What news has people up in arms recently?
Vector Group (VGR) is one of those companies that seem to attract articles on a regular basis that warn that the dividend is in danger. Basically the author will pull a couple of numbers out and claim that they show the dividend is sure to be cut soon. Well, VGR has been paying a dividend, and growing the amount paid out, for close to 20 years and yet none of these authors explain why the dividend is now in danger.
The latest article to do this is one by Robert Riesen. Robert's metric of choice is FCF (Free Cash Flow). As I pointed out in this article, where I explained why Robert's reliance on FCF to evaluate the dividend safety of Duke Energy's (DUK) dividend was wrong, FCF isn't a good metric to use for Vector Group, either, as it borrows a lot of cash for various uses. Robert is of the opinion that Vector has not demonstrated that it can afford the dividend, however I think that some 20 years of growing the total dividend payout while also growing revenues and total earnings (not EPS, as the share count has been growing, but total earnings) is demonstration enough. As Robert really likes FCF, I will look at it in my analysis below to see if it has any insights to offer.
With those caveats in place, Robert's article doesn't contain anything new about Vector Group. Everything he outlines was true 10 years ago, and in most cases 15 or more years ago too. So even if Robert is right and Vector can't afford the dividend it pays, it's still likely to be paying it and growing it for some time. And I don't think Robert is right.
This article from 2016 which predicted an imminent collapse in Vector Group is probably the most dire of this type of article. Had you actually bought at the time of this article you would have 11% or so more shares and with dividends included (not even reinvested) you would be up.
Why setting your hair on fire over this news is unwarranted?
Don't get me wrong, Vector Group is far from a perfect company. While the yield is nice and the 5% a year in payout growth (due to a stock dividend) is nice to have, this is not a stock for suitable for every dividend growth investor. Vector Group is a complicated and in some ways too opaque a company. I'd be much happier if management laid out exactly how it was paying and growing the dividend. While lots of companies don't explicitly detail how they afford the dividend, with Vector Group its complexity and lack of transparency make it harder to get the needed numbers. In fact, for the most part I have to rely on not seeing red flags rather than in seeing cash flows that support the dividend.
Vector Group is around 3.5% of my portfolio, placing it at the high end of my full position size (which is 3.1% to 3.5%). Ordinarily with an 8% yield and a 5% DGR, I would be modestly overweight. But the fact that I have to determine how safe the dividend is by indirect methods means that I see too much risk to ever-weight the position. For me, VGR works quite well as I use the dividends it pays me to buy shares in other companies. Were I to be retired, I would look at the stock and company very differently. In fact, over the next 8 years or so I will likely cut the size of this position in half. I don't want to be in a position where I need the income from this stock to pay expenses. I think dividend growth investors would be wise to only invest in Vector Group once they have their basic needs met and half room for investments with a good growth potential but also some risk.
This first YChart shows some of the things I was talking about only indirectly determining that the dividend is sustainable. Notice the trend in revenue is growing. So, since 2006, Vector Group has managed to grow its revenues when its big driver is sales of cigarettes. A market where the volume of units sold is declining. To me, and especially during the periods of faster revenue growth, I wouldn't expect that of a company that was consuming itself by paying out a dividend it couldn't afford.
Looking at the chart showing EPS, the trend there seems flat. It certainly bounces around a lot, and I think part of that is due to profits from the real estate part of the business. Understand also that while EPS is flat, total earnings isn't because the share count is going up by at least 5% a year (due to the stock dividend of 5% each year).
This YChart showing both EPS and FCF is of some interest. I don't see a lot of difference between these two metrics (and mostly those differences are that FCF is higher). Again, rather than positive information showing that is how the company pays the dividend, I instead see a lack of evidence that it is consuming itself by paying a dividend that is too high.
The YChart above is the most direct piece of evidence that Vector Group can afford its dividend. Here we see that the ratio between net long term debt and the FCF for the TTM (trailing 12 months) is fairly flat starting in 2011. There was a big spike in the ratio in 2010, but it's at a much more reasonable levels now. So the idea that management is borrowing primarily to fund the dividend is not born out. It certainly seems that for now the company's ability to fund the debt is growing about as fast as the debt itself.
It's always important to see how a company presents and sells itself to investors, so let's look at the latest investor presentation and see what information we can discover about how Vector Group is doing and how safe the dividend is. Below are the slides that I think best show that the company is growing even though it does devote so much cash to paying dividends.
The slide above shows what I see as the main reason to invest in Vector Group, its consistent and strong cash flow. And that heart of that is its position in the discount cigarette market. The $0.70 a pack advantage from not having to pay into the MSA fund gives them a pretty huge edge. And that is the type of thing to look for when looking for an investment partner. And with the number of cigarettes sold declining this cost advantage is even more important.
Litigation risk is a wild card in investing in tobacco companies. So it's very good, as the slide above indicates, that much of the litigation is now resolved. Other than the 3 suits that are class action suits (or have the potential to become such), I see most of the litigation risk as eliminated. With lower risks than in prior years, litigation doesn't look to be a danger to the dividend.
This final slide from the investor presentation shows a nice upward trend in both revenues and EBITDA (earnings before interest, taxes, depreciation, and amortization). The revenues from the real estate segment are dominated by commissions paid to the brokers. That doesn't translate into a lot of income because much of those commissions go to paying the agents. Since my wife is a broker and runs her own real estate company I know that the sales commissions go to pay the agents, advertising and other expenses involved with doing real estate transactions and that proportionately little profit is left for the company. My wife makes most of her income not from owing the company but from her own transactions.
Looking at the latest 10-K, I see a good reason not to be concerned about borrowing by Vector Group.
The aggregate net proceeds from the issuance of the 6.125% Senior Secured Notes were approximately $831,100 after deducting offering expenses. We used the net proceeds of the issuance, together with the proceeds from the sale of 2,100,000 common shares, to redeem all of our outstanding 7.75% Senior Secured Notes due 2021 and to satisfy and discharge the indenture governing the existing notes.
Basically Vector replaced $835 million of bonds that carried a 7.75% coupon with bonds having a face value of $850 million and a coupon rate of 6.125% that expire 4 years farther into the future. To fully cover the costs of retiring the 7.75% issue the company also issued 2.1 million additional shares. The old bonds cost $64.7125 million in interest a year while the new bonds cost only $52.0625 million. The additional shares will initially cost $3.36 million in dividends. Keeping in mind that each year each of these shares will become 1.05 shares, by 2025 that dividend payment will be around $5 million. So with this transaction Vector will save more than $7 million a year in debt expenses. After this debt swap, Vector Group has better coverage for the dividend. But also, look at the fact that in a rising interest rate environment Vector was able to extend a significant portion of its debt 4 years and lower the interest rate it had to pay. Clearly bond holders aren't worried that it will be able to pay all of its obligations.
Looking at Moody's ratings I don't find any evidence that the company is digging a hole for itself. The B2 rating is below investment grade and I would certainly like it to be higher. In large part this is due to the big dividend that Vector pays (Moody's say so), but bond holders don't like dividends and really don't like big ones. But the stable rating and no comments about the dividend being unsustainable are indications that the dividend can be supported, even if it does limit options for the company. Also note that while the corporate rate is B2 (and has been since 2010), the rating on individual bond issues is current Ba3, two steps higher, and this rating has improved since 2010. This is yet another sign that the company can support the dividend.
What's a good price?
To figure out a good price, I do a DDM calculation using my Excel based DDM calculator (pictured below, you can see the web-based calculator I based it on here and read a discussion on how the formulas were developed here). Looking at the David Fish's CCC List (which contains data on companies that have raised their dividend each year for 5 or more years), I see Vector Group has raised the dividend it pays each year for 20 years. The current dividend is $1.60 a year, so I will use that value for the dividends paid over the next 12 months. Since the dividend per share does not increase (rather because of the stock dividend investors get more shares over time), I will also assume that all dividend growth rates are 0%. This is very conservative, but I think it's prudent and fair.
** Special Note: Justin Law has produced an update to the CCC List since David Fish's untimely passing. Check out the article to help support Justin and keep this valuable resource going.
Using these parameters, I calculate that the NPV (Net Present Value) of the predicted dividend stream is $25. Because of the lack of transparency and the non-investment grade credit score I want an extra 15% discount to increase my margin of safety. That makes my buy price anything under $21.
With the current market price of VGR being under $20, my buy price of $21 means that it is trading at good value. For those who can handle a little risk it offers a very attractive dividend payment that increases on a regular basis by a very predictable and dependable amount.
What to watch for going forward?
Going forward I want to make sure that the credit rating agencies don't down-grade either the company or any of its bond issues. I also want be sure that it doesn't have a big increase in the rate it is issuing debt and the revenues and earnings trends continue.
VGR is a very complex stock to analyze. Vector Group isn't as transparent as I would like, but it does have a 20-year history of growing its dividends and no signs that it can't continue as it has been doing. This is a bit higher risk than more traditional dividend growth companies. But if you are willing to take the extra risk, and I recommend using position size to help manage that risk, this company can be a good source of growing dividends for a dividend growth investor.
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Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended. The price I call fair valued is not a prediction of future price but only the price at which I consider the stock to be of value for its dividends.
Disclosure: I am/we are long DUK.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.