Tobacco stocks like Altria Group (NYSE:MO) and Philip Morris International (NYSE:PM) have long been favorites of dividend investors. With good reason: their high, reliable dividends are perfect for income investors. In recent months, investor attention has swung to Vector Group (NYSE:VGR) as it invests in its real estate subsidiary. Upon first glance, Vector's 7.58% dividend yield looks too good to be true. However, a closer look at Vector's changing fundamentals suggests that the dividend may not be so risky after all.
A quick look at Vector's dividend coverage and debt capacity immediately raises red flags.
Vector has struggled to generate cash flow as it uses more of its operating earnings to make interest payments on its debt. Since 2009 Vector has paid out 2.5 times more than its cash generated by operations. Instead of using cash generated by its business, Vector has funded its high dividend by raising even more debt. The company has created enormous value for shareholders by borrowing against future earnings to pay the dividend immediately, but the financial maneuvering cannot go on forever.
Vector has racked up over $1 billion in debt. The company used $109 million in cash to cover interest payments in 2013, more than twice the cash generated by operations. Excluding litigation expense, the company generated about $200 million in operating income in 2013. Assuming it can continue to generate that amount going forward, the company's tobacco operations can contribute about $78 million toward a dividend each year after interest and $13 million in capital expenditures. With $407 million in cash on hand in addition to this, Vector can pay the $164 million per year required to maintain its current dividend for another 4.7 years without raising additional funds. After that, the dividend must come down significantly unless the company's cash flow improves.
Fortunately, Vector has a large hidden asset that could boost cash flows. For years, Vector maintained a 50% stake in an unconsolidated real estate entity called Douglas Elliman Realty. Vector recently purchased an additional 20.59% interest from Prudential Real Estate Financial Services of America for $60 million. That values the entire entity at $291 million.
Douglas Elliman generated $46.6 million in EBITDA during 2013, a 50% increase compared to 2012. The unit recorded $7.4 million in EBITDA for the first quarter of 2014, up from less than $1 million for the same period in 2013. Depreciation is not usually a real expense for real estate companies, which makes EBITDA a good measure of pre-tax cash flow. So it appears that Vector increased its stake in a growing real estate broker at just six times trailing pre-tax cash flow.
If Douglas Elliman retains its competitive advantage in the New York metro area, the company could be worth more than 12 times EBITDA, or double the valuation that Vector just paid. Moreover, it could contribute tens of millions toward the $86 million gap between Vector's tobacco cash flow and its dividend payments. This contribution, combined with the monetization of $130 million in real estate properties, could extend the current dividend for a decade or more.
In addition, there are several indications that the stake really is the bargain that it seems. Although Prudential would not willingly sell a growing real estate company for six times EBITDA, Vector may have had a contractual right to buy it using a pre-defined valuation method. That could explain why the two companies ended up in arbitration to decide the purchase price -- and why Vector got away with a bargain.
Moreover, lenders still believe the company has spare debt capacity and the CEO expressed confidence in the dividend on the latest conference call -- both are indications that insiders have confidence in the company's future cash flows. If the cash flows materialize, Vector's stock price could surge upward.
Better safe than sorry
Investing in Vector requires you to believe that the company's future cash flow will be much higher than it has been in recent years. Although there are some reasons to believe this will be the case, most income investors are more concerned about collecting safe dividends rather than participating in capital appreciation upside. For these investors, it's best to stick with tried-and-true dividend kings Altria and Philip Morris.
Altria yields 4.5% and Philip Morris yields 4.2%. Neither is as exciting as Vector's 7.6% yield, but they make up for it in safety and reliability. Although Altria pays out 87% of its earnings through a dividend, pricing power enables it to grow earnings even as the cigarette market shrinks. Altria has increased its dividend at an 8.7% annual rate since 2009, when it spun off Philip Morris. Philip Morris also raises its dividend each year, and has grown it at 12.43% per year since the spin off. You can't go wrong by buying and holding Altria and Philip Morris for income.
On the surface, it looks like Vector's dividend is doomed. However, the dividend may suddenly seem safe once Douglas Elliman's full-year results are consolidated in Vector's financial statements. It is hard to know how much cash flow the real estate subsidiary can provide, but it appears to be more than the market gives it credit for.
Still, it is not certain that Vector can cover its dividend for more than a few years. Investors looking for safe and reliable dividends should stick with Altria and Philip Morris -- two tobacco stocks that won't let you down.
Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.