One of Most Undervalued Sectors of the Market is Beginning to Rebound

In tough economic times, a high debt load can cripple a company. But when business is good, that debt can actually be a real benefit. That’s because equity comprises just a small part of the company’s total enterprise value (market value plus debt minus cash) and profits can become quite large relative to that small equity base. But investors remain wary of debt-laden companies, recalling that these were among the stocks that appeared to be headed toward bankruptcy when the economy started heading south two years ago.

As a result, shares of companies that buy and then lease airplanes to the major airlines, all of which carry lots of debt, are among the cheapest in the stock market. Yet if the global economy stays aloft and can finally grow, then these companies could see impressive profit and dividend growth.

Right now, the stars are aligning for this industry. Airline traffic is up +10% from a year ago, banks have become very supportive by providing very low interest rates for asset-backed loans for airplanes, and the key players are generating strong cash flow that is helping to reduce debt levels. Most importantly, a glut of unused airplanes that sat idle are returning to service, and with fewer airplanes available, lease rates are rising.

The industry is dominated by the finance arms of GE (NYSE: GE) and AIG (NYSE: AIG). But investors can play the sector through smaller players such as Aercap Holdings (NYSE: AER), Aircastle (NYSE: AYR), FLY Leasing (NYSE: FLY) and Willis Lease Finance (Nasdaq: WLFC). And as this table shows, all of these stocks appear quite cheap on a price-to-earnings basis:

Company Recent Price Market Cap Enterprise Value Price/
Div. Yield 2010 P/E 2011 P/E Est.
$11.93 $1,420M $4,811M 0.8 none 6.3 6.1
$8.32 $661M $2,860M 0.5 4.7% 9.1 9.1
FLY Leasing (NYSE: FLY) $12.48 $353M $1,468M 0.7 6.5% 7.8 10.1
Willis Lease (NYSE: WLFC) $9.83 $92M $742M 0.5 none 28.9 5.6

But these stocks are also inexpensive relative to their assets. For example, the value of Aircastle’s fleet of planes, even after subtracting the company’s debt, is around $1.02 billion, more than 50% above the company’s $661 million market value, according to analysts at Citigroup. They think shares should reflect that value and trade up to about $13 from a current $8.40. In a recent note to clients, they wrote that “with its share price trading as almost half of book value, and given more demonstrable evidence of a rise in aircraft market values, it is possible that Aircastle could spend surplus cash on buying back shares or raising the dividend.”

#-ad_banner-#As long as these stocks remain below book value, share buybacks make plenty of sense. And that’s what FLY Leasing is doing. The company’s fleet of planes (minus its debt) is worth more than $17 a share, well above the recent $12.50 share price. Of course, any weakening in the economy would change that equation. (In 2008, when the economy was sliding, airline lease rates fell sharply, dragging down the value of planes, so FLY Leasing’s book value then was just $12 a share.)

Action to Take –> If the economy weakens anew, then these debt-laden stocks would be especially vulnerable. But all signs now point to a healthier airline industry. Lease rates should continue to rise as demand for new and used planes exceeds production from Airbus and Boeing (NYSE: BA). If you’re in search of dividend yields, then Aircastle and FLY Holdings should hold great appeal, as these firms look set to hike their dividends further in 2011 as cash flow rises. Aercap is likely the most stable name in the group due to its relative size, which helps it to arrange special banks loans on especially favorable terms.