Dividend Stocks You May Not Know

by: Vince Martin

In the first part of a three-part series, I'm going to cover a series of dividend stocks with good yields (all stocks yield at least 3%) that the average investor may not know well - or at all.

Obviously, this group is dominated by small- and mid-cap stocks, which can provide more volatility than the traditional large-cap dividend stocks often favored by income investors, names such as Procter & Gamble (NYSE:PG) and Coca-Cola (NYSE:KO). Still, the list focuses on dividend safety and quality; these companies have strong business models, balance sheets, and/or dividend policies. They offer good yields with the potential for capital appreciation, and, in some cases, increased dividends in the future. Here are the first five on the list:

1. Cato Corporation (CATO)
Closing Price 3/22: $27.56
Dividend (Yield): $0.92 (3.34%)

I covered Cato's 2011 earnings on Wednesday, noting that the mid-priced women's clothing retailer has beaten its initial full-year guidance for four consecutive years, including 2011 earnings of $2.21 per share, versus guidance of $2.00-$2.11 per share.

Fiscal year 2013 guidance (for the twelve months ending January 2013) is for earnings between $2.10 and $2.25. As I argued, an earnings beat seems less likely this year, as the ability to lower expenses (which have driven up margins 640 basis points since 2007) runs out of steam, and top-line growth continues to be meager.

Still, at the midpoint of guidance, CATO trades at just over 9 times forward earnings when backing out the company's impressive $7.44 per share in net cash. Cato has often been criticized for its propensity to hoard its cash, with many pointing out that the controlling Cato family is using the cash balance to defer taxes. But, for income investors, the cash balance provides significant dividend safety, and two recent raises - 12% in May 2010 and 24% in May 2011 - provide the prospect of another raise this spring. Chairman John Cato noted in the 2011 release announcing the dividend raise that "Cato's longstanding practice" is to "increase [the] dividend as our earnings increase." Earnings rose nearly 10% in 2011, which could easily lead to a dividend increase to about $1.00 per share annually, pushing the yield over 3.6%.

As I pointed out in Wednesday's piece, I'd like to see an entry point closer to 25 to make up for the company's slow top-line growth. But income investors may be interested at current levels. The cash balance provides safety, two consecutive hikes provide the promise of a yield increase, and the company's growth through the 2008-10 recession should give confidence in the retailer's ability to handle economic weakness. The 3.34% yield is among the highest in the retail sector, and the company has proven its ability to manage difficult economic conditions (earnings actually grew sharply through 2008-2010). Even at 27, CATO is worth at least a detailed look for income investors.

2. Microchip Technology (MCHP)
Closing Price 3/22: $36.67
Dividend (Yield): 1.396 (3.81%)

The semiconductor manufacturer has raised its dividend for each of the last ten quarters - by one-tenth of a penny each time. The raises make for some strange accounting, but in nearly ten years of paying a dividend, the company has never cut its payout, pausing just four times as the dividend has increased from 2 cents in November 2002 to 34.9 cents payable earlier this month.

Microchip has also enjoyed 85 consecutive quarters of profitability, an impressive achievement in the volatile semiconductor industry. A net cash balance of $4.61 per share adds additional cushion.

There are some valuation concerns here; at the midpoint of fourth quarter guidance for the March quarter, the P/E is 22 on a GAAP basis, and 20 on a non-GAAP basis. Semiconductors have enjoyed a bullish run - the Philadelphia Semiconductor Index (SOX) is up 35% from October lows and about 18% year-to-date - and the cyclical sector may be due for a correction. Still, like more popular Intel (NASDAQ:INTC), MCHP is a market leader, and its 3.81% yield surpasses Intel's 3.02%. The current price may be a bit high, but below $34.90 - where MCHP's yield will surpass 4% - it may be an interesting long-term dividend growth play.

3. PetMed Express (PETS)
Closing Price 3/22: $11.91
Dividend (Yield): $0.60 (5.04%)

PetMed Express operates 1-800-PetMeds and 1800petmeds.com, offering pharmaceuticals, supplies, toys, and accessories for pets over the telephone and the Internet. After initiating a 10-cent quarterly dividend in August 2009, the company raised the dividend 25% a year later and, then, in January, hiked the payout another 25%, to 15 cents quarterly, or 60 cents per year.

With trailing twelve-month earnings of 78 cents per share, the payout ratio looks high at 77%; but the company's cash balance of $2.65 per share net of debt and long-term liabilities provides a cushion for the high dividend.

The fact that the company raised its dividend after what was admittedly a blowout quarter was an interesting one. With competition in the sector increasing, not only from traditional pet retailers like PetSmart (NASDAQ:PETM) and privately held Petco, but Wal-Mart (NYSE:WMT) and wag.com, now owned by Amazon (NASDAQ:AMZN), margins are compressing, hurting bottom-line growth. Indeed, analysts are expecting FY13 earnings (ending March 2013) of 78 cents, exactly equal to the projected 2012 results. With nine-month net sales up just 1%, and competition weighing on margins, growth will be hard to come by.

That said, cash flow has been outstanding; free cash flow in 2009 and 2010 combined equaled nearly one-third of the company's enterprise value. The cash generation was triple the amount required for the dividend paid out in those years. (Cash generation has slowed in FY12, but still easily covers the dividend payment.) PETS has a fourth $20 million stock repurchase authorization outstanding as well (representing over 8% of shares outstanding), representing both management's confidence in its cash flow and its commitment to return capital to shareholders.

There is no doubt that PetMeds Express faces challenges, but it has (so far) been successful. With a yield over 5% and shareholder-friendly management, PETS looks like a worthy candidate for an income-based portfolio.

4. TheStreet.com (TST)
Closing Price 3/22: $2.15
Dividend (Yield): $0.10 (4.65%)

There is a lot more risk with TST than one would expect at first glance. TST offers a ten-cent annual dividend, with $2.26 per share in cash and investments net of long-term liabilities. Free cash flow has been modestly positive over the last four years, with a $3.5MM burn in 2010 being countered by a $1.6MM gain in 2011.

Financially, certainly the dividend looks safe. Unfortunately, it almost certainly will not grow. From the company's Q2 conference call [emphasis mine]:

Michael Moskoff - MRM Capital

...Have you guys thought about maybe raising the dividend from a $0.10 to $0.15, doing something, because again, you still haven't had any coverage being picked up.

Daryl Otte

Mike, I think I know where we're going on this. Yes, I mean, I think that if you look at the terms of the preferred shares, which TCV holds 100% of, that one of the -- they have relatively few rights with respect to that. But one of them that they do have is we are required to seek their approval prior to raising the dividend. And I wouldn't expect that they would be interested in giving that approval. So share buybacks and dividend increases are not part of the arsenal tools we have.

TCV is Technology Crossover Ventures, which owns a large preferred stake in the company, convertible at $14.26 per share (yes, fourteen dollars and twenty-six cents, just slightly "out of the money.") So far, TCV has shown no interest in waiving the dividend restriction, and allowing additional cash to flow to the common shareholders.

That creates the key risk in TST: that the company will use its basically frozen cash balance and substantial net operating loss carryforwards (NOLs) to make an acquisition. Using the NOLs would create tax benefits (they could use previous losses to eliminate taxes paid on profits by a potential acquisition); but it might also compete with, or eliminate, the cash used for the dividend. Activist fund FiveT Capital, which has acquired a 6.3% stake in TST, appears to be arguing for just such a move.

Former CEO Otte resigned in December, and was replaced earlier this month by Elisabeth DeMarse. When questioned on the fourth quarter conference call, neither Otte nor CFO Thomas Etergino appeared to have any idea about DeMarse's plans for the company going forward. The market, so far, has cheered DeMarse's appointment, as the stock has risen 20% since the announcement, made in conjunction with fourth quarter earnings. (Those earnings don't appear to have caused an immediate uptick, and volume strengthened only in the following week, leaving the impression that factors other than the earnings report have driven the stock's strength.) But whether DeMarse will look to the M&A market remains unclear.

In the meantime, TST still trades below net cash, continues to post roughly breakeven results, and offers a 4.65% yield. An acquisition that removes the dividend -- if properly executed -- may provide enough market optimism for investors to exit the trade with some amount of capital appreciation. The dividend itself has some risk; but the cash cushion makes TST worth the gamble.

5. US Global Investors (GROW)
Closing Price 3/22: $7.26
Dividend (Yield): $0.24 (3.31%)

US Global Investors is an asset management firm focused on the gold and natural resources markets. Unlike most US firms, it offers a monthly dividend payment; the 2-cent per share payout has been paid for 58 consecutive months.

The volatility associated with US Global's key markets is one reason the company keeps a fortress-like balance sheet (with $1.76 per share in net cash, and no debt, as of December 31, 2011.) That volatility can be seen in the most recent quarter, as revenues were nearly halved and assets under management fell 27%.

Those struggles were likely mitigated in the first quarter, as equities and commodities performed well across the board. In addition, the well-managed company ties its bonuses to performance, lowering the bottom-line effect of market swings; despite the huge top-line fall in the December quarter, the company still earned 3 cents per share, compared to 15 cents in the year-prior period.

With equity funds still seeing outflows, GROW may struggle in the short-term. But it remains an interesting play on the long-term return of the retail investor, with a tidy 3.3% yield as a bonus. The company has grown revenues and profits sharply since suffering a loss in fiscal 2009 (ending June); though that growth seems likely to slow or reverse in FY12, the company has still earned 36 cents per share over the trailing twelve months. The P/E may seem high at 20x trailing earnings; but that is a company that is successfully navigating short-term troubles.

The company's cash balance and strong management should help maintain faith in the dividend, and the focus on gold and natural resources can add diversification to an income investor's portfolio - few gold mining stocks pay a dividend, with most of those offering relatively small yields. GROW offers a lot of benefits, cash and strong management to lessen downside risk, and a solid yield. With its exposure to natural resources, it could be an excellent addition to an income-focused portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.