2 out-of-favour stocks whose dividends could double

The Motley Fool
Halfords storefront
Halfords storefront

Over the past year, shares in Essentra(LSE: ESNT) and Halfords(LSE: HFD) have returned a dissipating 0.7% and -4.3%, respectively.

However, despite these two companies' lacklustre capital performances I believe that, as income stocks, Essentra and Halfords should not be ignored. Here's why.

Growing dividend potential

Today, Essentra announced that it had seen modest revenue growth in the third quarter after all divisions saw an improvement. This performance is impressive considering that the business has been subject to disruption by the hurricanes that have hit the US this year.

The division suffering from these storms the most is its Health & Personal Care Packaging division. Here, the division saw an "improved" revenue decline in the quarter, "notwithstanding the impact of Hurricane Maria on the two sites in Puerto Rico."

Still, the overall trend is positive, and this was the first such period of like-for-like revenue growth since fourth quarter 2015, according to management.

Essentra's biggest strength is its cash generation. Even though growth has vanished over the past few years, cash flows have remained robust. During the past five years, the firm generated £341m in free cash flow from operations, excluding dividends. Of this total, £195m was distributed to investors.

These figures indicate to me that, over the next few years, there's scope for Essentra to double its dividend payout. Last year, the company generated £153m in cash from operations, spent £47m on CapEx, and returned £54m to shareholders. A similar performance this year leaves room to payout an extra £52m for a total of £56m. If growth returns in the years ahead, cash generation will undoubtedly improve - giving management more headroom for payout growth.

At the time of writing the shares support a dividend yield of 3.9%.

Unloved by the market

Halfords currently supports a dividend yield of 5.5%, which indicates to me that the market doesn't think much of the company. Nonetheless, the group has plenty of room to grow its dividend payout in the years ahead.

Indeed right now, the payout is covered 1.7 times by earnings per share and analysts are already projecting a 3% payout hike next year. Looking at the group's cash flows, it appears there's scope of an even more significant distribution.

2015 was the company's most profitable year in the past five. For that year, the firm produced a pre-tax profit of £84m and a free cash flow of £120m. Dividends paid for the year cost £28m. If management can get the company back to this position, there's plenty of headroom for additional payout increases. Even doubling the distribution, in this case, would be viable. With a gearing ratio of only 25% as well, Halfords' balance sheet is strong enough to support higher distributions on an annual basis, or even a special payout.

The shares are currently trading at an attractive valuation of 11.2 times forward earnings.

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK owns shares of and has recommended Essentra. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.