Tobacco stocks such as Altria (MO) and Philip Morris International (PM) have long been favorites for dividend investors seeking generous, secure, and steadily growing yields.
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.
Business Overview
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.
Source: Vector Group Fact Sheet
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.
Business Analysis
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.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
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 4th largest 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.
Source: Simply Safe Dividends
