Investors hate dividend cuts, and companies know it. So when a company with a two-decade-long streak of annual dividend increases under its belt makes the choice to trim its disbursement by 50%, it isn't a decision that is taken lightly.

That's why tobacco and real estate company Vector Group's (NYSE:VGR) recent announcement that it will cut its dividend in half starting in 2020 is such a big deal. Here's what's behind that decision and what dividend-focused investors can learn from it.

A long time coming

Vector Group's dividend yield rose steadily through 2018 as the company's stock price fell. The yield peaked at over 15%. The yield has remained at double-digit levels throughout 2019, and it currently sits at around 11% following the November announcement that the board of directors had decided to cut the dividend from $0.40 per share per quarter in 2019 to $0.20 per share per quarter starting in 2020.

A man looking at a line crashing through the floor beneath him

Image source: Getty Images

It looks like investors were expecting something like this to happen, and in the end, the bad news wasn't as bad as expected. In fact, the stock actually rose following the revelation of the pending dividend cut, which the company stated would "strengthen the Company's balance sheet and help it maintain its liquidity."

Still, after building a 20-year streak of annual dividend increases, there are likely to be many income-focused investors who were taken by surprise. A streak that long is usually a testament to a company's commitment to returning value to shareholders through a steadily rising dividend. So why did a company with such an impressive streak of rewarding investors choose to reset the dividend? 

This is an important question for anyone who owns Vector Group, of course, but the answer can also provide insight into why other companies might look to cut their dividends as well. Here are five key factors that warned of the risks at Vector Group and might help you avoid cuts at other companies, too.

1. An abnormally high yield

A high yield that is out of line with a company's history could be a buying opportunity, but it could also be a warning sign. In hindsight, the latter was the case at Vector group. To be fair, Vector Group's yield has long been in the high-single digits, which is material on an absolute basis. But when it peaked at over 15% in late 2018 investors should have wondered why the yield had spiked higher than at any point in the last 20 years.

In fact, the last time the yield was that high was in the 1990s. Ominously, that 1990s peak occurred right before a dividend cut. At the very least, the high yield at Vector Group in late 2018 and through most of 2019 was a clear sign that Wall Street was worried about the company's future. And that should have led to a reevaluation of the dividend's safety for anyone who owned Vector Group.

2. Business breakdown

Vector Group is really three companies in one. First and foremost it owns Liggett Group, the fourth-largest tobacco company in the United States. This division made up around 60% of the company's top line through the first nine months of 2019. Liggett had an operating income of roughly $200 million over that span. The other two businesses within Vector Group are a portfolio of owned and operated properties and real estate agency Douglas Elliman, which are both housed in the company's real estate segment. This division accounted for about 40% of the top line and produced a net income of around $14 million. Clearly tobacco is the bigger contributor today.

But the tobacco business is facing notable headwinds, the biggest of which has been a long-term trend away from smoking. More recently, vaping has provided smokers with an alternative to the cigarettes that Vector makes. While the company's products are relatively cheap compared to those of its peers, that doesn't offset these bigger picture issues. The game plan throughout the tobacco industry has basically been to raise prices on those customers who continue to smoke. That model is good in the near term, but can only go on for so long before it runs into trouble since increasingly high prices are just another reason to quit smoking.

The real estate business, meanwhile, hasn't been doing that well over the last few years. Both the owned portfolio and Douglas Elliman have seen adjusted EBITDA heading lower since 2016. So this business provides diversification, but it hasn't been much of a benefit lately. Overall, the company's collection of businesses doesn't feel particularly well positioned for the future right now. To be fair, all companies go through ups and downs -- but when you combine the business dynamics with other factors you start to see the bigger problem here.

3. Debt issues

The rising risks here becomes quickly apparent when you take a look at Vector Group's balance sheet. Long-term debt hit a low point in 2016 and then started to increase. It peaked in early 2019 before starting to drop again. The late 2018 acquisition of the 29% of Douglas Elliman that the company didn't already own was a big piece of the debt spike. While some may view that acquisition as a net positive, the balance sheet changes here are notable. Long-term debt was roughly $900 million at the start of 2016 and ended 2018 at just under $1.4 billion, a 55% increase. That's a pretty large change over just a couple of years.  

Debt to EBITDA, meanwhile, has been on a steady march higher. In 2016, the company's debt-to-EBITDA ratio was in the mid-3 space. That has risen into the mid-to-high-4 space more recently. So despite an effort to reduce long-term debt (which currently stands at around $1.2 billion), leverage remains relatively high. For reference, Altria (NYSE:MO), one of the largest domestic tobacco companies, has a debt-to-EBITDA ratio of just 2.5 times.

VGR Times Interest Earned (TTM) Chart

VGR Times Interest Earned (TTM) data by YCharts

Looking at this in a different way, the company's ability to cover its interest expenses fell to around 1.5 times in 2018. That number has risen to around 2 times more recently, but that's still not a great figure (though it is in-line with the company's historical trends). Altria, for example, covers its interest expenses by more than 9 times. While you can argue that Vector Group's real estate operations make it different from Altria in some key ways, debt should still have been a growing concern for investors here -- a fact highlighted (after the fact) by the company's comments about the dividend cut.

4. How about that dividend?

With increasing leverage, there was another factor that should have been a big concern: dividend coverage. Vector Group's payout ratio has been above 100% for years. This metric compares the dividend to earnings, and means that the company hasn't generated enough earnings to pay its dividend. That's not as troubling as it initially seems, given that dividends don't actually come out of earnings. But it is still not a good sign. It basically means investors need to do some more research on the financials to see if there is a real cause for concern.

Dividends technically come out of cash flow, which doesn't get impacted by non-cash charges like depreciation (which is usually a sizable number in the real estate business). However, Vector Group's cash dividend payout ratio, which compares dividends to cash flow, has also been over 100% for years. This is a much more troubling issue.

VGR Payout Ratio (TTM) Chart

VGR Payout Ratio (TTM) data by YCharts

Over short periods of time a company can muddle through difficult periods by taking on debt or issuing stock to come up with the cash it needs to pay dividends. But that's not something that can go on forever. The payout ratio and cash dividend payout ratio should have been very troubling figures here, particularly given the company's increasing leverage. 

5. Negative shareholder equity

The last worrying trend at Vector Group is shareholder equity. This is essentially the value of the company that is owned by stockholders and built up from retained earnings. Dividends reduce this figure. Since the company has been paying out more in dividends than it earns for many years, however, shareholder equity has been falling deeper and deeper into negative territory. This is a trend that can persist for years, but it isn't something investors should be pleased to see. Shareholder equity provides a cushion against adverse events like big write offs when something goes wrong (the loss of a legal case or the need to reduce the value of a division, for example). Adding this to the other issues only makes the safety of the dividend look that much worse.

Was there a warning here?

Rising debt levels and a dividend that wasn't covered by earnings or cash flow should have been ample warning that something was amiss at Vector Group. Add in recent weak performance in the real estate division and the long-term headwinds in tobacco, and conservative investors should have been avoiding this company even though it had an impressive record of annual dividend increases. Negative shareholder equity was another confirmation of the risks. All in all, it shouldn't have been a huge surprise that Vector Group decided to hit the reset button on its dividend. 

That's easy to say in hindsight, of course, but for anyone who was taken by surprise, it is worth remembering that elevated leverage and poor dividend coverage generally don't turn out well for dividend investors. If there is a silver lining here for anyone that got stung by Vector's dividend cut, it's that the lessons here can be used to avoid similar surprises in the future. Next time you see a company with an abnormally high yield, remember Vector Group and dig deeper into the numbers before making a final call.