With cigarette sales volumes falling as fewer people smoke and others switch to electronic cigarettes, discount cigarette maker Vector Group (VGR 2.39%) is bolstering its other avenues of business, namely its real estate brokerage Douglas Elliman Realty.
With a core but shrinking primary tobacco business, a stout and storied real estate company, and the promise of new emerging technologies, dividend investors need to understand these seven things about the maker of Eagle 20's, Pyramid, and Grand Prix cigarettes and the operator of various hotels and golf courses in the U.S.
Vector Group is the leading deep discount cigarette maker, but that essentially makes it a big fish in a small -- and growing smaller -- pond. Image: Liggett Vector
1. Vector Group's share of cigarette market continues to decline.
Cigarette industry shipments continue to decline, with Management Science Associates' data indicating domestic shipments decreased by 4.7% in 2013, and by approximately 2.2% in 2012. Lorillard (LO.DL) reports industry shipments were down 2.3% last quarter, but Vector, which focuses on the popular discount brand end of the market, saw its volumes deteriorate at a much steeper rate, falling 5.3% in the third quarter.
2. Discount cigarettes are highly competitive.
Discount smokes enjoy much less brand loyalty from consumers who focus more on price than regular cigarettes, and Vector, as the leading deep discounter in the industry, also faces intense competition as a result. Management Science suggests the market share of these smaller rivals were as much as 33.7% in 2013, down from 34.4% the year before.
On its own Liggett -- Vector's cigarette division -- had market share of 11.6% last year, but also down from its 12.1% share during 2012. It notes if its share were to continue declining in the future, Liggett's sales volume, operating income, and cash flows could be substantially affected.
3. Industry consolidation heightens competitive environment.
If Lorillard's merger with Reynolds-American (RAI) is completed, Vector will find in Imperial Tobacco Group (NASDAQOTH: ITYBY) a stronger competitor as part of the deal has the cigarette giants calving off a number of brands, including Kool, Salem, and Winston. Imperial will immediately become the fourth biggest cigarette maker, and one that's more relevant.
Equally significant will be the cost savings realized by a merged Lorillard-Reynolds, which will create a rival that can perhaps at last assail the brand dominance of Marlboro, the top-selling cigarette with a 43.8% share of the entire U.S. cigarette market.
4. Vector has an advantage over other cigarette makers.
So long as Vector (and Liggett) remains a relatively small tobacco company, it won't have to make payments under the Master Settlement Agreement signed by Lorillard, Reynolds, and Altria (MO 1.91%) following the lawsuits filed against them in the 1990s. Even though tobacco accounts for nearly two-thirds of Vector's sales, so long as its share doesn't account for more than 0.28% of the industry and Liggett's doesn't exceed 1.65%, it will remain exempt.
Vector estimates that exemption is worth about $160 million annually, and gives it a cost advantage of about $0.62 per pack of cigarettes compared to the three biggest companies and a quality advantage of its discount rivals.
5. Vector was a late entrant to the electronic cigarette market.
The deep discounter only got into the electronic cigarette market with its new Zoom brand this year, which means it is far behind the competition when it comes to gaining acceptance. Lorillard's blue Cig is by far the biggest name in the business, with a 29% share.
Better late than never? Vector took its time entering the e-cig market. Image: Vector Group
That's well below the near-50% ownership stake it previously had in the e-cig business as Reynolds and Altria both rolled out their own brands this past summer, but the brand will also be transferred to Imperial when Lorillard's merger is completed.
6. The e-cig business is producing significant losses.
Vector only realized $1.6 million from its electronic cigarette in the third quarter and has less than $10 million in revenues across the first nine months of 2014. Even so, it had losses in adjusted EBITDA of $2.9 million and $7.1 million, respectively. Because the operating losses are so large, Vector found it necessary to break it out as a separate reporting division.
7. Real estate will continue to be a key component of Vector's business.
With roots that extend back to a relationship with Wells Fargo, Vector's Douglas Elliman Realty division is the largest residential brokerage company in the New York metropolitan area where it is a partner in 12 current developments.
The real estate business accounts for 36% of total revenues as Vector now owns 70% of it, and the increase in revenues in the third quarter was large part a result of the greater contribution it now makes to the whole. And as a result of that maneuver, it raised the profile of the division and of Vector, which has seen its stock rise nearly 50% this year.
8. Vector sports a sky-high valuation.
The cigarette company trades at more than 34 times estimated earnings, twice the level of its rivals, though now that the real estate holdings are consolidated into the company it may soon revert to a comparable level. Vector's dividend of $1.60 per share currently yields 7.3% , also well above its peers, which yield around 4% annually.
A dividend darling still?
With its diversified base, Vector Group ought to provide dividend investors with a measure of safety they might not find if betting solely on Altria, Lorillard, or Reynolds-American. But as its high yield indicates, the dividend may not be sustainable at such lofty levels as it's making distributions to investors that exceed what it brings in in net income.
Vector's payout ratio of 170% is about twice as large what its cigarette-making rivals display, and it also pays a 5% annual stock dividend, which it's done every year since 1999. Investors also need to be mindful that the tobacco industry contains an elevated risk element and the real estate market in New York could suffer substantially in another economic downturn.
While Vector Group has several buffers built in (like having a competitive cost advantage) that could still make the tobacco player a key addition to a dividend investor's portfolio, the risk to its payout's sustainability must be factored in and caution exercised before buying.
