growing real estate business, as well as a major competitive advantage under the Tobacco Master Settlement agreement.
Specifically, as long as any individual brand Vector sells achieves 1.65% or higher market share, it doesn’t have to pay any financial obligations to the states.
All of Vector’s brands combined have only a 3.3% market share, thus granting Vector a $0.68 per pack cost savings that can be passed onto customers and retain its dominant position in the discount cigarette market.
In fact, this cost saving (about $165 million a year) has helped Vector to achieve superior volume growth over time.
For example, during the first nine months of 2016 Vector’s cigarette volume declined by just 1.7%, compared to Altria’s, the industry’s, and Philip Morris’ declines of 2.4%, 4.0%, and 4.1%, respectively.
However, where Vector shows its weakness is in profitability. That’s due to both lower gross margins on its discount cigarettes (which by definition have less pricing power than more popular brands) and the lower margins from the real estate business.
In fact, the real estate business acts as a drag on profitability and returns on shareholder capital, as well as increasing overall profit volatility.
Due to its far less profitable real estate business, Vector Group has one of the worst profitability profiles in its industry.
For example, note its low free cash flow (FCF) margin of just 6.1%. That is far smaller than larger, pure-play tobacco rivals such as Altria and Philip Morris International, which earn a FCF margin closer to 26%.
|Company||Operating Margin||Net Margin||FCF Margin||Return On Assets||Return On Equity|
But isn’t the real estate business a major benefit to long-term investors? After all, with global smoking rates in long-term decline, Vector’s large and fast growing real estate operations (revenue up 10% through the first 9 months of 2016) should provide much better long-term growth going forward than most other tobacco blue chips.
However, remember that while revenue growth is nice, what really matters at the end of the day for dividend investors are profits and cash flows.
As you can see, while Vector’s New Valley subsidiary has been doing massively more business in recent years, that hasn’t translated into growing profits.
In fact, on an Adjusted EBITDA basis, New Valley has reported a 43% decline in profitability, indicating that management may be reaching for growth for growth’s sake.
Why would it do that if it threatens to destroy long-term shareholder value?
That brings me to the major risks involved with Vector, namely that management, in recent years, seems to have overextended itself with its dividend growth. The company is now playing a potentially unsustainable game of trying to hide the fact that the high payout has made this a risky stock.
Over the past decade Vector Group has managed to put up some incredible total returns, courtesy of very impressive growth in its dividend.
In fact, Vector’s stock has beaten not just the market as a whole, but most other tobacco stocks, as well as real estate investments.
However, that strong returns hide’s an ugly truth, mainly that management has grown so quickly not by retaining earnings and cash flow and then consolidating smaller, discount brands of cigarettes, but by taking on increasing levels of debt to pay for those acquisitions.
In addition, Vector has tried to appeal to dividend investors not just by offering the highest yield in the industry, but also through an annual 5% share dividend.
However, while this may appear shareholder-friendly at first (and explains why it’s proven so popular with investors over time), it also results in an increasing amount of dilution that risks the long-term growth and safety of Vector’s dividend.
That’s because most tobacco companies are free cash flow machines and use that cash to buy back shares over time. That in turn reduces the payout ratio and allows for more consistent and sustainable dividend growth over time.
Since long-term total returns follow a company’s dividend yield and earnings growth, tobacco stocks have historically been excellent long-term income investments.
However, because of management’s annual dividend policies Vector’s sky-high yield is one of the least safe dividends of any tobacco stock you can own.
That’s especially true because, as its real estate business becomes a larger portion of the business, Vector’s revenue, earnings, and cash flows will shift from a defensive nature (courtesy of its stable tobacco business) to one that is far more interest rate sensitive and tied to more volatile and cyclical economic growth (as with most real estate businesses).
Vector Group’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Vector Group has a Dividend Safety Score of 34, indicating its payout is riskier than most stocks and should be approached with some caution. Compared to most tobacco stocks, the payout does not look very safe at all.
For one thing, the company hasn’t been able to cover its dividend with earnings over any of the last 10 years. While part of that is because the high depreciation of its real estate holdings depresses “as reported” earnings, the fact that the company’s FCF payout ratio has only been under 100% once in the past decade should give investors pause.
That’s because, combined with the unsustainable growth in dividends over the past decade and the 6% annual share dilution (combination of the 5% share dividend and dilution to pay for ongoing dividends), what Vector has really been doing is paying the dividend out of a combination of new equity capital, debt, and returns of capital.
How can we tell that the company’s dividend might not be sustainable? By looking at the annual Form 8937, which shows how much of a company’s dividend is a qualified dividend and how much is a return of capital (ROC).
In 2014, 37% of Vector’s total distributions were treated as a taxable dividend and 63% were treated as ROC.
Now, it’s true that some of that ROC (basically just giving investor’s back their money) is because of the company’s real estate holdings.
However, the fact that 63% of Vector’s 2015 dividends were a ROC, while only 10% of the company’s adjusted EBITDA comes from that segment of its business, tells us that Vector is playing a potentially dangerous game.
Specifically, it appears to be trying to keep its stock price high (thus allowing it to raise cheap equity capital) in order to pay its ongoing, possibly unsustainable dividend.
What’s worse is that because the share count is rising by 6% per year, Vector’s ability to continue growing, or even sustaining, the dividend at current levels is going to decrease each year.
But what about the company’s impressive growth rate? Isn’t it possible that it might be able to grow its way out of trouble?
While that might be true in theory, consider the fact that over the past 12 months Vector’s FCF payout ratio was 280%.
Vector would have to grow its free cash flow at a furious pace to make the dividend safe.
In fact, the company would need to increase FCF by 6% a year over the long-term just to keep its FCF per share constant and thus prevent its high payout ratio from rising to even riskier levels.
Just to bring its free cash flow payout ratio back under 100%, the company’s free cash flow would need to grow by more than 15% per year over the next decade – feat very few companies have ever achieved, especially in a mature industry such as tobacco.
But what about Vector’s apparently strong balance sheet? As you can see below, Vector enjoys a high current ratio and has a relatively small amount of total debt. The company even has enough cash on hand to pay the dividend for nearly three years.
Unfortunately, Vector’s balance sheet is far weaker than it initially appears. The company’s current ratio is much higher than the average tobacco companies, but note that the leverage ratio is more than double its industry peers.
|Company||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Current Ratio||S&P Credit Rating|
Sources: Morningstar, Fastgraphs
That explains why Vector Group has a junk bond credit rating, which forces it to pay far higher interest rates than most other large tobacco companies.
In fact, Vector Group’s average interest rates on its loans are 6% to 8%, and that’s before interest rates potentially rise by as much as 3% in the next three to four years.
Vector Group’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Vector Group’s Dividend Growth Score of 23 indicates that investors should expect slower dividend growth in the years ahead – certainly lower than the double-digit dividend growth rate enjoyed over the past 20 years.
In fact, since Vector’s dividend appears unsustainable on an FCF per share basis, investors need to be prepared for a potential dividend cut in the future.
Even after such a cut to bring the dividend more in line with the company’s annual FCF, future dividend growth would have to be closer to the company’s underlying 1% to 2% growth rate in FCF per share.
In other words, Vector Group, as it stands now, appears to be a potential value trap. Given the current valuation and slow future dividend growth potential, Vector is a stock I plan to avoid.
Today, Vector Group’s stock is trading at nosebleed levels, at least when it comes to its P/E multiple, which is more than double the industry’s median.
In fact, Vector Group’s P/E is higher than 93% of global tobacco companies.
|Company||TTM P/E||13 Year Median P/E||Yield||13 Year Median Yield|
While it’s true that the yield is greater than 90% of other tobacco companies, remember that in this era of record low interest rates, a very high yield often means high risk.
As you can see, Vector’s historical yield is significantly higher than the stock’s yield today, indicating that those who buy shares at today’s elevated levels are likely not being adequately compensated for the risks of a dividend cut.
Concluding Thoughts on Vector Group
While Vector Group’s long-term growth dividend growth record and 7.6% yield might initially appear attractive, dividend investors need to always consider payout security first and foremost.
After all, StoneMor Partners (STON) also had an impressive payout growth record and yet, because of a similarly unsustainable payout, was forced to slash its dividend, resulting in substantial investor losses.
Given that Vector’s valuation is currently much higher than its historic norm, even dividend investors with high risk tolerances would likely do best to avoid this potential value trap at the current time.