Published January 3rd, 2017 by The Financial Canadian
Dividend growth investors love high yields and growing dividends, but it’s rare to find both of these characteristics in the same company. This often results in splitting portfolio allocations into “growth” and “income”.
What if I told you that there was a Dividend Achiever with a 7% dividend yield?
Dividend Achievers are stocks with 10+ consecutive years of dividend increases. You can see the full list of 273 Dividend Achievers here. The tobacco stock analyzed in this article has increased its dividends every year since 1999.
This article outlines the investment prospects of Vector Group (VGR), a company with the characteristics mentioned above.
Business Overview
Vector Group is divided into two main operating segments: tobacco and real estate. While these businesses seem unrelated, in many aspects they are actually complimentary.
Their tobacco business operates under the name The Liggett Group (a wholly owned subsidiary of VGR). They are quite a bit smaller than the Big 4 tobacco companies, and were founded in 1873. They sell a wide variety of cigarette products including Pyramid, Grand Prix, Liggett Select, Eve, and Eagle 20’s.
Source: Vector Group Investor Presentation, slide 6
The company focuses on discounted tobacco brands, and since they are a small company, they receive a partial exemption from the Tobacco Master Settlement agreement. This agreement was between the largest U.S. tobacco companies and a group of various attorneys, and gives the companies immunity from lawsuits associated with the health consequences of tobacco in exchange for the elimination of tobacco-related marketing. Large U.S. tobacco companies pay continuing fees for the use of the benefits associated with this agreement.
Since Vector’s tobacco business is so small, they are exempt from these payment obligations unless their market share exceeds a certain threshold (1.65%). This agreement (and the associated cost savings) are outlined in the following slide.
Source: Vector Group Investor Presentation
Vector’s real estate business operates under the name New Valley, and has two primary components. The first is a major (70.59%) stake in Douglas Elliman Realty, LLC, the largest residential real estate brokerage firm in the New York metropolitan area. It is also the fourth-largest residential brokerage firm in the U.S., with ~6,000 affiliated agents and 90 different offices.
Along with facilitating transactions in the markets, Vector also invests directly in real estate deals. The company’s real estate investments are domestically diversified in various markets across the United States according to the following slide.
Source: Vector Group Investor Presentation, slide 12
In terms of concentration, Vector owns a significant amount of property within New York City. These investments are described in the following diagram.
Source: Vector Group Investor Presentation, slide 13
It is very important for investors to understand the effect of Vector’s real estate business on the company’s financial statements.
The real estate industry is naturally exposed to certain accounting charges that may effect the way that financial statements are interpreted by investors. Two significant non-cash accounting expenses for real estate companies are amortization and depreciation. These charges are deducted from revenues to eventually arrive at EPS.
These charges will reduce EPS to a level that might be seen as not accurate, which increases PE ratios and dividend payout ratios. The overall effect is a reduction in the apparent investment attractiveness of the company.
There are multiple alternative methods that can be used to analyze Vector in lieu of EPS. Because of the company’s real estate exposure, it might be appropriate for potential investors to consider using free cash flow (FCF) or EBITDA.
Growth Prospects
Over the long run, The Vector Group has soundly outperformed the overall stock market as measured by the S&P 500 Index.
Source: Vector Group Investor Presentation, slide 17
On a total return basis, Vector’s performance has been largely driven by their dividend yield and growth. They have a current dividend yield just north of 7%.
Vector is also a Dividend Achiever, a group of strong companies with 10+ years of increasing dividend payments. This is indicative of a strong underlying business with shareholder-friendly management.
Vector is quite unique because along with raising their cash dividend payments, Vector pays a stock dividend of 5% each year in September. For every 20 shares of VRG in a brokerage account, an additional 1 share is issued from treasury and deposited into investors’ brokerage accounts. This 5% stock dividend has been ongoing for 18 years and shows no signs of stopping.
This stock dividend has the potential to work beside dividend reinvestment plans (DRIPs) to increase both the number of shares owned and (more importantly) the dividend income from these shares.
This has resulted in a remarkably steady level of dividend growth for investors.
Source: Value Line
Note that this diagram excludes the 5% stock dividend, so an investor’s actual increased income would be higher than displayed above.
Vector has two significant growth prospects that will propel the company moving forward.
The first is the continued introduction and implementation of Vector’s electronic cigarette products. With the continued awareness of the consumer on the health effects of traditional tobacco products, many will be looking for healthier alternatives. This will increase sales in Vector e-cig business.
The second is the continued growth of Vector’s real estate business. The company appears to be focused on transitioning more of their earnings to this segment, and revenues in their real estate business are growing much more quickly than tobacco.
Source: Vector Group Investor Presentation, slide 16
Competitive Advantage & Recession Performance
Much of Vector’s tobacco earnings come from discount cigarette brands. Since these products are inexpensive and addictive, one would expect their sales to remain healthy during an economic recession. This is true of cigarette stocks in general – they tend to perform well in downturns.
Unfortunately, Vector’s real estate business does not have the same level of recession resistance as their tobacco business. The Global Financial Crisis demonstrated to millions of U.S. homeowners how housing prices can be reduced dramatically during depressions.
With all that in mind, let’s consider the data. Here is a snapshot of the company’ EPS performance during the 2008-2009 financial crisis.
- 2008: $0.54
- 2009: $0.33 (39% decrease)
- 2010: $0.53 (61% increase)
Evidently, Vector Group’s earnings experienced a significant downturn during the recession, but bounced back after only a year.
The company also continued to grow their dividend through the Great Recession, which is a testament to the ability for the company to grow dividends through all economic conditions.
One thing to consider is the company’s dividend payout ratio. In fiscal 2015, for example, Vector’s earnings on a per-share basis were $0.47 and their dividends paid were $1.47 without accounting for the 5% stock dividend.
This is equivalent to a payout ratio of 313% – which is unsustainable. Vector has been growing their long-term debt to finance these dividends. In the event of a significant recession, it is possible the company would have to cut their dividend.
This is a risk that dividend investors should be aware of.
Valuation & Expected Returns
As a small company with strong growth prospects, it would not be surprising if the Vector Group traded at a premium valuation multiple relative to both their larger tobacco peers and the aggregate stock market (as measured by the S&P 500 Index).
Vector earned $66.5 million during the 9 months ending September 30th, or $0.52 per diluted common share. On an annualized basis, this is equivalent to $0.69 of EPS for fiscal 2016.
December 30th’s closing stock price of $22.74 is about 33 times 2016’s YTD earnings (expressed as an annual number).
To provide a benchmark, Vector’s stock closed on December 30, 2015 at $22.79 adjusted for splits and dividends, and the company’s earnings for fiscal 2015 were $0.47 on a per-share basis. In other words, the company traded at 48.5 times earnings a year ago.
Both of these valuation multiples are significantly higher than the S&P 500’s PE ratio of ~26. However, Vector is a high growth stock and trades at a high multiple as a result. The following diagram displays how these two valuation multiples compare with average annual PE ratios of the Vector Group over time.
Source: Value Line
While Vector’s current PE of 33 seems high relative to the overall market, it is actually quite in line with the stock’s historical averages. There is an above-average volatility in the stock’s valuation multiple because the company experiences fluctuations in both earnings and stock price.
Future returns for VRG investors will be composed of potential earnings growth, dividend yield and 5% stock dividends. The company has not had meaningful earnings growth since 2008, and gains that had previously been made were lumpy and quickly lost. Consider the following diagram.
Source: Value Line
In the long run, I expect VRG to return 13-15%, composed of:
- 7% dividend yield
- 0-2% earnings growth
- 5% annual stock dividend
Final Thoughts
On the surface, the Vector Group had many of the characteristics of a strong dividend investment.
They are a Dividend Achiever, have a high yield, and a long track record of paying dividends.
The company also has an interesting program in place where investors receive a 5% stock dividend once per year. This works alongside the company’s steady dividend increases to boost investor income over the long run.
However, this stock is not without its risks. It has significant exposure to the real estate industry, which has traditionally not performed well during recessions. It also pays more than three times its annual earnings as dividends, and has been financing these payments via increases in long-term debt.
For investors seeking potential high rewards in return for high risk, the Vector Group presents an opportunity to gain exposure to the tobacco industry. The risk-conscious investor might be better off investing in blue chip tobacco stocks like the Altria Group (MO) or Philip Morris International (PM).
