Dividend stocks can be the foundation of a great retirement portfolio. Dividend payments not only put money in your pocket, which can help hedge against any downward moves in the stock market, but they're usually a sign of a financially sound company. Dividends also give investors a painless opportunity to reinvest in a stock, thus boosting future payouts and compounding gains over time.
Yet not all income stocks live up to their full potential. Utilizing the payout ratio, or the percentage of profits a company returns in the form of a dividend to its shareholders, we can get a good bead on whether a company has room to increase its dividend. Ideally, we like to see healthy payout ratios between 50% and 75%. Here are three income stocks with payout ratios currently below 50% that could potentially double their dividends.
If you want a large-cap income stock in the financial sector with long-tail growth opportunities, look no further than investment banking giant Morgan Stanley (MS -2.73%) and its sub-eight forward P/E.
Based on the fourth-quarter results the company reported last week, it's fairly safe to say that it's put many of its recession woes in the rearview mirror. Wealth management profits hit an all-time record of $3.3 billion, and it's possible the latest stock market correction could lure shaky hands away from managing their own investing and toward advisors at established firms such as Morgan Stanley.
The company's investment banking arm had another exceptional year, ranking, by its own accord, No. 1 in global IPOs, and No. 2 in terms of mergers and acquisitions. The Federal Reserve's eggshell approach to the economy is creating an extended growth opportunity for investment banking giants, since access to capital remains inexpensive, and multiple industries want to exploit it.
Best of all, Morgan Stanley is beginning to put its major legal expenses from the great recession behind it. For example, in the fourth quarter of 2014, it took a $3.1 billion litigation charge related to the mortgage and credit crisis. The absence of this charge dramatically lowered non-compensation expenses in Q4 2015, and it's allowing Wall Street and investors to once again focus on the underlying growth story here.
With the blessing of the Fed to step up distributions to shareholders, Morgan Stanley announced in the first quarter of 2015 that it was boosting its dividend 50% to $0.15 per quarter and returning up to $3.1 billion to shareholders via buybacks through the end of Q2 2016. If Morgan Stanley merely shifts some of its buyback funds into dividends, and continues to grow its profits at a slow but steady pace, it would seem that doubling its annual payout is easily within the realm of possibility.
Morgan Stanley is forecast to earn $3.01 in EPS in 2016, and I'd suggest income investors keep an eye on it.
Huntington Ingalls Industries
Another great idea for income investors would be to ignore the white noise in the defense sector and take a good look at one of America's largest defense contractors, Huntington Ingalls Industries (HII -0.04%).
As my Foolish colleague and defense industry guru, Rich Smith, pointed out recently, Huntington Ingalls is the ninth-largest contractor in terms of defense spending, accounting for more than $4 billion in 2014. This is a company that makes supercarriers and amphibious assault ships for the U.S. Navy, as well as national security cutters, which are designed for the U.S. Coast Guard.
The allure of a Huntington Ingalls is simple: minimal competition and a near inelastic demand. While it may seem like there's an abundance of competition for government defense contracts, there are only a handful of shipbuilding companies that can really rival Huntington Ingalls' scale. This provides the company decent pricing power, a somewhat predictable cash flow, and the ability to generate a substantial backlog of orders. As of the third quarter, it was sitting on a $23.3 billion backlog, of which $12.5 billion was funded. All told, that's about three full years' worth of revenue.
Another key component of Huntington Ingalls' success has been its ability to expand its margins. It's done this in two ways. First, it's been winning contracts that have come with better margins. Second, it's looked at ways to reduce costs internally, whether through layoffs to reduce expenses, or through innovation in the design and manufacturing process so as to reduce input costs. If Huntington Ingalls can deliver its new Gerald R. Ford-class of aircraft carriers at or below expected cost, it could go a long way toward helping it secure future lucrative contracts.
Currently it's paying out just $2 annually, but the company is expected to see its EPS jump to more than $10 per share annually by 2018, so I'd look for this dividend to possibly double.
Lastly, I'd opine that income investors looking for attractive dividend stocks should pay attention to Brocade Communications (BRCD).
Brocade is a provider of storage area network and IP-networking solutions. The proliferation of the cloud and data centers should be a long-term boon for the company. The two big snags Brocade has faced were its untimely purchase of Foundry Networks for $3.4 billion back in 2008 -- a choice that still haunts long-term Brocade shareholders today -- and the entrance of Cisco Systems into Fibre Channel over Ethernet (FCOE) switches earlier this decade. Brocade doesn't have the deep pockets or broad product lineup to push back against Cisco, which has made growth challenging and somewhat costly for Brocade.
Nonetheless, is has made inroads with enterprise consumers over the past half-decade, and is modestly growing once more. As noted above, the growth of the cloud is still in its early stages, meaning there's going to be increased demand for storage solutions with each passing year. This bodes well for Brocade, which has done a good job of introducing new products that attempt to differentiate it from its peers. In fiscal 2015, Brocade generated 2% revenue growth and 48% GAAP EPS growth.
But here's the thing: Because the Ethernet switching business is so commoditized, and because Brocade is facing such tough competition, it's in the company's best interest to make its stock as attractive as possible. How? I believe by doubling its dividend, it could attract value investors and income seekers, and actually improve the value of its stock. Brocade is currently paying $0.18 annually, but it's projected to earn $1.04 per share by fiscal 2017. The easiest way to satiate investors who want more than low-to-mid single-digit growth would be to offer a yield of 4% to 5%, which is the range a $0.36 annual payout would fall in. Brocade is also sitting on $640 million in net cash, so it's not as If liquidity is of any immediate concern.
It remains to be seen if Brocade will make a move on dividends anytime soon, but I believe it could only help the valuation of this mature networking solutions company.