Vector Group (VGR) is the 4th largest tobacco company in the US.  Vector Group has a market cap of just $2.3 billion, making it significantly smaller than its larger rivals. The company sells discount tobacco products under the Pyramid, Liggett, Eagle20’s, Grand Prix, and Eve brands.  In addition, Vector Group has significant real estate investments totaling around $150 million. The company owns about 70% of Douglas Elliman Realty, which is the largest residential real estate brokerage in New York.  Doug Elliman realty also has a presence in South Florida and California.

Investors may be enticed by Vector Group’s dividend yield of nearly 8%.  The company has not reduced its dividend payments (excluding special dividends) since 1995.  Vector Group is a shareholder friendly business as evidenced by its extremely high dividend yield and long history of dividend payments.  The company is the highest yielding stock in the Dividend Achievers Index.  The Dividend Achievers Index is made up exclusively of businesses with 10 or more years of consecutive dividend payments.  Vector Groups current events, competitive advantage, and future growth prospects are analyzed in this article.

Business Overview

Vector Group’s operations are split into three segments:  Tobacco, Real Estate, and E-Cigarettes.   Each segment’s percentage of total adjusted revenue generated in the last 12 months is shown below to give an idea of the relative importance of each segment:

• Tobacco: 63.52% of revenue
• Real Estate: 35.85% of revenue
• E-Cigarettes: 0.63% of revenue

Vector Group’s E-Cigarette operations are still in their infancy.  The company will likely garner a small portion market share in E-Cigarettes in the US just as it has done in traditional cigarettes.  Vector Group does not have the advertising or research and development strength larger tobacco companies have to outcompete them in E-Cigarettes.

Vector Group’s Tobacco segment is its largest based on both revenue and EBITDA contributed to the company.  The Tobacco segment is focused ondiscounted cigarette sales.  Vector Group’s discounted cigarette prices appeal to cost conscious smokers.

The company’s Real Estate segment is its second largest by both revenue and EBITDA contributed to the company.  Vector Group owns 70.59% of real estate brokerage Douglas Elliman.  Douglas Elliman has 5,290 agents spread over 74 offices in New York, California, and Florida.  The Real Estate segment also owns the Escena master planned community in Palm Springs.  Additionally, the company has fractional ownership in 13 condos and mixed use facilities, primarily in New York.  Vector Group has the largest percentage of ownership in the following two properties:

• 11 Beach Street – 49.5% ownership
• 23-10 Queens Plaza South – 45.4% ownership

Vector Group has 25% or less ownership in the other 11 facilities mentioned above.  Finally, the company has ownership in 5 apartment buildings and hotels.  Each property is listed below including the percentage of ownership attributed to Vector Group:

• Park Lane Hotel: 5% ownership
• Maryland Portfolio (apartments/rentals): 5% ownership
• ST Portfolio (apartments/rentals): 4% ownership
• Hotel Taiwana: 17% ownership
• Coral Beach: 49% ownership

Competitive Advantage

Vector Group’s largest cash generator is its Tobacco segment.  The tobacco segment created the cash flows that have allowed the company to pay out a tremendous dividend and invest in real estate businesses and brokerages.  The Tobacco segment has a competitive advantage in cost of production for cigarettes.

Vector Group is a ‘small’ ($2.2 billion is small in the Tobacco industry) company.  Its small size gives it a unique legal competitive advantage.  The company’s small size gives it partial exemption from the Tobacco Master Settlement agreement.  This exemption is worth about $160 million a year to Vector Group.  As a result, Vector Group has a $0.62 cents/pack cost advantage on average over other US cigarette companies.

Vector Group’s small size has given it a low-price competitive advantage.  At first glance, one would assume Vector Group’s cigarette business is in declinebut this is not the case.  The company has managed to consistently grow EBITDA and market share for its cigarette brands over the last 15+ years as the image below shows.

Source:  Vector Group Investor Presentation

Growth Prospects & Shareholder Return

As one would expect from a company with a dividend near 8%, much of Vector Group’s cash goes to paying its dividends.  Through the first 9 months of its fiscal 2014, Vector Group has generated about $100 million in operating cash flows. The company has paid about $122 million in dividends.  Obviously, a dividend yield higher than operating income is not sustainable.  Vector Group’s dividend does not appear to be in any danger, however.

The company has about $562 million in net current assets.  As mentioned earlier, Vector Group has generated about $100 million in operating cash flows over the last 9 months.  The company has spent about $22 million on capital expenditures over the same time period, giving the company about $78 million from operations.  The $122 million dividend payment creates a shortfall of $44 million for the company. At current spending rates, Vector Group could maintain its dividend payments for about a decade before extinguishing its liquid assets.  Vector Group is not in immediate danger of reducing its dividend, though the company must grow its operations to fund its dividend long-term.

Vector Group has been growing at a quick pace thanks to its growing presence in the real estate industry and continued market share gains in tobacco.  The  company is using stable cash flows from the Tobacco industry to raise capital and invest in real estate. The company has grown its Real Estate EBITDA from $20 million in 2011 up to $63 million for the first 9 months of 2014.  Tobacco EBITDA has grown from $174 in 2011 to $207 through the first 9 months of 2014.  The company is seeing strong growth in real estate as it takes part in the economic recovery and continued growth in Tobacco as it continues to benefit from its low cost advantage in cigarette production. Shareholders are likely to see strong double digit returns from the company’s growing operations and nearly 8% dividend yield going forward. The company is not without risks, however.

Recession Risk

As discussed above, Vector Group must keep growing to sustain its dividend payments. Historically, Vector Group’s cash flows have been very stable due to its reliance on cigarette sales. The cigarette industry tends to do will regardless of whether the economy is prospering or in a recession.

Vector Group has fairly recently diversified outside of cigarettes and into real estate. Approximately 36% of revenue is now generated from its real estate segment.  Unlike cigarettes, real estate does not do well during recessions. The last recession is a prime example of how real estate prices and transactions can plummet when the economy falters. If Vector Group’s real estate operations begin to incur losses during a recession, the company may cut its dividend payments to be prudent. If it did, its share price would likely plummet.

Final Thoughts

Vector Group’s cigarette business does have the qualities I look for when analyzing businesses. It has a strong price competitive advantage as well as some brand recognition. Unfortunately, the company’s real estate operations do not have the same level of stability as its core tobacco business.  By itself, this would not matter.  With the dividend payout ratio as high as it is (well over 100%), the company has little room for errors before it has to cut its dividend.

Vector Group does not qualify for investment using The 8 Rules of Dividend Investing because it does not pass the strict stability and quality screens required. The company is a high risk, high reward investment. I believe Vector Group will continue to grow until we see another recession.  If we are hit with a recession soon, the company’s dividend could be in jeopardy. If the next recession does not come for 5 or 10 years, Vector Group’s dividend will not be at risk, and shareholders will likely be sitting on large profits.