With many income-seekers focusing on the high-yield blue chip area of the market today, now may be a good time to explore "dividend growth" opportunities. Dividend growth shares tend to be smaller in stature and have lower yields than blue chips do, but have the potential to grow their payout at double-digit rates over the next decade and throw off higher levels of cash down the road.
Here are three mid-cap shares that have such potential and may be worth further research.
Filtrona (FLTR)
- Market capitalisation: £1.1 billion
- Dividend yield: 1.75%
- Sector: Industrials
Since 2009, Filtrona's share price has more than trebled but the dividend has been slow to keep pace. After being held at 7.78p in 2008 and 2009, Filtrona's annual dividend was 10.5p in 2011--a 35% increase from 2009. The dividend growth rate could accelerate given that the company’s dividend cover is over two times on both an earnings and free cash flow basis and its average five-year return on equity over the last five years is over 20%. Indeed, the company recently boosted its interim payout by 18%.
The dividend growth rate could accelerate given that the company’s dividend cover is over two times on both an earnings and free cash flow basis.
Filtrona’s balance sheet is solid, as well. Despite making a few acquisitions in the past year, its net debt-to-EBITDA ratio is a manageable 1.6 times and it covers each £1 of interest expense with £10 in EBITDA.
Another tailwind supporting dividend growth at Filtrona is that 
Reckitt Benckiser’s (RB.) former CFO Colin Day is running the show. During Day's legendary tenure as Reckitt CFO from 2000 to 2011, the consumer goods giant's dividend grew from 25.5p to 115p—a near-15% annualised growth rate. When Day joined Filtrona, he added a progressive dividend policy to the company’s “Vision 2015” programme, which also aims to improve company cash conversion rates and deliver double-digit earnings per share growth.
Bwin.Party Digital Entertainment (BPTY)
- Market capitalisation: £770 million
- Dividend yield: 3.3%
- Industry: Gaming and Gambling
Bwin.Party Digital Entertainment was created in 2011 following the merger of bwin Interactive Entertainment and PartyGaming and the combined business formed the world’s largest listed online gambling company. Bwin.Party initiated a progressive dividend programme after the merger, has more cash than debt, and generates more than enough free cash flow to cover the current dividend. While it lacks a long dividend track record, it does have the financial health necessary to support a growing dividend.
Bwin.Party generates more than enough free cash flow to cover the current dividend.
The company has four lines of business--sports betting, casino and games, poker and bingo--and each of these markets is expected to grow in the mid- to high-single digits in the coming years as more individuals adopt digital gambling and gaming alternatives to physical brick and mortar casino gaming. Perhaps more importantly, if online gambling regulations in Europe and North America become more favourable to the industry, the added compliance and licence costs may strengthen the remaining companies’ economic moats as they would keep out smaller would-be competitors.
Regulation can cut two ways, however, and Bwin.Party has tumbled year-to-date due in part to adverse tax rulings in Germany and Spain. Put simply, this share may not be for the faint of heart and is probably best considered by patient long-term investors.
Domino Printing Sciences (DNO)
- Market capitalisation: £630 million
- Dividend yield: 3%
- Industry: Electronic Equipment
Domino Printing Sciences has been a steady dividend payer for nearly three decades and has increased its dividend payout each year since it floated on the market in 1985. Over the past five years, the dividend has grown about 17% each year on average--a very good pace in a difficult trading environment. The company's success is attributable in part to its wide geographic reach and razor-and-blade business model.
The dividend has grown at a very good pace in a difficult trading environment.
Domino sells industrial printing and coding equipment and consumables such as ink in over 120 countries around the world (almost half of its 2011 turnover came from emerging markets) and to various business sectors including food, beverages and pharmaceuticals. Approximately 60% of its 2011 sales came from consumables and after-market products, resulting in a high level of recurring revenue that can help produce steadier results year after year. The company normally spends about 5% of its sales on research and development, which also helps it stay ahead of the competition.
From a financial standpoint, Domino has a healthy balance sheet and consistently generates high levels of free cash flow. In 2011, for example, it had a £12 million net cash position, no pension deficit and covered each £1 of dividends paid with £1.60 in free cash flow and £2.20 in earnings.
Bottom Line
When purchased for a good price, dividend growth shares can produce tremendous results for long-term investors. Each of these three companies has the potential to be a strong dividend growth share, but the key (as with any investment) is to purchase them at a discount to fair value. Even if you don't think any of these names are undervalued at the moment, they may be worth keeping on your watchlist in the event of a market pullback.
Author disclosure: Todd Wenning owns shares of Reckitt Benckiser.
