Dividend stocks tend to be owned by investors for their income. However, some dividend stocks offer both a high yield and high total return potential because of a low valuation. This combination can lead to out-sized returns for investors as they collect a high yield and stock price appreciation as the valuation returns to normalized levels. 

Undervalued Dividend Stock #5 – Walgreens Boots Alliance (WBA)

Walgreens Boots Alliance has increased its dividend for over 40 consecutive years, making it one of 53 Dividend Aristocrats.

Walgreens is the largest retail pharmacy in both the United States and Europe. Through its flagship Walgreens business as well as joint ventures, Walgreens has a presence in more than 25 countries and employs more than 385,000 people. Walgreens operates in three financial segments: Retail Pharmacy USA, Retail Pharmacy International, and Pharmaceutical Wholesale.

WBA’s recently reported Q2 earnings showed a sales increase of 12.1% and adjusted diluted earnings-per-share increased by 27.2%. Walgreens also hiked its guidance for fiscal 2018, now expecting adjusted earnings-per-share in the range of $5.85 to $6.05. The company’s robust performance was driven by its Retail Pharmacy USA segment, which is in the process of acquiring more than 2,000 stores from Rite Aid. Given Walgreens’ track record of acquiring other pharmaceutical chains, we believe the Rite Aid acquisition should close smoothly and continue to boost the company’s performance moving forward.

Source: Q2 Earnings Presentation, page 4

This slide shows WBA’s long term growth drivers and why we believe it offers investors not only compelling value today, but a strong case for earnings expansion. As people live longer, the world’s middle class grows and as medicine continues to advance to treat more ailments effectively, providers like WBA stand to gain.

Walgreens has compounded its adjusted earnings-per-share at 9.6% per year over the last decade. Due to the company’s expanding international presence and competency in the mergers and acquisitions arena, we believe that Walgreens is capable of delivering similarly high single-digit growth for the foreseeable future. Our earnings growth estimate for Walgreens is 9.0% per year, which is implied in our $9/share earnings estimate for 2023.

From a dividend perspective, we believe that Walgreens is likely to increase its dividend at a faster pace than its earnings for the foreseeable future. Our 2023 dividend-per-share estimate implies 12% annualized growth over the next five years.

The stock trades for a current price-to-earnings ratio of just 10.7. Walgreens has traded at an average price-to-earnings ratio of 16.7 over the last decade, implying a fair value of $99. As a result, the company is deeply undervalued. If Walgreens’ stock can revert to this historical valuation over the next 5 years, this will add 9.3% per year to the company’s annualized returns during that time period.

With 9% earnings growth and a 2.5% dividend yield, Walgreens already has attractive total return potential. Combine this with the company’s compelling valuation and it presents a rare opportunity. Valuation reversion should contribute 9.3% per year to Walgreens returns if such multiple expansion occurs over a 5-year period. This gives 20%-21% annualized total return potential and earns the company a buy recommendation from Sure Analysis.

Undervalued Dividend Stock #4 – Fortis Inc. (FTS)

Fortis is Canada’s largest investor-owned utility business with operations in Canada, the United States, and the Caribbean. It has a market capitalization of US$13.7 billion and has increased its dividend for 44 consecutive years.

Fortis’ recently reported Q1 results were in-line with the market’s expectations. Fortis saw sales decline by 3.4% (largely due to foreign exchange fluctuations) but managed to offset this top-line erosion through prudent cost management. Adjusted earnings-per-share declined by 2.8% due entirely to a significant, one-time increase in the number of shares outstanding (Fortis issued $500 million of common equity in March of 2017). However, adjusted net earnings increased by 2.1%.

Source: Earnings Presentation, page 5

The company’s rate base growth is being supported by its strong capex spending, which is being funding by robust operating cash flow performance. Fortis’ future growth is largely coming from this virtuous cycle of spending that produces rate base growth, and as seen above, there is little reason to doubt this will continue.

Fortis has compounded its earnings-per-share at 6.4% per year since 2008. Looking ahead, we believe that continued ~6% annualized earnings-per-share growth is feasible. However, this year is expected to be a flat or slightly down year for Fortis’ earnings, as we are expecting $2.60 for 2018. Applying a 6% growth rate to this earnings estimate allows us to calculate a 2023 bottom line projection of $3.48.

Fortis’ future growth will be driven by a substantial capital expenditure plan that the company is currently executing. More specifically, Fortis is working through a $15.1 billion capital investment program that is expected to increase its rate base to $33 billion by 2022, which implies a five-year compound annual growth rate of 5.4%. The capital expenditure plan is focused on areas like grid improvement, natural gas distribution, cyber protection, and clean energy. Importantly, this growth rate is before the impact of acquisitions, which have historically been important for Fortis; for example, Fortis closed the $11.3 billion acquisition of Michigan-based ITC Holdings Corporation in late 2016.

Even using very conservative assumptions, Fortis appears positioned to deliver double-digit total returns over long holding periods. Moreover, the company is likely to do so with far less volatility than the stock market averages. We are forecasting total returns of 14%-15% annually, consisting of the current 4.2% yield, 6% earnings-per-share growth and a 4.2% tailwind from an increase in the valuation. Accordingly, we are recommending Fortis as a buy for conservative, income-oriented investors who are averse to portfolio volatility.

Undervalued Dividend Stock #3 – Cardinal Health (CAH)

Cardinal Health is one of the “Big 3” drug distribution companies along with McKesson (MKC) and AmerisourceBergen (ABC). It serves over 24,000 United States pharmacies and more than 85% of the country’s hospitals. Cardinal Health is a global company with operations in over 60 countries and approximately 50,000 employees. With 32 years of consecutive dividend increases, Cardinal Health is also a member of the Dividend Aristocrats Index.

The company’s recently reported Q3 earnings were mixed as revenue rose 6% YoY but operating earnings fell 10% and EPS fell 33%. The company’s medical segment actually showed a nice bump in operating profit margins but it was more than offset by the much larger pharmaceutical business and its decline in operating profit from its generic program.

Source: Q3 Investor Presentation

Indeed, the company’s assumptions for its core pharmaceutical segment assume that its generic drug pricing will experience mid-to-high single digit deflation for this year, which will continue to compress margins for the rest of the year. This year looks to be one of transition for Cardinal after years of robust growth.

Cardinal Health’s financial results around 2009 and 2010 are materially impacted by its spinoff of CareFusion Corporation, which was completed on September 1, 2009. Despite this material spinoff, the company’s segment revenues, segment earnings, and per-share dividends continued to grow during this tumultuous operating period.

Since 2010 – the first full fiscal year after the CareFusion spinoff – Cardinal Health has compounded its adjusted earnings-per-share at 13.5% per year. We believe that this growth rate is likely higher than what the company will achieve over the long-term. Instead, we’re forecasting Cardinal Health’s long-term earnings growth rate at 9% per year moving forward.

From an income perspective, Cardinal Health has actually grown its dividend at a slower rate than earnings. The company’s dividends per share have compounded at about 10.4% per year since the CareFusion spinoff. We expect this trend to reverse in the future – Cardinal Health’s dividend growth rate has the potential to accelerate, especially if the company’s earnings continue to grow at the rate we anticipate.

Cardinal Health has traded at an average valuation of 15.5 since the 2010 CareFusion spinoff. Based on comparable valuations elsewhere in the healthcare industry, we believe that an earnings multiple of 15.5 times earnings is a reasonable multiple for Cardinal Health, which compares very favorably to its current multiple of 9.9. If the company’s valuation multiple can expand to 15.5 times earnings over the next 5 years, this will add 9.3% to the company’s annualized returns during this time period.

We believe that Cardinal Health’s investment thesis is very strong right now, primarily due to the company’s valuation. Three factors are resulting in widespread market pessimism surrounding Cardinal Health. The first is the potential entry of Amazon into the drug distribution industry, which seems unlikely given the industry’s laser-thin margins. The second is Cardinal Health’s perceived role in the opioid crisis, which we believe is being overblown by the markets. The third factor is an ongoing price war among participants in the drug distribution industry, which is temporary in nature.

All of this means that today’s investors are being given a rare opportunity to buy an excellent company at a great price. Dividend payments, earnings growth, and valuation expansion give Cardinal Health the potential to deliver robust ~22% total returns annually, consisting of the current 3.6% yield, 9% EPS growth and a 9%-10% tailwind from the valuation.

Undervalued Dividend Stock #2 – GameStop Corporation (GME)

GameStop is a global retailer with more than 7,000 outlets producing about $9B in annual revenue. However, a lagging stock price has its market cap at just $1.3B after peaking at several times that amount five years ago.

GME’s recently reported Q1 earnings showed a sales decrease of 5.5% as comparable sales fell 5.3% on tough comparables from last year’s Q1. Hardware and software sales fell 8% and 10% respectively, but last year’s Q1 saw the introduction of the Nintendo Switch. GME’s business ebbs and flows on new product releases so Q1 results were still roughly in line with expectations. Strength in Collectibles and Accessories helped to offset new hardware and software weakness but on the whole, GME’s Q1 showed continued stabilization in its business.

Source: Q1 Earnings Presentation

Guidance for this year is for a decline in comparable sales but adjusted earnings-per-share should still come in better than $3. Given the current share price, the stock remains tremendously undervalued.

GME’s earnings-per-share history looks more like that of a utility than a retailer, but such is the fate it has been confined to for the past decade. However, it has consistently earned $3+ in the past several years despite the negativity surrounding the stock. The stock has experienced an ~80% decline from its peak to today.

We see roughly $3 in annual earnings-per-share continuing as GME sees stabilization – but not necessarily strength – in its core product categories. We forecast a small earnings decline of 1% annually going forward but given how cheap the stock is, that should be plenty good enough to see the share price rise off of the cyclical low at which we find it today. Keep in mind GME’s earnings have the potential for significant volatility depending upon how hardware and software releases are timed as well as how sales momentum in the Digital business progresses.

However, GME is still highly profitable and should remain so in the coming years. We see roughly flat revenue over time, although from year to year, it isn’t unusual to see double digit changes in revenue up or down. Margins should be maintained around where they are today, although the outlook is slightly skewed towards the downside as the necessity of promotions is a significant variable as well.

GME used to buy back enormous amounts of stock but has been more interested in maintaining the dividend of late, something we see as continuing to be the case. On the whole, GME’s earnings predictability from year to year is low, but over time, it should maintain its ~$3 in annual earnings.

We see the dividend as remaining where it is today because without earnings growth, GME doesn’t have the financial flexibility to raise the payout. At the current 10.7% yield, there is no reason to raise it anyway, so it should stay put.

GME’s price-to-earnings multiple has fallen all the way to just 4.7 for this year, a number that is difficult to reconcile. We therefore see expansion of the price-to-earnings multiple as a primary source of total returns going forward, rising to 10 over time, which represents a more normalized valuation than today’s trough value. That should bring the yield back to 5.2%, which is more representative of its historical yields as the share price rises but the payout stays flat. It is difficult to overstate just how undervalued GME is; the company is trading for less than half of its fair value.

The price-to-earnings multiple GME sports today is almost unbelievably low. We therefore see total annual returns of 25%-26% going forward, consisting of the current 10.7% yield, -1% earnings growth and 16% tailwind from the rising valuation. GME is not for the risk-averse investor but those seeking a very high yield as well as deep value may find it appealing.

Undervalued Dividend Stock #1 – Owens & Minor (OMI)

Owens & Minor is a healthcare logistics company that provides packaged healthcare products for hospitals and other medical centers. The company has a market capitalization under $1.0 billion and distributes ~220,000 different medical and surgical supplies to ~4,400 hospital systems worldwide.

The company’s recently reported Q1 earnings showed a YoY revenue increase of 1.9% but a slight decline in adjusted earnings per share from 44 cents to 43 cents. OMI is in a state of transition as it is incorporating two recent, sizable acquisitions in the form of Halyard Health as well as Byram Healthcare. OMI has been pressured in terms of revenue and earnings of late but we believe that earnings will rebound next year, and continue to grow moving forward.

Source: Analyst Day Presentation, page 14

This slide shows how OMI’s strategy is chasing a larger addressable market and bolsters its margin profile, which is key as the company’s margins are razor-thin. The company’s recent acquisitions and subsequent buys will follow this playbook and we see this as a significant growth driver going forward.

Owens & Minor’s earnings-per-share are currently lower than they were in 2008. However, sales and free cash flow per share have both compounded at ~3% per year during that time period. Owens & Minor has recently completed a number of promising acquisitions that should fuel its growth for the foreseeable future, including Byram and Halyard. Earnings should rebound next year as these two acquisitions begin to impact the company’s financial results.

Beyond that, we believe further acquisition-based growth should allow Owens & Minor to compound its earnings in the high single digits – around 8% per year – moving forward.

The company is currently trading at a low price-to-earnings ratio of just 8.2. Undervaluation is the most notable component of Owens & Minor’s current investment thesis and will be the driver of its expected total returns. If the company’s valuation can revert to 18 times earnings (near its 10-year average of 18.2 times earnings) over the next 5 years, this will add 17% to the company’s annualized returns during that time period.

Undervaluation has also lead to a remarkably high dividend yield for this medical distribution company. Owens & Minor’s 6.3% dividend yield has a comparably low payout ratio of ~65% due to low earnings multiple being assigned to the company.

Owens & Minor’s expected total returns are some of the highest in our coverage universe, driven by its potential for valuation expansion and its high dividend yield. If the company’s recent acquisitions can be integrated successfully and if the corresponding cash flows are used to pay down the associated debt, Owens & Minor’s stock should handsomely reward today’s investors over the next 5 years.

Our estimates of 8.0% earnings growth and 17% annualized valuation expansion combined with the company’s 6.3% dividend yield give expected total returns of 31%-32% per year.