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3 Small Cap Stocks with Big Buyback Plans

Friday, July 15, 2011 9:00 AM

Many investors tend to ignore stock buyback announcements. Seemingly massive share repurchase programs become a lot less impressive when you realize they are mostly attempting to offset generous stock option grants for insiders by reducing growth in the share count. Adding insult, some buyback programs are put in place even as a stock is surging to multi-year highs.

But it doesn't mean stock buybacks should be ignored altogether in your investing strategy. Indeed, finding a stock with a substantial buyback program can send a major signal that the company thinks its shares are undervalued. If they're right, then a buyback program coupled with solid bottom line results can lead to serious stock gains. The problem is you simply have to look for the right buyback plan.

To avoid the risk of picking a stock with a "phony" buyback plan, investors should focus on companies committing cash to shares when a stock is really out of favor. Beaten-down stocks benefit the most from buyback efforts because they can more quickly shrink the share count.

In the past few quarters, I've looked at buyback plans among blue chip companies. Now, I'm taking a look at smaller stocks with a market value below $1 billion that announced buyback plans in the second quarter. I'm also focusing on stocks trading well below their 5-year high. Why? They may be down right now, but the combination of a smaller stock with a buyback plan of shares that are out of favor may well signal much better days for a stock ahead.

1. Denny's (Nasdaq: DENN)
This operator of quick-service casual dining restaurants announced a 6 million share repurchase plan when shares moved above $4. They're now back below $4, even as signs of a turnaround begin to take shape.

Denny's, which operates 230 company-owned restaurants and franchises another 1,400, has surely been challenged in recent years. Sales, EBITDA (earnings before interest, taxes, depreciation and amortization) and EPS (earnings per share) have all steadily fallen as consumers came under duress. This led management to cull weak stores and take a look with a cost-cutting knife at every aspect of the business. It also sought to reduce long-term debt, which has fallen by half since 2005 to a recent $244 million.

The good news: sales have stopped shrinking. The bad news, sales aren't growing yet, either. But the company is now so lean, and the debt load is now deemed manageable, so share buybacks have become the preferred course. "Now that the company's leverage ratio is around 3x, we believe that management will increasingly turn its focus from further repaying debt to returning larger amounts of the company's healthy free cash flow to shareholders," note analysts at BGB Securities. They're right. Denny's is on track to deliver an impressive $50 million in free cash flow this year. Denny's trades for less than 10 times projected 2011 profits, and those profits would likely surge much higher once consumers are under less duress.

2. Advanced Battery Technologies (Nasdaq: ABAT)
At first glance, you have to wonder why a company worth less than $80 million would have the audacity to spend vital cash on a buyback. But with $87 million in cash on the balance sheet -- worth more than the company's entire value, management had to do SOMETHING.

Despite its sexy name, this company is actually a vehicle manufacturer, focusing on electric scooters. Sales have grown very quickly lasting the past few years (hitting $97 million in 2010), and 40% net profit margins are nothing short of stunning -- if the company is to be believed. Trouble is, the company's Chinese-born management team seems to lack credibility, perhaps explaining why the stock has lost nearly 75% of its value since late March. Financial statements of all companies associated with China have come under extreme scrutiny in recent months, and more than a few have simply proven to be a house of cards.

I am not in a position to formally endorse such a potentially dubious business model. But this is a stock that bears close watching. If this turns out to be a legitimate company with trustworthy financial statements, then it's the steal of the decade. Keep an eye on this one. Any moves to prove the veracity of this business model through the vetting of a legitimate "Big 4" auditor would quickly attract value investors to the stock.

3. Aircastle (NYSE: AYR)
Even though shares have risen 10% since I recommended them in March, I still think shares are too cheap. Management agrees, recently announcing a $30 million buyback plan.

After I wrote about this aircraft owner and lessor, Aircastle delivered a blow-out first quarter, topping profit estimates by a hefty 35%. Why the outperformance? Because the company found a home for 99% of the planes it owns. As long as the global economy doesn't slip, this business model should continue to work like a charm. Borrowing costs are low, enabling the company to finance planes at a low cost, while lease rates for those planes are quite firm.

Book value (the value of Aircastle's assets on paper) now stands at $17.65 -- 46% above the current share price. The $30 million stock buyback will reduce the share count, pushing book value even higher. Throw in still-strong profits and book value could approach $19 sometime in 2012. Not bad for a $12 stock.

Action to Take -->
These companies aren't trying to make a "look at me" statement with their buyback plans. Their stocks are simply really cheap. As their share counts shrink, rising per-share profits are bound to resonate with investors and send share prices higher.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.