Tobacco stocks such as Altria (MO) and Philip Morris International (PM) have long been favorites for dividend investors seeking generous, secure, and steadily growing yields.

However, with massive consolidation in the tobacco industry, courtesy of the secular decline in world smoking rates, the number of quality tobacco blue chips continues to decline.

Vector Group (VGR) is now the highest-yielding tobacco stock trading in U.S. markets with a 7.6% dividend yield, and the company has even raised its dividend for 19 consecutive years.

Is the stock’s high yield a signal that this relatively tiny ($2.7 billion market cap) cigarette provider is a hidden gem that investors living off dividend income should consider owning?

Or is the market providing an important warning sign that Vector Group is a value trap that needs to be avoided at all costs?

Let’s take a closer look at the business.

Business Overview

With roots dating back to 1873, Vector Group operates two major business segments.

Tobacco Products (60% of sales, 90% of adjusted EBITDA): 117 total cigarette brands sold through its Liggett and Vector Tobacco subsidiaries. These include mostly discount cigarette brands such as: Eagle 20’s, Pyramid, Grand Prix, Liggett Select, Eve, Bronson, USA, and Tourney. In total, Vector is America’s 4th largest tobacco company.

Vector Group (VGR)

Source: Vector Group Fact Sheet

Real Estate (40% of sales, 10% of adjusted EBITDA): Vector’s New Valley subsidiary owns 70.6% of Douglas Elliman Realty LLC, one of the largest real estate brokers in New York City. Through Douglas Elliman, Vector owns properties in some of the fastest growing regions of the country such as California, Florida, New York City, and Texas, as well as international holdings in Bermuda and St. Bart’s. In total, Vector’s real estate ventures own 23 properties, consisting of land, condos, apartments, hotels, minority stakes in commercial properties.

Vector Group (VGR)

Vector Group’s total sales and operating profits are very diversified, with Real Estate providing over 40% of both. That certainly is good news for investors concerned about the secular decline of the tobacco industry.

Business Analysis

At first glance, there is a lot to like about Vector. Unlike most tobacco stocks, the company has a very fast growth rate, especially in terms of free cash flow, which is ultimately what secures, and provides for a growing dividend.

Vector Group (VGR)

Source: Simply Safe Dividends

Vector Group (VGR)

Source: Simply Safe Dividends

This faster growth rate is courtesy of the company’s fast growing real estate business, as well as a major competitive advantage under the Tobacco Master Settlement agreement.

Specifically, as long as any individual brand Vector sells achieves 1.65% or higher market share, it doesn’t have to pay any financial obligations to the states.

All of Vector’s brands combined have only a 3.3% market share, thus granting Vector a $0.68 per pack cost savings that can be passed onto customers and retain its dominant position in the discount cigarette market.

In fact, this cost saving (about $165 million a year) has helped Vector to achieve superior volume growth over time.

For example, during the first nine months of 2016 Vector’s cigarette volume declined by just 1.7%, compared to Altria’s, the industry’s, and Philip Morris’ declines of 2.4%, 4.0%, and 4.1%, respectively.

However, where Vector shows its weakness is in profitability. That’s due to both lower gross margins on its discount cigarettes (which by definition have less pricing power than more popular brands) and the lower margins from the real estate business.

In fact, the real estate business acts as a drag on profitability and returns on shareholder capital, as well as increasing overall profit volatility.

Vector Group (VGR)

Source: Simply Safe Dividends

Vector Group (VGR)

Source: Simply Safe Dividends

Due to its far less profitable real estate business, Vector Group has one of the worst profitability profiles in its industry.

For example, note its low free cash flow (FCF) margin of just 6.1%. That is far smaller than larger, pure-play tobacco rivals such as Altria and Philip Morris International, which earn a FCF margin closer to 26%.

Company Operating Margin Net Margin FCF Margin Return On Assets Return On Equity
Vector Group 13.7% 4.4% 6.1% 5.2% NA
Industry Average 46.6% 27.4% NA 13.9% 155.6%

Source: Morningstar

But isn’t the real estate business a major benefit to long-term investors? After all, with global smoking rates in long-term decline, Vector’s large and fast growing real estate operations (revenue up 10% through the first 9 months of 2016) should provide much better long-term growth going forward than most other tobacco blue chips.

However, remember that while revenue growth is nice, what really matters at the end of the day for dividend investors are profits and cash flows.

As you can see, while Vector’s New Valley subsidiary has been doing massively more business in recent years, that hasn’t translated into growing profits.

In fact, on an Adjusted EBITDA basis, New Valley has reported a 43% decline in profitability, indicating that management may be reaching for growth for growth’s sake.

Vector Group (VGR)

Source: New Valley Fact Sheet

Why would it do that if it threatens to destroy long-term shareholder value?

That brings me to the major risks involved with Vector, namely that management, in recent years, seems to have overextended itself with its dividend growth. The company is now playing a potentially unsustainable game of trying to hide the fact that the high payout has made this a risky stock.

Key Risks

Over the past decade Vector Group has managed to put up some incredible total returns, courtesy of very impressive growth in its dividend.

In fact, Vector’s stock has beaten not just the market as a whole, but most other tobacco stocks, as well as real estate investments.

Vector Group (VGR)

However, that strong returns hide’s an ugly truth, mainly that management has grown so quickly not by retaining earnings and cash flow and then consolidating smaller, discount brands of cigarettes, but by taking on increasing levels of debt to pay for those acquisitions.

Vector Group (VGR)

Source: Simply Safe Dividends

In addition, Vector has tried to appeal to dividend investors not just by offering the highest yield in the industry, but also through an annual 5% share dividend.

However, while this may appear shareholder-friendly at first (and explains why it’s proven so popular with investors over time), it also results in an increasing amount of dilution that risks the long-term growth and safety of Vector’s dividend.

That’s because most tobacco companies are free cash flow machines and use that cash to buy back shares over time. That in turn reduces the payout ratio and allows for more consistent and sustainable dividend growth over time.

Since long-term total returns follow a company’s dividend yield and earnings growth, tobacco stocks have historically been excellent long-term income investments.

However, because of management’s annual dividend policies Vector’s sky-high yield is one of the least safe dividends of any tobacco stock you can own.

That’s especially true because, as its real estate business becomes a larger portion of the

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