Top 3 dividend stocks with prospects to boost capitalization. Vector Group: discount cigarette manufacturer with 43.5% upside potential

High interest rates, persistent inflation, the threat of recession and political controversy — it's hard to list all the challenges the global economy and stock markets have been facing lately. The emergence of new headwinds could prompt stock market participants to sharply reduce their investments in risky assets and turn their attention to so-called "safe havens." A classic example of a refuge from global challenges is the tobacco industry.

The tobacco industry is characterized by a high degree of resilience, as the demand for its products is based on human addiction and is not discretionary in nature. Although this fact carries risks for the ESG profiles of tobacco companies, it can provide investors with positive results during periods of macroeconomic instability. For instance, during the crisis year of 2008, the MSCI World Tobacco index lost 27.04% while the decline of the MSCI World index exceeded 40%. In financial performance, tobacco companies demonstrate even greater resilience. While sales of consumer goods sector companies significantly decreased in 2008, revenues of tobacco giants Philip Morris and British American Tobacco rose by 6% and 17%, respectively.

MSCI World Tobacco vs. MSCI World; source: MSCI

Through its subsidiaries, Liggett Group and Vector Tobacco, Vector Group manufactures and sells cigarettes under brands such as EAGLE 20’s, Pyramid, Montego, Grand Prix, Liggett Select, Eve, and USA. Montego is the fourth most popular cigarette brand in the US after Marlboro, Newport, and Camel. Under the perpetual Master Settlement Agreement (MSA) signed by tobacco companies and US states in 1998, Liggett has no tax obligations as long as its market share does not exceed approximately 1.65% of the total cigarettes sold in the US. Similarly, Vector Tobacco has no obligations until its share exceeds 0.28%. Consequently, about 35% of Vector Group's sales are exempt from tax payments and have a price advantage of $0.95 per pack over the largest tobacco companies.

This price advantage, driven by state regulation, provides Vector Group with a strong position in the tobacco market. According to Statista, the US tobacco products market is valued at $107.5 billion and is expected to grow at a modest below-inflation rate of 0.62% per year through 2028. New tobacco products are seen to contribute significantly to this growth. The US cigarette market, valued at $82.7 billion, is expected to decline at a rate of -0.17% annually.

US cigarette industry volume change by segment; source: Company Presentation

Against this backdrop, the discount cigarette segment has a strong competitive advantage, as consumers prefer price over brand. According to retail data from Management Science Associates, in Q4 2023, the discount cigarette market grew by an impressive 10.5%, while overall sales volumes in the industry declined by 8.8% YoY. Vector Group is the only tobacco company whose market share has been steadily increasing: its share rose to 5.5% in 2023 from 3.4% in 2014. For comparison, the share of Philip Morris USA during the same period decreased from 47.4% to 43.2%, and the share of Reynolds American dropped from 32.4% to 29.1%.

Vector Group market share; source: Company Presentation

Adjusted US tobacco industry market share; source: Company Presentation

The main driver of Vector Group's growth is the Montego brand, which targets the low price segment. Cigarettes under this brand are sold at approximately 50% cheaper than the key brands of tobacco giants such as Altria, Japan Tobacco, and British American Tobacco. Likely, increased inflation will further motivate consumers to look for more affordable alternatives and switch to Vector Group's cigarettes.

Sales price of Vector Group cigarettes compared to competitors; source: Company Presentation

Furthermore, Vector Group owns New Valley LLC, which holds stakes in various real estate properties across the US, including condominiums and mixed-use complexes, apartment buildings, hotels, and commercial real estate. As of December 31, 2023, New Valley has invested about $179 million in a broad portfolio of real estate enterprises. However, the contribution of this segment to the overall results of the company is minimal. In 2023, the real estate subsidiaries contributed only $2.20 million in other income to Vector Group.

Financial performance

Vector Group's financial results in 2023 can be summarized as follows:

• Revenue decreased by 1.5% YoY to $1.42 billion. The decrease was mainly due to the lack of revenue from the real estate segment since the 2023 segment's results are accounted as other income. Excluding the impact of the real estate segment, revenue decreased by only 0.1%.
• Gross profit rose from $442.4 million to $458.9 million due to higher prices and effective cost management. Gross margin increased from 30.70% to 32.22%.
• Operating income declined to $328.0 million from $339.0 million due to a one-time charge of $18 million related to the settlement of a long-standing dispute with Mississippi. Operating margin decreased slightly: from 23.53% to 23.03%.
• Net income amounted to $183.5 million versus $158.7 million a year earlier. The growth was driven by other income, including income from investments and real estate vehicles. Net margin increased from 11.01% to 12.89%.

Dynamics of the company's financial results; source: compiled by author

Company margin dynamics; source: compiled by author

• Vector Group's cash from operations rose from $181.3 million to $210.0 million, driven by increased net income and a lower net working capital.
• Free cash flow rose from $171.4 million to $199.4 million as capital expenditures remained at comparable levels.

Company cash flow; Source: compiled by author

Vector Group has a healthy balance:

• Total debt is $1.37 billion, while cash and cash equivalents account for $379.5 million.
• Net debt is $992.3 million, corresponding to 2.73x of adjusted EBITDA (Net debt/EBITDA — 2.73x). For comparison, at the end of the previous year, the Net debt/EBITDA ratio stood at 3.07x.

Sustainable revenue, high profitability and stable cash flow enable Vector Group to actively reward shareholders through dividend payments. In mid-February, Vector Group announced quarterly dividends of $0.20 per share, maintaining the payout level it has upheld since the beginning of 2021. Thus, the forward dividend yield is 7.3%.

Vector is not only able to maintain but also to increase dividends, as the payout ratio in 2023 was 63.3% of free cash flow, which is a premium indicator for tobacco companies. For comparison, industry giant Altria Group pays out 74.6% of its free cash flow to shareholders.

Stock valuation

Despite its growing market share, stable business and solid dividend yield, Vector Group is trading at a discount to the industry average based on the following multiples: EV/Sales — 1.93x, EV/EBITDA — 7.63x, FWD EV/EBITDA — 7.02x, P/CF — 9.09x, P/E — 9.59x, FWD P/E — 8.85x.

Comparable valuation; source: compiled by author

Vector Group's stock is covered by only two major investment banks: Barclays and Oppenheimer. Barclays values VGR at $15 per share, which implies a growth potential of 34.29%, while Oppenheimer estimates the stock at $16 per share, suggesting an upside of 43.24%. Therefore, according to the consensus, the Vector Group’s fair market value is $15.5 per share, implying an upside potential of 43.5%.

Price targets of investment banks; source: compiled by author

Key risks

• The tobacco industry carries high regulatory risks. For example, in September 2023, the US Food and Drug Administration (FDA) announced that menthol cigarettes would be banned in the coming months. Vector Group's main brand, Montego, offers menthol cigarettes, therefore the company opposes the ban. Further regulatory tightening could affect the quality or cost of Vector Group's products and impact the company's financial results.
• A major risk for Vector Group is the sustained decrease in tobacco consumption over time. Although the company's metrics are stable, thanks to a shift in consumption towards discount cigarettes, it is likely that long-term trends will impact the company's ability to achieve organic growth on a more distant horizon.
• The tobacco business does not align with ESG principles. This factor is generally taken into account by the market and is largely built into a discount rate, which affects stock prices.

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