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Dividend growth investors typically focus on stocks with the longest streaks of annual dividend increases, such as the Dividend Aristocrats or Dividend Kings. Investors looking for better returns could also consider the Dividend Challengers, which may have stronger growth potential.

The Dividend Challengers are a group of companies with 5 to 9 years of dividend growth. These stocks not only have solid current yields but they are also undervalued, leading to high total return potential going forward.
 

M&T Bank (MTB)

M&T Bank Corporation is a regional bank with branches in New York, Maryland, Pennsylvania, and West Virginia. The company has more than 800 total branches spread out amongst these four states and employs about 23,000 people. Almost half of M&T Bank’s loan book is composed of commercial real estate (47% of portfolio), with the remainder of loans consisting of consumer real estate (8%), commercial loans (29%), and consumer loans (16%).

For the 2023 second quarter, revenue grew 31.3% to $2.6 billion, which was $200 million more than expected. Adjusted earnings-per-share of $5.12 compared to $3.12 in the previous year and was $1.09 above estimates. The increase in revenue was once again largely due to the addition of People’s United. Average loans of $133 billion represented growth of 4.5% from the prior year and a 0.3% increase on a sequential basis. The company recorded a provision for credit losses of $150 million for the quarter, compared to a provision for credit losses of $120 million in the first quarter of 2023

Net interest margin of 3.91% was up 90 basis points from the same period a year ago but was lower by 13 basis points from the first quarter of the year. Total deposits decreased 4.9% to $162.1 billion. Noninterest expense of $1.29 billion was a 7.9% decrease year-over-year and 5.1% lower than the preceding quarter. We expect 6% annual EPS growth over the next five years.

Due to increasing earnings and low dividend growth, M&T Bank’s payout ratio has declined in the last decade. The bank is expected to have a very low payout ratio of 33% for 2023, leaving the company plenty of room to pay its dividend as well as offer the potential for payout growth. Total returns are estimated at 14% per year over the next five years.
 

Dollar General Corp. (DG)

Dollar General Corporation is the leading U.S. “dollar store”. About 80% of its items are offered at $5 or less. Dollar General sells a wide variety of merchandise in four categories: consumables, seasonal, home products, and apparel. About 77% of sales are from consumables. Dollar General operated 19,488 stores as of May 5, 2023. The company has increased its dividend for 9 consecutive years.

The company is experiencing weakness and 2023 will be challenging. But Dollar General is still growing because of new store openings and higher transaction amounts, offset by store closures and lower customer traffic. However high inflation is affecting input costs. Net sales increased 3.9% as organic growth fell (-0.1%) offset by new store openings. Diluted earnings per share decreased (-28.5%) to $2.13 from $2.98 in the prior year. The company experienced growth in consumables (+6.0%) offset by a decline in seasonal (-1.0%), home products (-7.7%), and apparel (-7.1%).

Despite the difficult operating conditions this year, we have a positive long-term view. The company has been highly successful with its long-term growth strategy and still has future growth in store due to new openings. First, the company started the new pOpshelf store concept. It is also expanding internationally for the first time in Mexico. Additionally, Dollar General is opening new stores in a larger format, resulting in higher sales. We expect 8% annual EPS growth.

In addition, the stock appears undervalued, with a forward P/E of 14.9, compared with our fair value estimate of 18, roughly on par with the stock’s 10-year average multiple. Shares also yield 2%, leading to total estimated returns of 13.7% per year.
 

Norfolk Southern (NSC)

Norfolk Southern Corporation is a freight railroad company that operates in the Southeast, East, and Midwest geographic regions of the United States. Norfolk Southern services several ports on the Atlantic as well as on the Gulf Coast. NSC has increased its dividend for 7 consecutive years.

In the 2023 second quarter, the company generated revenues of $3.0 billion during the quarter, which represents a revenue decline of 8% compared to the prior year’s quarter. Revenues were lower due to lower volumes and lower fuel surcharges. Adjusted earnings-per-share came in at $2.95 for the second quarter, which missed estimates by $0.16, and represented a decline of 14% year over year. We expect 6% annual EPS growth over the next five years.

Norfolk Southern’s dividend payout ratio has never been above 50%, and most of the time, the dividend payout ratio has been below 40%. This makes the company’s dividend look quite safe. NSC enjoys significant competitive advantages.

The US railroad business is an oligopoly, where each of the companies is focused on certain geographic markets. There is some overlap, but generally, there are no significant competitive pressures. Due to the tremendous asset base that is required to operate a railroad business, there is also a huge moat versus new market entrants.

NSC stock has a 2.7% dividend yield. Shares are valued at approximately 16.4 times 2023 EPS, below our fair value estimate of 18. Total estimated returns could reach 10.7% per year.

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