Interactive Brokers - Vector Group Eyes US$325m Note Sale As Rising Leverage And Higher Prices Stunt Growth

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Includes: ACB, APH, BTI, CGC, JAPAY, MO, PM, PYX, VGR, XLP
by: Interactive Brokers
Summary

Florida-based cigarette maker Vector Group is set to sell US$325m worth of senior unsecured notes to refinance existing bonds, as the company continues to struggle with a hefty debt burden.

Moody's Investors Service assigned a junk-status, 'B2' credit rating to the deal and downwardly revised its outlook on the company from stable to negative.

Vector's debt offering also falls against a backdrop of soured sentiment about riskier assets, amid elevated U.S.-China trade tensions, as well as a host of tariff-related corporate concerns.

Florida-based cigarette maker Vector Group (NYSE:VGR) is set to sell US$325m worth of senior unsecured notes to refinance existing bonds, as the company continues to struggle with a hefty debt burden.

Vector Group, parent of tobacco company Liggett, as well as New Valley, which owns a majority stake in Douglas Elliman Realty, plans to enter the primary market with a Rule 144A private placement, Reg S sale - an offering solely intended for qualified institutional buyers and persons outside the U.S.

The company said it intends to use the net cash proceeds from the offering to repay its outstanding 7.5% variable interest senior convertible notes due 2019 as well as to pay transaction-related costs and expenses, and for general corporate purposes, including to repurchase its outstanding 5.5% variable interest senior convertible notes due 2020 at, or prior to, maturity.

Moody's Investors Service assigned a junk-status, 'B2' credit rating to the deal and downwardly revised its outlook on the company from stable to negative.

Moody's analyst Kevin Cassidy recently noted that Vector's 'B2' rating "reflects its relatively small scale and limited pricing flexibility in the deep discount segment of the highly regulated and declining domestic cigarette industry." He continued that the firm's credit profile is further constrained by its negative free cash flow and the "ongoing threat of adverse tobacco litigation and regulation."

Vector's high pro-forma financial leverage of 6.2x, and continued negative free cash flow in excess of US$100m annually, reflect the company's high dividend payments.

Moody's said it expects debt to EBITDA to remain high over the next 12-18 months due to modest earnings growth that should help lift the company's real estate brokerage business that has been under pressure over the past year.

Cassidy added that the 'B2' rating on the proposed notes also reflects the benefits from a security interest in the stock of DER Holdings, which holds the company's 71% interest in the Douglas Elliman real estate brokerage. Moody's said it expects "this security interest would enhance recovery value in the event of a default," given the proposed notes are guaranteed on a senior unsecured basis by Vector's tobacco subsidiaries.

The new notes are effectively subordinated to the company's credit facility and US$850m of senior secured debt with respect to those assets.

Beleaguered business

Vector's note offering comes as tobacco companies have been generally pursuing alternative paths towards growth, as the population of smokers declines.

For the second quarter of 2018, Vector's tobacco segment generated a less than 1% revenue rise to US$274.8m and a near 3% decline in operating income to US$62.5m.

Meanwhile, conventional wholesale shipments of cigarettes remained roughly flat at 2.30bn units in Q2'18 from the prior year, while Liggett, whose portfolio of discount cigarette brands include Eve, Grand Prix, and Pyramid, saw its retail shipments increase 4.3% despite a 2.7% decline in the overall industry.

In terms of costs, producer prices in the beverage and tobacco manufacturing subsector have increased about 2% in 2018 year-to-date, with consumer prices of tobacco and smoking products up 0.3 in September from 0.1 in the prior month, according to the Bureau of Labor Statistics.

Against this backdrop, Vector's stock has fallen roughly 38.6% since its 52-week high of US$21.92 set in early December 2017, and yields on the firm's 6.125% notes due February 2025 have risen by almost 321bps to around 8.1% since January.

Risk-off backdrop

Vector's debt offering also falls against a backdrop of soured sentiment about riskier assets, amid heightened geopolitical volatility, underscored by elevated U.S.-China trade tensions, uncertainties over Brexit negotiations, Italy's fiscal budget plans, as well as a host of tariff-related corporate concerns.

The adverse market conditions appear to have relegated many issuers to the sidelines, while some bond funds have experienced a recent uptick in withdrawals.

According to SIFMA researchers and recent data sourced by Thomson Reuters, high yield note sales have plunged 27.7% year-to-date in 2018 from the prior year to US$155bn, while investment-grade corporate bond offerings have sunk 13.2% to US$954bn.

Also, in the week ending October 24, a total of nearly US$2.4bn flowed out of high yield corporate funds while investment-grade funds reported net inflows of only US$415m, according to Lipper.

Recent U.S. interest rate volatility, as well as the Federal Reserve's rate hikes, have also not helped matters, as bond issuers grapple with pricing and interest among investors.

Friday, market participants' focus will be generally fixed on the Bureau of Labor Statistics' October reading on the employment situation. The strong labor market has been one major factor behind the Fed's decision to continue normalizing monetary policy.

While September's headline number had disappointed market expectations, the unemployment rate fell to 3.7%, the lowest level since December 1969.

Investors generally continue to think the central bank will decide to raise rates for the fourth time in 2018 at its December meeting, with the market widely dismissing the softer headline jobs number for September as a weather-related aberration, mainly due to Hurricane Florence, and not indicative of broader weakness.

The yield on the 10-year U.S. Treasury note had last risen 0.54% intraday Tuesday to 3.10%.

Note: This material was originally published on IBKR Traders' Insight on October 30, 2018.

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