The Most Promising Dividends in Specialty Retail

Dividend payers deserve a berth in any long-term stock portfolio. But seemingly attractive dividend yields are not always as fetching as they may appear. Let's see which companies in the specialty retail industry offer the most promising dividends.

Yields and growth rates and payout ratios, oh my!
Before we get to those companies, though, you should understand just why you'd want to own dividend payers. These stocks can contribute a huge chunk of growth to your portfolio in good times, and bolster it during market downturns.

As my colleague Matt Koppenheffer has noted: "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."

When hunting for promising dividend payers, unsophisticated investors will often just look for the highest yields they can find. While these stocks will indeed pay out the most, the yield figures apply only for the current year. Extremely steep dividend yields can be precarious, and even solid ones are vulnerable to dividend cuts.

When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors:

• The current yield
• The dividend growth
• The payout ratio

If a company has a middling dividend yield, but a history of increasing its payment substantially from year to year, it deserves extra consideration. A $3 dividend can become $7.80 in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.

Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. That money can fund the business's expansion, pay off debt, buy back shares, or even buy other companies. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.

Peering into specialty retail
Below, I've compiled some of the major dividend-paying players in the specialty retail industry (and a few smaller outfits), ranked according to their dividend yields:

Source: Motley Fool CAPS. NM = not meaningful due to negative earnings.

Dividend investors typically focus first on yield. Ferrellgas Partners (FGP +0.00%) and United Online (NASDAQ: UNTD) are the highest-yielding stocks among these specialty retailers. But they're not necessarily your best bets. Ferrellgas is saddled with a lot of debt and has posted net losses lately. United Online actually halved its dividend back in 2008 and it might not have much more room to grow, given the 83% payout ratio. Still, its fans like that it's spinning off its FTD flower delivery business. Its free cash flow has been shrinking in recent years, though, as has revenue.

Instead, let's focus on the dividend growth rate first, where PetSmart (PETM +0.00%) and Finish Line (FINL +0.00%) lead the way. Their growth rates are so steep, though, that they may be hard to maintain for long.

Some specialty retailers, such as EZCORP (EZPW 1.73%), Office Depot (ODP +0.00%), and Zagg (ZAGG +0.00%), don't pay dividends at all. That's because smaller or fast-growing companies often prefer to plow any excess cash into further growth, rather than pay it out to shareholders.

EZCORP, with a market capitalization near $1 billion, is in the pawn and payday-lending business, which has been challenged by increasing legislation and rising gold prices. Its revenue and earnings have been averaging double-digit growth rates, though. Office Depot faces tough competition online and from companies such as Staples, Amazon.com, and Wal-Mart, along with many businesses transitioning to more digital communications. It does sport positive earnings and free cash flow, but revenue has been shrinking.

Gadgetry accessories specialist Zagg, which is down roughly 40% over the past year, has many investors worried about the sustainability of its success. Competition looms, but the company has got some solid distribution channels in place. Margins have been shrinking, though, and much of its revenue is concentrated on very few products.

Just right
As I see it, Staples and United Online offer the best combination of dividend traits, sporting some solid income now and a chance of solid dividend growth in the future. They're not without risk, though, as office suppliers face serious challenges, and United Online's future is a bit uncertain, with its spinoff looming. You might want to keep an eye on fast-growers PetSmart and Tractor Supply (TSCO 2.47%) as dividend up-and-comers. Their payouts are low today, but rising fast, at least for now. Tractor Supply should get a boost from recent drought conditions as farmers buy whatever might help boost their crops in a high-price market. The main knock against it is that it's not a screaming bargain right now, up 35% this past year.

Of course, as with all stocks, you'll want to look into more than just a company's dividend situation before making a purchase decision. Still, these stocks' compelling dividends make them great places to start your search, particularly if you're excited by the prospects for this industry.

Do your portfolio a favor: Don't ignore the growth you can gain from powerful dividend payers.