The nation's major banks are facing a real conundrum. They have billions of dollars parked in cash, but recent regulatory changes prevent them from deploying those funds into once-profitable areas such as proprietary stock trading. And the analysts who follow them spot trouble ahead.
As new restrictions envisioned by the Dodd-Frank Wall Street Reform and Consumer Protection Act become fully implemented, these banks may see their profit margins come under pressure during the next few years as excess cash just sits on the sidelines, earning almost nothing.
In response, major banks are scrambling to find new areas to generate robust returns on investment. Case in point: A mid-January announcement from Wells Fargo (NYSE: WFC) that it will commit $500 million to enter into the business of aircraft leasing. This financing niche is loved by the major airline carriers, as they can avoid the expensive purchase of new airplanes but instead pay-as-they-go on long-term leases.
Wells Fargo predicts that a $500-million capital commitment to this niche (in tandem with an Irish joint venture partner named Avolon) may just be the first step on a bigger push. "We are hungry for earning assets," Wells Fargo CEO John Stumpf said in a recent interview with The Wall Street Journal.
The business of aircraft leasing sure earns its keep. How do we know that? Because four publicly-traded aircraft-leasing firms have been generating some very impressive financial metrics.
These firms are capable of generating very robust financial returns when global economic conditions are good, but also carry considerable risk. If the global economy tanked, then major airlines would return the planes to these leasing firms, which are already heavily-indebted. A quick trip into bankruptcy would be the more obvious result.
Yet the global outlook currently appears stable and poised for possible improvements. The International Monetary Fund expects the U.S. economy to strengthen this year, with European economies turning up in 2014. Therefore, the odds of another deep plunge for the airline industry look quite low, which is why Wells Fargo now sees this as a safe time to enter this business.
I looked at this industry in late 2010 and though these stocks were remarkably undervalued back then, they still remain quite undervalued, despite impressive gains. As a group, they've beaten the S&P 500 by nine percentage points.
One of the main areas of appeal for this group back in 2010 was that they traded at a sharp discount to book value. After all, if the value of their planes (which are marked down for depreciation annually) are still worth more than the company's market value, then they could be liquidated tomorrow at a profit.
The important question is, are those pillars of value is still in place?
The answer is a resounding yes.
And some of these firms are doing precisely what they should whenever shares trade below book value: Buying back stock, as is the case with Aercap (NYSE: AER) and Aircastle (NYSE: AYR). Stock buybacks at below-book prices always delivers an especially strong boost to the price/book metric. Aercap, for example, repurchased $320 million in shares in 2012, on top of $100 million in shares repurchased in the second half of 2011. Analysts at Deutsche Bank looked at just-released 2012 fourth-quarter results and found that they "demonstrate AER's focus on driving shareholder value via opportunistic aircraft trades, tapping the lending market at attractive terms, and share buybacks."
If Wells Fargo wants to move quickly in this space, then it might look to acquire one of these firms. Yet they shouldn't wait too long. A consortium of Chinese investors shelled out $4.2 billion in December 2012 to acquire an 80% stake in the industry's second-biggest player, International Lease Finance, which had been a division of American International Group (NYSE: AIG). (Only GE (NYSE: GE) Capital Aviation Services is larger.) Clearly, this industry has been steadily consolidating.
Risks to Consider: The clear risk is a slowing global economy, which would lead to a fresh wave of airline bankruptcies.
Action to Take –> As long as these stocks trade well below book value, they hold great appeal on their own merits. And as long as major financial firms are sniffing around, one or two of them may get snapped up at a considerable premium.
– David Sterman
This article originally appeared on StreetAuthority
Author: David Sterman
Wells Fargo is Investing $500 Million in this Undervalued Sector