3 Reasons Vector Group Ltd is Not a Top Dividend Stock

By Markets Fool.com

At first blush, it might actually seem like a fairy-tale investment for those nearing or in retirement: a company hawking an incredibly addictive product, a 7.2% dividend yield, and a yearly stock dividend that nets an additional 5% gain.

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But if you don't dig into Vector Group's full story, you could be making a big mistake. The maker of ultra-discount cigarettes like Pyramid, Grand Prix, and e-cigarette Zoom isn't as solid as the stock's 40% jump in 2014 might have you believe.

Some of Vector Group's most popular discount brands. Source: Vector Group

Here are three big reasons why investors need to be cautious when it comes to buying shares of this cigarette company.

Discount cigarettes are in steep decline
For most of its life as a publicly traded company, Vector was one of the few players focused on the ultra-discount brands of cigarettes. It worked fairly well for them since bigger players like Altriaand Reynolds American focused on the pricing power of upscale brands, and the rest was left to Vector.

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But times have changed. Competition is heating up for discount cigarettes, and Vector is having trouble keeping pace. While the company's domestic market share topped out at 3.8% in 2011 -- following six straight years of increases -- it has declined to 3.3%over the past twelve months.

Within the discount cigarette industry, rivals have begun capturing more customers. Vector's cigarette business recorded a 5.3% drop in volume during the third quarter, and its market share within the sub-industry fell from 12.1% in 2012 to 11.6% last year.

It's not just cigarettes anymore
Many retirees -- and dividend investors in general -- are comforted by buying shares of companies that produce things they understand. While buying shares of Vector Group might lead you to believe you are mainly investing in a cigarette company, that is quickly changing.

Perhaps sensing the decline in the discount cigarette market, Vector management began branching out a few years back into the real-estate business. Through its wholly owned subsidiary New Valley, Vector has a 70% stake in one of New York City's biggest residential real-estate companies, Douglas Elliman. From a purely financial standpoint, that decision has actually been a boon for investors and helps explain why shares are up 40% this year, despite declining cigarette volumes.

The amount of adjusted EBITDA the real-estate division has brought in has boomed over the past three years. In 2011, it accounted for just 11% of adjusted EBITDA; over the past twelve months that percentage has mushroomed to 25%.

At first glance this isn't a terrible development, but it requires extra due diligence on the part of investors and a realization that any trouble in the NYC real-estate market could wreak havoc on this cigarette company's cash flow.

An unsustainable dividend
But perhaps the most damning evidence that Vector Group isn't a top dividend stock is the simple unsustainability of its dividend. In the end, there's a reason today's yield sits at about 7.2%: investors don't think it's that safe.

Consider the fact that free cash flow (FCF) -- the amount of cash a company puts in its pocket every year, minus capital expenditures -- is the lifeblood of any dividend paying company. Over the past four years, Vector's free cash flow has come nowhere near being able to cover the company's payouts.

Vector Group's Unsustainable Dividend |Create infographics

It should be noted that in last quarter's investor presentation, management showed how Pro-Forma FCF was much higher than in the chart above, but that these numbers represented "Pro-Forma Adjusted EBITDA less Pro-Forma Capital Expenditures."

Unfortunately, the whole reason to analyze a company's FCF -- instead of earnings or pro forma adjusted EBITDA -- is because it represents the real amount of money a company took in during a year, minus what it spent on capital expenditures. By using pro forma adjusted EBITDA, we simply don't get the same kind of reliability.

Add these three factors together, and I think there are definitely better places for your investment dollars today.

The article 3 Reasons Vector Group Ltd is Not a Top Dividend Stock originally appeared on Fool.com.

Brian Stoffel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.