In search of merger targets
While the credit crunch has weighed heavily on U.S. mergers and acquisitions over the past year, activity appears to be on the upswing. In July, U.S. deal volume hit its highest monthly total since July 2007, partly fueled by a wave of foreign spending.
The combination of a weak dollar and depressed U.S. stock prices has made many stocks look undervalued, and thus attractive targets to overseas investors. Case in point: Venerable brewer and American icon Anheuser-Busch ($68; NYSE: BUD), which in July agreed to be acquired by Belgian brewer InBev for about $52 billion.
Determining when foreign spending will dry up is impossible, and identifying bona fide takeover plays is not easy. But investors in search of stocks with the kicker of potential takeover appeal can look for a few key factors:
Attractive enterprise ratios. Enterprise ratios (EV/EBITDA) have long been used by mergers-and-acquisition analysts to identify potential targets, as the metric approximates a company’s total takeover price relative to its earning power. The ratio equals enterprise value (the sum of stock-market value and debt, minus cash) divided by EBITDA (earnings before interest, taxes, depreciation, and amortization). Interestingly, the enterprise ratio has good predictive power as a Value factor in our Quadrix® stock-rating system. Based on EV/EBITDA, the 16 takeover candidates listed below rank among the cheapest 50% of U.S.-traded stocks.
Moderate debt levels. Companies with solid balance sheets and reasonable debt are attractive targets because they may augment an acquirer’s capacity to take on debt.
Solid cash flow. Because acquirers often issue debt to finance a deal, a target company’s ability to generate sufficient cash flow to help support the new debt burden is vital.
Based on the above criteria, we screened for potential takeover targets and found 16 quality names. While they may or may not be in the crosshairs of mergers-and-acquisition analysts, all appear attractively valued. Two notable companies are reviewed below.
Harris ($53; NYSE: HRS), a leading maker of communications systems, has retreated 22% from its 52-week high set in November. The pullback partly stems from somewhat disappointing June-quarter results. While revenue jumped 19%, profits fell short of Wall Street expectations, reflecting higher costs and accounting errors at 56%-owned subsidiary Harris Stratex Networks ($9; NASDAQ: HSTX). But Harris seems cheap considering its strong market position, solid finances, high expected profit growth, and improving cash flow. The stock earns a 75 in Quadrix Value, with a below-average enterprise ratio of 8.8. Long-term debt is a reasonable 24% of total capital, and Harris holds roughly $2.90 per share in cash. Harris is a Focus List Buy and a Long-Term Buy.
Laboratory Corp. of America ($73; NYSE: LH) has been volatile since late July, when the provider of medical-testing services cut its full-year 2008 revenue and earnings guidance. Management now targets per-share earnings of $4.54 to $4.66, up 9% to 11% from 2007 but below prior guidance of $4.74 to $4.90. However, the underlying growth story remains compelling. LabCorp enjoys strong cash flow and a cash position large enough to fund acquisitions or debt reduction. Over the past 12 months, cash flow rose 12% to $742 million. LabCorp is a Buy and Long-Term Buy.