Vector Group's (VGR +0.00%) stock price has been surging as of late, up 40% year to date. Yet Vector still maintains a robust 7.5% dividend yield. That's tempting for dividend investors, especially when dividend-paying tobacco stocks Altria Group (MO 3.49%) and Philip Morris International (PM +0.63%) offer smaller yields.
Vector Group data by YCharts. Vector's total return is 21% higher than its stock price appreciation, thanks to a hefty dividend.
Of course, Vector's high dividend yield could be a sign of future trouble. Dividend investors need both high yields and stable dividends to generate reliable income. Dividend investors should examine why Vector's dividend is so high and whether it's sustainable.
No clean classification
Ultimately, Vector's dividend yield is high because the market isn't convinced that it's sustainable. That's why Altria and Philip Morris International yield between 4% and 5% while Vector yields over 7%.
There are two primary reasons investors may have less faith in Vector's shares. The first has to do with company size and product categories. Altria and Philip Morris International are much bigger than Vector and operate in more stable categories. Vector generates about $1 billion in revenue each year from selling discount cigarettes. By comparison, Altria generated over $24 billion in revenue during 2013, and Philip Morris International's sales topped $80 billion. Moreover, Altria and Philip Morris operate in the price-inelastic premium category, giving them pricing power. As a result, Vector's tobacco business is subject to greater competitive and regulatory risks, and thus its dividend isn't as secure as those of Altria and Philip Morris International.
Second, Vector is not a pure-play tobacco company, which could make it difficult for some investors to get comfortable buying its shares. In addition to its discount cigarette business, Vector owns a 70% stake in Douglas Elliman, New York City's largest residential real estate broker. Douglas Elliman accounts for a growing percentage of Vector's overall revenue; Vector's real estate business accounted for more than one-third of overall revenue through the first three quarters of 2014, up from less than 3% in 2013. Tobacco investors may be avoiding the shares because they aren't comfortable owning the real estate broker, and vice versa.
Taken together, Vector's tobacco scale disadvantage and its dual business ownership could be keeping the market from valuing its dividend higher. Let's look at whether the market is correct or if the dividend is sustainable.
Can the dividend hang on?
Buying and holding a stock yielding 7.5% is a good investment -- regardless of what happens to the stock price -- as long as the dividend can be maintained. Vector has ample cash flows, but it also has a large debt load. So far in 2014, the company has generated $100 million in cash from operations. That's about $133 million in cash from operations on an annualized basis. However, it also maintains close to $1 billion in debt -- a scary debt load in relation to cash flow.
Fortunately, the company's dividend may be safe after all. Vector has over $700 million in cash and liquid securities on its balance sheet -- more than enough cash to consider its debt burden reasonable.
The only remaining concern is whether Vector's cash flows will remain high enough to maintain its dividend. The company paid $122 million in dividends through the first three quarters of 2014 -- more than it generated from operations. Raising debt has allowed Vector to pay a higher dividend than it generates in cash for many years.
Source: Morningstar
Whether this habit can continue hinges on how durable Vector's discount cigarette business is and how quickly Douglas Elliman grows. Neither of these key factors is knowable right now -- hence the high dividend yield. Vector could be a good stock for investors willing to take on extra risk; it will pay off tremendously if the New York real estate market continues to boom. However, most dividend investors will find the safety of Altria and Philip Morris International preferable to Vector Group.
