The stock of Vector Group Ltd. (NYSE:VGR), a holding company with a portfolio of tobacco and real estate businesses that I brought to the attention of my dear readers in March, is now yielding close to 7%, a level that income-focused investors might find appealing, especially considering that the number of high-yield dividend opportunities in the market had plummeted due to the S&P 500 rally on the hopes of quick economic recuperation and bumper growth ahead.
In the previous article, I gave a lukewarm rating to VGR due to its insufficient dividend coverage in the past. Now, after VGR delivered startling quarterly cash flow bolstered by stockpiling trends in March, I am slightly more confident in its dividend sustainability, but a few risks still exist.
Tailwinds spurred Q1 sales
Vector Group's first quarter was remarkably robust. VGR topped Wall Street's top- and bottom-line expectations posting total revenue of $454.5 million and adjusted earnings per share of $0.27. On the negative side, GAAP EPS fell short of expectations, as the pundits did not foresee that some of VGR’s long-term intangible assets including goodwill would fail the impairment test. However, investors should not shortsightedly focus only on the overall sales performance, as VGR's portfolio is complex and multifaceted. If we delve a bit deeper, we will notice that the 8% revenue growth was bolstered principally by the Tobacco segment (which includes Liggett and Vector Tobacco) that delivered an almost 12% sales improvement. Both core discount brands including EAGLE 20’s, PYRAMID, GRAND PRIX, LIGGETT SELECT, and EVE and non-core brands’ sales were much stronger than in 1Q19. But while Tobacco shone, growth in Real Estate was tepid. Upon deeper inspection, the key sources of division’s revenue (commission and brokerage income) were down significantly vs. 1Q19, mostly because of softness in New York City, where commission and brokerage income of Douglas Elliman Realty fell by almost 24%, primarily because of the coronavirus-related issues. Northeast, Southeast, and West were slightly stronger, and, thanks to them, the overall segmental revenue was 2% higher and added up to $167.4 million.
The question that should be asked here is if the robustness of cigarette sales (which, among other things, are believed to be immune to the economic downswings) was in line with a long-term pattern or driven by the short-term factors that are no longer relevant and hence have little to no impact on dividend sustainability. As Tobacco is the principal EBITDA and cash flow generating division, its performance is at the crux of dividend coverage.
There were a few factors that bolstered cigarette sales, and unfortunately, not all of them have long-term nature. Let us first take a look at a few of them that have a prolonged impact. The market share of Liggett Group (a part of the Tobacco segment) went up 0.1% to 4.3%, mostly because of the marketing success of EAGLE 20’s, the third-largest discount tobacco brand in the United States. Another tailwind was pricing, as VGR has been increasing selling prices of the above-mentioned brand since late 2018 in line with the long-term income growth strategy.
But these stimuli were far less important than the trend that emerged at the very beginning of the abrupt growth in the coronavirus cases in the U.S. in March, as wholesalers, retailers, and consumers had been stockpiling cigarettes on the fears that the outbreak could lead to temporary shortages. During the earnings call, the President & COO of Liggett Vector Brands confirmed that Liggett’s quarterly earnings were bolstered by that tendency.
As the COVID-19 situation unfolded in March, there were some anticipatory wholesaler, retailer, and consumer buying related to initial concerns of the ongoing availability of cigarettes... we estimate that approximately 60% of Liggett's year-over-year earnings increased as the result of this buying pattern.
Citing the data from Management Science Associates, he also clarified that Liggett had been even stronger than the overall industry which enjoyed tailwinds in March:
...overall industry wholesale shipments for the first quarter were up 7%, while Liggett's wholesale shipments increased 8.2% versus the prior-year quarter.
However, as the coronavirus-related fears have already eased in April, I am highly skeptical the same revenue and cash flow growth are achievable in Q2 and FY 2020, as temporary trends with excessive buying of essentials are relatively unlikely to repeat during the remaining quarters this year, except for the second wave scenario. The only Wall Street analyst who covers VGR is also bearish on the current quarter sales predicting an around 1.6% contraction.
Negative net income is of secondary importance
The principal issue readers should keep in mind is that VGR is not a high-margin business. Federal excise tax and agent commissions eat into gross profit and leave only a relatively small portion available to cover opex, interest, and shareholder rewards. Its narrow margins were among the culprits of negative Q1 net income. In theory, sub-zero profit indicates that the company will not be able to cover the quarterly dividend, as it delivered no earnings. Nevertheless, accounting profit has only limited impact on dividend payments, as companies use not GAAP earnings but cash flows to cover rewards they pour into shareholders’ coffers. So, it would be much better to switch attention to operating cash flow, especially considering that sub-zero profit was impacted by the one-off, non-cash impairment.
Regarding net CFFO generation, the first quarter was remarkably strong. Cash its operations brought was higher than the amount it generated during the entire FY 2019; LTM cash flows have been the highest since 2013. That was not just a seasonal fluctuation; the primary reason behind such a sharp increase was the stockpiling trend discussed above.
Of course, $115.3 million easily covered capex of $4.9 million and around $32 million (considering a 50% reduction in DPS vs. 2019) in dividends. The capital deployment model had barely changed, as the firm invested only 1% of revenue in PP&E, almost equally split between the Tobacco and RE divisions.
But what about the medium-term dividend sustainability? After the DPS has been halved this year, VGR needs around $128.3 million in cash to fully cover annual shareholder rewards. That is well above the 2019 net CFFO of $124 million, let alone free cash flow to equity. Nevertheless, while I am highly skeptical net CFFO will continue to grow in the coming quarters, the full-year dividend looks relatively protected thanks to the phenomenal cash flow surge in Q1.
Net worth crept lower
A dividend investor who is doing a quick research of VGR’s fundamentals will likely be negatively surprised with the company’s balance sheet that makes an impression Vector Group has been heading straight into default. Negative net worth that has been creeping lower since FY 2015 makes a somber impression and raises concerns regarding the company’s future.
However, Vector Group represents a rare case when the humongous debt on the balance sheet poses only relatively limited risks even despite the fact that the last time it had positive shareholder equity was almost five years ago.
As of end-March, $203.5 million in debt were due in the next 12 months. Liquid assets, including cash, cash equivalents, and investment securities on the balance sheet, stood at $571 million. As CEO Mr. Lorber said during the earnings call, convertible notes had already been successfully repaid:
In April, we used $170 million of cash to retire our convertible notes upon their maturity.
As of my calculations, with this adjustment, net debt did not change, as the total borrowings and cash fell simultaneously. Now it is standing at approximately $1.03 billion. The company's ND/EBITDA is now equal to approximately 3.76x; that is not the level a risk-averse dividend investor would like to see.
The silver lining is that the next substantial maturities of notes are only in 2025 and 2026. The company said it "was in compliance with all debt covenants" related to both 10.5% Senior Notes due 2026 and 6.125% Senior Secured Notes due 2025 as of end-March (see page 31 for details).
In sum, VGR is not on the brink of insolvency, but its financial position is still far from perfect.
After the dividend cut that I reckon was hastened by the looming debt maturities, the sustainability of the shareholder rewards has improved dramatically.
In May, the company announced an offering of 5 million shares (up to 5.75 million, see the document) and hence its annual dividend payments will go up by $4 million-$4.6 million to approximately $133 million in total. I expect the company will still cover the bulk of shareholder rewards using organic FCFE.
Being a predominantly cigarette company, VGR has some cash flow stability. At the same time, the cigarette smoking rates in the U.S. are in decline, which means Vector Group will not generate equally strong cash flows ad infinitum. Also, I would not say VGR is a stock worth considering for risk-averse investors, as high debt load, even despite recent principal repayment, multiplies risks (e.g., breach of debt covenants).