This year has been transformational for business in so many ways.
Specifically, there’s been an acceleration of trends that were already playing out.
From the digitization of work to millennials buying houses, things are moving much faster than before.
This has created volatility, dislocation, and opportunities.
I’ve taken advantage of many opportunities over the last 10 years of investing.
That responsive nature helped me to retire in my early 30s, as I share in my Early Retirement Blueprint.
I live off of dividends.
A dream come true.
My six-figure stock portfolio produces enough dividend income to cover my bills, freeing me up to spend time on projects I enjoy.
I built that portfolio using the tenets of dividend growth investing.
These stocks make for great long-term investments because of the inherent quality required to consistently pay increasing cash payments to shareholders.
More than 700 US-listed dividend growth stocks can be found on the Dividend Champions, Contenders, and Challengers list.
The important thing is to buy quality cheap.
But I’m not talking about just a low price.
Price is only what you pay. It’s value that you actually get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value. And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Taking advantage of market opportunities by buying high-quality dividend growth stocks when they’re undervalued can lead to life-changing financial results over the long run.
The good news is, valuation is not a difficult concept to understand.
Fellow contributor Dave Van Knapp even provided an easy-to-understand valuation guide, via Lesson 11: Valuation.
Part of his comprehensive series of “lessons” on dividend growth investing, it builds a valuation framework that can be applied to almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Huntington Bancshares Incorporated (HBAN) is a regional bank holding company that offers a range of traditional banking services, such as deposits, auto financing, mortgages, and insurance products.
Founded in 1866, Huntington is now a $12 billion (by market cap) major Midwest player that employs almost 16,000 people.
Huntington operates over 800 branches which are located in the American Midwest region.
Their core market is Ohio. They rank third in deposit share in Ohio, holding 15% of the state’s deposits.
2020 has been a tough year for bank stocks.
A combination of a pandemic and low interest rates have challenged banks like never before.
But I think this year has been a blessing in disguise.
The Federal Reserve has stress tested US banks this year using stricter requirements than ever.
In an unprecedented move, the Fed has actually tested banks twice this year.
And the banks have been largely passing with flying colors – with buybacks back on again.
Furthermore, and more to the point, the pandemic has been in and of itself the biggest stress test you could possibly imagine.
Real life has trumped even the toughest regulators.
Again, US banks have held up remarkably well.
If there were any doubts before about the strength of US banks, there shouldn’t be now.
2020 has also been a year of acceleration.
Trends that were already playing out before are speeding up.
One of those trends is consolidation within banking, especially among smaller regional banks.
With low interest rates making it more challenging to make money in traditional banking, scale has become more important than ever.
Recognizing this challenge and taking advantage of the environment, Huntington recently announced a merger with fellow Midwestern bank TCF Financial Corp. (TCF). The transaction is expected to close in Q2 2021.
This move will see the two organizations combine and become a top-10 regional bank with approximately $135 billion in deposits.
This is instant scale, giving the bank even more headroom to move out nationally, increase its market position, and improve digital capabilities.
Due to an overlapping footprint in the Midwestern region, Huntington (which serves as the acquirer and will retain its name post-merger) sees room for significant synergies – we’re talking 37% of TCF’s noninterest expense.
While it’ll take time to flesh out, this move could end up being a tremendous win for the combined enterprise. Huntington expects the transaction to be 18% accretive to 2022 EPS.
That kind of accretive growth would give them even more firepower for dividend raises, which obviously bodes well for shareholders.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Huntington has already increased its dividend for nine consecutive years.
The five-year dividend growth rate is an astounding 23.3%.
While dividend raises are currently on pause due to the coronavirus situation, I fully expect Huntington to get back to raising the dividend once more in 2021.
And with the new-and-improved Huntington emerging next summer, precisely as we’re moving past the virus, this could be a one-two punch to get the dividend moving aggressively again.
This dividend growth potential comes on top of the stock’s yield of 4.82%.
That yield is more than twice as high as the broader market’s yield.
It’s also more than 180 basis points higher than the stock’s own five-year average yield.
The payout ratio is high, at 84.5%, but this is more of a temporary blip than a sign of long-term trouble.
US banks, including Huntington, started to set aside reserves earlier in 2020, which had the effect of reducing earnings. Releasing reserves will cause earnings to rebound.
For perspective, this bank has typically sported a payout ratio between 20% and 40%. I believe they’ll get back to that level soon enough.
These are really solid dividend metrics. And I think the dividend will look even better next year.
Revenue and Earnings Growth
However, these metrics are looking backward.
It’s really those future dividends that today’s investors care most about.
We’re risking today’s capital for tomorrow’s rewards.
As such, I’ll now build out a forward-looking growth trajectory for the bank, which will later help us estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Combining the proven past with a future forecast in this manner should allow us to arrive at a reasonable conclusion regarding the company’s growth path.
Huntington grew its revenue from $2.674 billion in FY 2010 to $4.667 billion in FY 2019.
That’s a compound annual growth rate of 6.38%.
Earnings per share moved from $0.19 to $1.27 over this period, which is a CAGR of 23.50%.
This is extremely impressive growth.
For those who think banks don’t grow, Huntington has grown faster than a lot of tech companies I know of.
A consistent expansion in margins over the last decade definitely helped the bottom line.
Moving forward, CFRA believes that Huntington will compound its EPS at an annual rate of 4% over the next three years.
This would be a material slowdown compared to what the bank has been accustomed to.
I’m not quite sure what has led CFRA to such a conservative forecast.
It is interesting that they actually raised their price target on the stock by $2 after the TCF Financial news was announced.
CFRA also says this about Huntington: “The bank’s solid franchise in the Midwestern U.S. generates low-cost core deposit funding, while its loan granularity is excellent with limited large single-name concentrations. [Their] conservative underwriting is evidenced by its reduced risk profile and sound asset quality.”
In my view, low interest rates act as the elephant in the room.
And I think that is partially what led Huntington to make their move on TCF Financial.
At the core of it, it’s all about the float.
That’s the low-cost, low-risk source of capital that a bank builds up as a natural course of doing business. You take in at one rate, and lend out at another rate.
This spread can be incredibly profitable, but low interest rates are challenging.
That said, low interest rates aren’t new. And Huntington has been growing briskly anyway. With the TCF move expected to be so accretive, I think CFRA’s view is overly cautious.
But even if the bank does only grow at this mid-single-digit rate, the dividend can also easily grow at a similar rate. And when paired with a near-5% yield, that’s a lot to like for investors.
Moving over to the balance sheet, Huntington has a rock-solid financial position.
They have total assets of $109 billion against $97.2 billion in total liabilities.
Credit ratings are as follows: A-, S&P; A3, Moody’s; and A-, Fitch.
Profitability for the bank is good, and I like that there’s been a steady margin expansion in recent years.
Over the last five years, the firm has averaged annual net margin of 23.81% and annual return on equity of 10.92%. Net interest margin is at 3.26% over the last year.
This bank offers investors a lot to like. The yield is quite high. And the stock hasn’t yet rebounded to its pre-pandemic levels.
A large float is a competitive advantage for an entrenched bank. And the “sticky” nature of deposits means this competitive advantage is not easily lost once gained. The bank already has scale, with that scale set to grow meaningfully after the TCF Financial transaction closes.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
A “lower-for-longer” paradigm around interest rates is a major headwind for all banks.
Banks are highly exposed to economic cycles, and the current cycle is fraught with uncertainty. Any residual effects from the pandemic and economic shutdowns could leave a lasting scar on the bank.
If a long-term recession results from the pandemic, this will hurt the bank twice over. Less economic activity limits growth, while loan losses stress the balance sheet.
There’s also near-term execution risk with the TCF transaction.
With these risks known, I still think this stock is a compelling long-term investment right now.
The valuation makes it extra compelling, with the stock still 18% off of its 52-week high…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 17.60.
That’s higher than it really should be, as the reserves the bank took earlier in the year have reduced TTM EPS.
Yet it’s still lower than the broader market.
Consider the P/CF ratio of 6.7 is markedly lower than its three-year average of 9.0.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 9% discount rate and a long-term dividend growth rate of 5.5%.
This DGR is on the low end of what I ordinarily account for.
It’s much lower than the company’s long-term EPS growth rate and recent dividend growth rate. It’s also not a lot higher than CFRA’s near-term EPS growth forecast, which I see as extra conservative.
Plus, there’s the exciting TCF transaction which boosts the combined enterprise.
However, I’m being cautious here because we simply don’t know what kind of lasting effects the pandemic will cause.
I think Huntington could easily outpace this mark, but I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $18.09.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
Even after a careful valuation, the stock still looks cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates HBAN as a 3-star stock, with a fair value estimate of $14.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates HBAN as a 3-star “HOLD”, with a 12-month target price of $13.00.
I came out high, which is surprising. Averaging the three numbers out gives us a final valuation of $15.03, which would indicate the stock is possibly 21% undervalued.
Bottom line: Huntington Bancshares Incorporated (HBAN) is a high-quality business that’s set to get even bigger and better with an exciting merger coming up. With a market-smashing yield near 5%, double-digit dividend growth, almost a decade straight of dividend raises, and the potential that shares are 21% undervalued, this is an off-the-radar stock for dividend growth investors to strongly consider buying before it fully recovers.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is HBAN’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 50. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, HBAN’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & Income
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