Vector to Maintain Dividend Following Real Estate Spin-off But Balance Sheet Remains Weak

Discount cigarette maker Vector Group recently announced plans to spin off most of the firm's real estate businesses, including one of the nation's largest brokerage firms, Douglas Elliman.

Once the separation takes place on December 29, the real estate business will continue as Douglas Elliman (DOUG) and trade on the NYSE. 

As part of the transaction, investors will receive one share of Douglas Elliman for every two shares of Vector owned.

Vector will maintain its $0.20 per share quarterly dividend, while Douglas will adopt a $0.05 per share quarterly payout. 

However, we're not sure if the real estate broker will be able to maintain that payout over a complete investment cycle, given the highly cyclical nature of the real estate business.

Looking back, the pairing of tobacco and real estate services was always unusual, with few synergies between the two. The marriage didn't make much sense other than an attempt to diversify away from the secularly declining tobacco industry.

Vector's decision to reverse its expansion into real estate is driven by several factors, including the opportunity to potentially unlock more value in the real estate business by expanding its pool of investors to include those who do not want exposure to tobacco.

Furthermore, a red-hot housing market has sent Douglas Elliman's real estate brokerage commissions soaring, perhaps increasing the company's standalone valuation prospects with investors.

While the real estate spin-off is an abrupt strategy adjustment, Vector has always been primarily a tobacco company. Cigarettes have consistently accounted for at least 80% of the firm's profits.

Even so, Vector's payout ratio and leverage metrics will drift higher following the transaction, as roughly 20% of earnings leave with the spin-off.

These lost earnings will be hard to recapture given the lack of growth opportunities in the tobacco industry. Despite a slight reversal in 2020, the long-term decline in smoking volumes is unlikely to be deterred.

As such, other tobacco companies, like Altria and Phillip Morris, are attempting to combat declining smoking rates by investing in next-generation products (NGPs) like e-cigarettes and heat-not-burn tobacco.

In contrast, Vector has instead just focused on being a leader in the discount and deep-discount cigarette markets, an area it has specialized in for decades.

Discount cigarettes have long been more attractive to those in lower-income communities, areas with higher smoking rates (nearly 3 in 4 smokers live in low-income neighborhoods).

In other words, while cigarette use is in secular decline, it is less so in Vector's end markets, which have had lower cessation rates historically.

Furthermore, as cigarette manufacturers have countered declining volumes by consistently raising prices, there has been a shift by some smokers to "down-trade" from premium cigarettes to cheaper alternatives like those offered by Vector. 

And, as higher-tier cigarettes makers raise prices, so can Vector as long as they maintain a reasonable spread in price.

Despite tobacco being an unfavorable growth industry, Vector's low-priced cigarettes and more accommodating end markets should provide a longer runway as the pool of smokers slowly evaporates.

The firm's unique discount niche looks poised to generate enough stable cash flow to support the dividend, while the 50% dividend cut in 2020 created a margin of safety for Vector to maintain the payout for now as the industry slowly declines.

Given Vector's reliable cash flow and much-improved payout ratio, even after the spin-off, we are upgrading the company's Dividend Safety Score from Very Unsafe to Unsafe.

That said, Vector's elevated leverage metrics remain a concern and earn the firm a B junk credit rating. We also estimate the company's payout ratio will sit near 85% once the spin-off completes, which would put Vector's dividend coverage below levels maintained by peers, reducing the margin of safety as the industry continues evolving. 

Until Vector makes more progress deleveraging its balance sheet and improving its payout ratio, another Dividend Safety Score upgrade is unlikely.