Image source: Getty Images.
Dividend stocks can be the foundation of a great retirement portfolio. Not only do the payments put money in your pocket, helping to hedge against any dips in the stock market, but they're also usually a sign of a financially sound company. Dividends also give investors a painless opportunity to reinvest in a stock, thus compounding gains over time.
However, not all income stocks live up to their full potential. Using the payout ratio -- the percentage of profits a company returns to its shareholders as dividends -- we can get a bead on whether a company has room to increase its dividend. Generally, a healthy payout ratio is between 50% and 75% (though payout ratios outside that range are common and accepted in certain industries). Here are three income stocks with payout ratios below 50% that could potentially double their dividends.
Fifth Third Bancorp
As we did last week, we'll kick things off within the financial sector -- often a stronghold of solid dividends -- and take a closer look at why regional bank Fifth Third Bancorp (FITB 0.05%) should be on income investors' radars.
Like most banks, Fifth Third has struggled with notoriously low lending interest rates. While they're a boon to the consumer, low yields constrain banks' interest-based income and shrink net interest margins. Furthermore, depressed oil prices have put pressure on much of the banking sector. About 2% of Fifth Third's loan portfolio in 2015 was made up of energy loans, and crude oil's dive over the past two years has led many banks, including Fifth Third, to shore up their loan loss reserves, which can reduce profitability in the near term.
Image source: Fifth Third Bank.
Despite these concerns, Fifth Third has a lot of things dividend investors would like. For starters, Fifth Third's loan portfolio is probably in much better shape than skeptics have insinuated. It ended the first quarter with net charge-offs of $96 million, or 0.42% of loans and leases. Yes, this was up 8 basis points from the sequential fourth quarter, but Q1 was also the nadir for crude oil prices. Since February, crude prices have stabilized between $40 and $50 a barrel, which should ease energy loan tension. Fifth Third also ended Q1 with a healthy tier 1 risk-based capital ratio of nearly 11%. Translation: Its credit quality is probably better than Wall Street realizes.
The bread and butter of banking continues to work well for Fifth Third, which is based in various states east of the Mississippi River. Total commercial loans and leases grew 5% year over year in Q1 2016, while consumer loans and leases rose 1%. Similarly, total average deposits increased by 1% from Q1 2015. When lending rates do rise, this growth in loans and deposits should help lift Fifth Third's bottom line.
That's another key point: Lending rates won't stay near record lows forever. At some point, lending rates will rise, and bank margins will expand.
Having repurchased approximately 15 million shares of common stock during Q1, Fifth Third has signified the importance of improving shareholder value. But it's the company's $0.52 annual payout (2.8% yield) that looks even more enticing. Wall Street is forecasting EPS of $1.69 in 2017 and a good chance of $2-plus in full-year EPS if there are one or two rate hikes. Therefore a doubling in Fifth Third's dividend seems doable in the next five to 10 years.
Target
Next up for income seekers is a company that's right on the bull's-eye when it comes to potential dividend growth. I'm talking about none other than retail giant Target (TGT -0.25%).
Shareholders in Target have the same concern as most retail investors: They need economic growth. Target relies on discretionary spending to drive its growth, and if the U.S. economy is struggling, or if growth is tepid, then Target's top and bottom line can suffer. Target is also battling some fierce rivals in the retail space, including Wal-Mart and even Amazon.com, which is using its low overhead to undercut brick-and-mortar store pricing.
Image source: Target.
Yet Target is making plenty of smart business moves, and its business looks poised to thrive in the years that lie ahead. For instance, Target is investing heavily in direct-to-consumer sales, which rose 23% on a comparable basis during the first quarter. Target understands that convenience is vital to keeping its consumers loyal, so it has turned to omnichannel offerings, as well as its REDcard, to encourage consumers to stay within the Target universe for their shopping needs.
Secondly, Target made the wise decision to admit its faults and cut its losses in Canada. After a two-year effort that saw more than $4 billion spent and 133 stores opened, Target's management realized in early 2015 that achieving profitability in Canada across this network of stores by 2021 simply wasn't feasible. Rather than hoping for a turnaround, which isn't a viable business plan, Target announced its exit from Canada and cut its losses. Doing so prevented further uncertainty from clouding Target's future results, and it gave the company new resolve to focus on the U.S. market.
Target has also had great success in drawing foot traffic by focusing on brand-name merchandise at a discount. Consumers have a strong desire to own exclusive or brand-name items. Target uses its size and purchasing power to negotiate exceptional deals with its vendors, which can in turn be passed along to the consumer in the form of discounts, without impacting Target's margins much at all.
Currently, Target is paying out a delectable 3.3% yield, or $2.40 annually. With the company paying out right around 50% of its profits, it would need to earn around $9.60 a year in EPS for its dividend to double. Based on its mid-to-high single-digit percentage EPS growth trajectory and the $6.78 Wall Street currently has forecast for 2020, it's quite possible that Target's dividend could double within the next decade.
NetEase
Lastly, dividend investors might be surprised to learn that growth stocks offer some of the best opportunities to find rapidly growing payouts. In this respect, I'd suggest that dividend seekers dig into Chinese online gaming and web portal provider NetEase (NTES 1.06%).
The biggest concern for investors with a company like NetEase is whether or not it can stay ahead of the curve. We've witnessed with domestic mobile gaming companies, such as Zynga, that consumers' appetite for games can be fleeting and incredibly fickle. If NetEase doesn't constantly innovate and give the consumer what he or she wants, then its valuation could take a hit. There's also concern that China's slowing GDP growth could hurt NetEase's business.
Image source: Pixabay.
Despite these risks, NetEase appears to have a solid business model conducive to profit and dividend growth over the long term. One of the big reasons NetEase has adapted so well to China's growing market was its relatively early push into mobile apps and gaming. Traditionally known to favor PC games, China now has 600 million mobile users, and many of them are eager to enjoy life's little luxuries via apps and games. This is a huge market that's just being tapped from an advertising perspective in both China and other developed countries around the world. NetEase's 90-plus mobile games are a source of pricing power when it's negotiating with advertisers.
This product diversity is also a big factor in NetEase's success. NetEase has a portfolio filled with legacy games that continue to attract loyal consumers and advertisers. On the fli pside, it has a number of new games being regularly introduced, including games that target different genres. Because its product portfolio is so large, and its profits are growing so quickly, NetEase has been able to take risks on new games that other gaming developers simply haven't tried.
There's also China's exceptional GDP growth rate of more than 6%. As long as China continues to grow at this quick clip, skepticism surrounding NetEase's ability to grow probably won't gather much steam.
Although NetEase doesn't exactly have a set quarterly dividend, it has paid out the equivalent of $2.37 over the trailing 12-month period, which is good enough for a 1.2% yield. Yet Wall Street believes NetEase could deliver $14 or more in EPS as soon as fiscal 2018. Even with heavy reinvestment into its business, this leaves plenty of room for NetEase's dividend to grow -- and perhaps double -- in the coming years.
