This Tobacco and Real Estate Stock Pays 10%, But Which Way Does Its Performance Vector Point?

Jonathan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Hoping to juice their returns, today's investors are pursuing all sorts of esoteric investments. Emerging markets debt, master limited partnerships, and the more conventional real estate investment trusts (REITs) have caught their eye. In this climate, it's a wonder that tobacco stock Vector Group (NYSE: VGR), with its 10% cash dividend and 5% stock dividend, remains little-known.

Perhaps it's the generic corporate name and the lack of imagery associated with it, but the same could be said about Altria (NYSE: MO), Lorillard (NYSE: LO), or Reynolds American (NYSE: RAI). These better-known competitors sport less generous 5% yields, but have outperformed Vector since 2010 nonetheless. 

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VGR data by YCharts

Maybe Altria's Marlboro Man, Lorillard's premium Newport brand, and Reynolds' Camel indicia foster warm fuzzy feelings from investors, while Vector's Liggett Group - the fourth-largest tobacco manufacturer in the U.S. - doesn't benefit from packaging its cigarettes in unremarkable cartons that just look cheap.

But there's more to Miami-based Vector than tobacco. The company has interests in real estate too. Let's delve into its businesses.

Liggett's Leg Up on the Competition

The domestic tobacco business is a dying one, but despite its dimming prospects, it remains the cash cow that funds Vector's ventures into real estate. Competition is fierce, but Vector has one key competitive cost advantage: Liggett does not have to make any tobacco settlement payments to the states and territories until its market share exceeds 1.65%, in which case its payments will only be based on the difference between its market share and 1.65%.

Furthermore, due to the popularity of its Pyramid discount brand carried at Wal-Mart and 7-Eleven, Liggett has managed to grow sales volume and bolster margins through increased prices. It has also implemented higher prices for its three other brands: Liggett Select, Grand Prix, and Eve.

These bright spots stand out, especially as industry-wide shipments are down and hefty state taxes and reduced social acceptance continue to dampen demand.

The Effect of Million-Dollar Listings on This Billion-Dollar Company  

Vector's glamorous side is exemplified by its 50% stake in Douglas Elliman Realty, which focuses on high-end properties; with almost 4,000 agents, it sells them, originates mortgages on them, and then manages them.

Elliman is the largest brokerage in New York City, rivaled in reach by few, namely The Corcoran Group, a subsidiary of Realogy Holdings (NYSE: RLGY) and privately held Brown Harris Stevens. It holds the exclusive Prudential real estate brokerage franchise for Manhattan, Brooklyn, and Queens, as well as for all of Long Island. Its Florida offices serve the Miami Beach to Palm Beach corridor. Last year, Elliman offices sold $11.1 billion in property, generating $16.6 million in income for Vector on revenues of $346.3 million.

Apart from Elliman, Vector has also dabbled in real estate speculation. The company's annual report outlines multi-million dollar investments in Manhattan townhomes for resale, the Hotel Taiwana on the Caribbean island of St. Barts, a minority stake in acreage in Milan, and a loan collateralized by developable land in Palm Springs.

Despite the many vanity projects, this portfolio does appear to be a success, but whether real estate becomes Vector's second act is yet to be determined. Real estate is still a minority of Vector's business, accounting for less than 10% of the company's operating income.

The Bottom Line

The greatest source of uncertainty with Vector is its dividend, which is sustained using Liggett's cash flow and without which the stock price could tumble. Weakness in the tobacco business is a real risk, but more concerning are the firm's high level of debt and the restrictive covenants contained within some of the debt. For example, Vector's 11% senior secured notes due 2015 were issued with limitations on the company's ability to pay dividends, make investments, and divest assets that come into play if consolidated EBITDA does not total $50 million over a four-quarter period.

Betting against the company's heavily invested leadership team, which has included renowned corporate raiders Bennett LeBow and Phillip Frost, has proven foolish time and time again. It is worth mentioning, however, that over the last two years, the stock price has dipped, and the payout ratio has reached 571%.

Interpreting this ratio, and the rest of the balance sheet for that matter, is not for the dilettante. Derivatives make 100 appearances in the annual report. Changes in their fair value account for some of the company's income, while at the same time, these derivatives are considered liabilities; they are embedded within convertible debt, which itself seems to have been designed to manage the company's tax burden.

Don't put your life savings here. This is no stock for the average Main Street investor.

Fool blogger Jonathan Lim has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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