Ratio-obsessed credit investors are misanalyzing this tobacco company’s credit to their own disadvantage
Looking at the total debt of a firm does not give investors a clear view about the company’s ability to pay obligations. It is necessary to look at when the debt matures and the company’s ability to pay with cash flows.
Today’s firm is stronger than credit markets are pricing due to its cash position and refinancing ability for debt maturity headwalls.
Below, we show how Uniform Accounting restates financials for a clear credit profile.
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One aspect of debt analysis many investors overlook is when debt maturities come due. Often, investors simply look at total debt, which might paint a misleading picture for the firm in question.
Two companies could have the same amount of debt. One company might have the maturities spaced out. The other could have all of its debt maturing in a single year.
The second company would likely be a higher credit risk due to this debt maturity headwall. It requires the firm to refinance or stockpile large amounts of cash to pay down this debt.
Long-term debt (10+ years) could almost be viewed more as preferred equity instead of debt when thinking of a company’s credit risk. Maturities aren’t a real risk or concern—credit risk for these bonds is all about the coupon, much like how the value of preferred stock is about the dividend you are paid.
Similar to issues with looking at total debt, just focusing on cash flow metrics relative to obligations misses the point. This does not consider companies with significant cash liquidity.
While cash flows are recurring, cash liquidity can still be used to pay down outstanding debt.
When investors look at Vector Group (VGR), they will see two concerning things.
The first issue for investors is how dividends and interest expense are almost equal to cash flows. Cash flow focused investors would be concerned about the company’s ability to pay their obligations, considering the limited margin of safety the company has.
The second is that the company has an elevated debt-to-EBITDA ratio of 5.7x. This measures the amount of income available to pay down debt.
Typically, a ratio above 5.0x is considered to be high. Vector’s 5.7x means the firm is taking on high debt loads relative to their cash flow generation.
Investors are understandably spooked and demand a premium on the yield-to-worst ratio of the bonds.
But what those investors are missing is the company’s strong cash position. It has roughly $600 million in cash, which alone covers a significant amount of the $1.6 billion outstanding.
On top of that, most of the company’s debt is not due until 2025 and 2026. It has time before it needs to refinance these debt maturity headwalls.
The company also possesses a 28% ROA, well above corporate averages. This should allow it to refinance the debt when it comes due. Not only that, but Vector has a dividend it can cut if it needs more cash as well.
Despite its refinancing ability, strong cash position, and long runway for debt maturities, bond yields for Vector are 6.5%. The market sees Vector as possibly unable to pay off its debt and has priced incorrectly because of its misunderstanding.
Understanding the company’s cash position and debt maturities explains why that does not make sense. It is only when investors look past ratios and do real credit analysis that a company’s real credit risk can become apparent.
Recent Follow-on Offering Makes VGR’s Perceived Credit Risk too Pessimistic
Credit markets are grossly overstating credit risk with a cash bond YTW of 6.503% relative to an Intrinsic YTW of 3.873% and an Intrinsic CDS of 355bps. Meanwhile, Moody’s is materially overstating VGR’s fundamental credit risk with its highly speculative B2 credit rating five notches below Valens’ XO (Baa3) credit rating.
Fundamental analysis highlights that VGR’s cash flows should roughly match operating obligations in each year going forward. In addition, after its recent follow-on offering, the combination of the firm’s cash flows and cash on hand should be sufficient to service all obligations including debt maturities until 2025, when the firm faces a material $875mn debt headwall.
As a result of this offering, the firm has a long runway to improve cash flows, and its moderate 60% recovery rate and robust profitability should allow it access to credit markets to refinance.
Incentives Dictate Behavior™ analysis highlights mixed signals for credit holders. VGR’s compensation framework should drive management to focus largely on margin expansion and top-line growth, which should lead to Uniform ROA improvement.
In addition, management members hold material amounts of VGR equity relative to their annual compensation, indicating that they are likely well-aligned with shareholders for long-term value creation.
However, management is not penalized for overleveraging the balance sheet, increasing risk for credit holders and potentially reducing cash flows available for servicing debt obligations. Moreover, management is well compensated in a change-in-control event, indicating that they may be incentivized to seek a sale of the company or accept a buyout, elevating event risk.
Earnings Call Forensics™ analysis of the firm’s Q1 2020 earnings call (5/8) highlights that management may be concerned about their liquidity at Liggett Group, the value of their investments, and the impact of pantry loading on their results.
Moreover, they may lack confidence in their ability to sustain revenue and adjusted net income growth and continue to drive higher earnings at Liggett through product efficiencies and promotional spending.
Finally, they may be exaggerating their ability to adapt to market uncertainty, and they may be concerned about stimulus checks’ ability to boost consumer spending.
Substantial cash on hand, a multi-year debt runway, and robust profitability suggest that credit markets and Moody’s are overstating credit risk. As such, a tightening of bond spreads and a ratings improvement are both likely going forward.
SUMMARY and Vector Group Tearsheet
As the Uniform Accounting tearsheet for Vector Group Ltd. (VGR:USA) highlights, the company trades at a 13.8x Uniform P/E, which is below global corporate average valuation levels and its historical average valuations.
Low P/Es only require low EPS growth to sustain them. That said, in the case of Vector Group, the company has recently shown a 244% Uniform EPS shrinkage.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Vector Group’s Wall Street analyst-driven forecast projects a 24% EPS growth in 2020 followed by a 7% EPS shrinkage in 2021.
Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Vector Group’s $9 stock price. These are often referred to as market embedded expectations.
The company can have Uniform earnings shrink 7% each year over the next three years and still justify current prices. What Wall Street analysts expect for Vector Group’s earnings growth is below what the stock market valuation requires in 2021.
Furthermore, the company’s earning power is 5x corporate average levels. Additionally, cash flows and cash on hand are above its total obligations until 2024—including debt maturities, capex maintenance, and dividends.
However, Vector’s cash flows are insufficient to service the material debt headwalls in 2025 going forward. This, together with the company’s intrinsic credit risk being 355bps above the risk-free rate, signal a high risk to its credit.
To summarize, Vector Group’s Uniform earnings growth is above peer averages. However, the company is trading below its peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research