With Mergers, Seller Tends To Win

9/3/2012


Takeovers can inspire strong opinions. Investors argue about whether acquisitions benefit shareholders of the acquiring company, whether the method of financing matters, and whether the buyers' reasons for making the deal make a difference. Study data vary greatly, and combatants can find evidence to support many positions. But there is one fact nobody disputes.

The value of companies to be acquired usually jumps. Often quite a bit.

A study of 100 mergers between 2000 and 2005 found that from five days before the announcement to five days afterward, acquired firms averaged returns more than 23% higher than those of the market. That premium has risen and fallen over time, but studies reaching back more than 30 years have found that purchased firms tend to outperform.

Acquirers usually pay a premium to buy another company, and many of them end up paying more than the target is worth, for several reasons:

• The acquired firm's management doesn't want to sell and requires a windfall to relinquish control. Some researchers have labeled this the hubris factor, and it applies on the buy side (acquirers paying too much rather than bowing out) as well as the sell side.

• Acquirers overestimate the potential growth or cost synergies.

• Multiple bidders enter the fray and drive up the price, creating a phenomenon known as the winner's curse.

We can't tell which factor is most important, and the three listed above are not the only ones. Of course, if your company gets taken over, you don't care why the share price goes up.

After a strong start in 2012, merger activity has cooled in recent months. According to Dealogic, U.S. merger deals announced through the end of July totaled $477 billion, down 26% from a year earlier. However, those numbers don't tell the whole story. While the average deal size is down by about one-third from last year, the number of deals has increased.

A survey of executives by consultant Deloitte found that 46% expect a pickup in merger activity over the next two years, with manufacturing executives particularly optimistic. Companies certainly have the cash to spend on acquisitions — the Federal Reserve estimates U.S. nonfinancial companies hold $1.7 trillion in cash, up 17% from three years ago.

The Forecasts does not advise buying a stock simply because it might be acquired. But if you can find a fundamentally strong, reasonably valued stock that also happens to have takeover appeal, so much the better. We screened for such companies, starting with stocks earning high Quadrix® Overall scores, which suggest strong fundamentals. We also looked for the following characteristics:

Small size. Larger firms are less likely to be acquired, simply because fewer suitors can afford them. Smaller companies also tend to command larger merger premiums. We limited our screen to firms below $15 billion in enterprise value (stock-market value plus value of debt, preferred stock and minority interest, minus cash).

Low enterprise ratios. Price/earnings and other price-based valuation ratios don't take into account debt and minority ownership interests, obligations a purchaser may have to satisfy. Divide enterprise value by earnings before interest, taxes, depreciation, and amortization (EBITDA), and you have the enterprise ratio, which compares the total price tag of a company to the underlying cash flow available to service its debt.

Solid cash flow. Acquirers want companies that can pay their own freight. Ideally, operating cash flow should exceed net income and comfortably cover interest on debt, with enough left over to invest in the business.

STOCKS WITH TAKEOVER APPEAL
All 12 of the recommended stocks below look cheap relative to their peers and generate solid cash flow. Stocks in bold are recommended by our sister newsletter Upside.
Enterprise
--- Ratio ---
--- Oper. Cash Flow ---
Company (Price; Ticker)
Enter-
prise
Value
($Mil.)
Curr.
Industry
Average
12
Mos.
($Mil.)
As %
Of Net
Income
As %
of Debt
Quadrix
Overall
Score
Sector
AMERCO
($96; UHAL)
2,762
4.3
7.4
861
414
56
97
Industrials
Bed Bath & Bey.
($67; BBBY)
12,463
7
8.6
1,239
122
NM
89
Consumer
CACI Int'l
($52; CACI)
2,027
5.7
9
267
159
49
96
Technology
CF Industries
($207; CF)
13,071
3.7
8.1
2,206
126
137
100
Materials
Chico's FAS
($19; CHS)
2,228
6.1
7
358
226
NM
86
Consumer
Coinstar
($51; CSTR)
1,538
3.6
7.2
429
269
115
99
Consumer
EnerSys
($38; ENS)
1,732
6
8.3
211
135
78
99
Industrials
Foot Locker
($34; FL)
4,231
6.6
8.6
476
153
358
94
Consumer
Helix Energy
($18; HLX)
2,414
4
8.7
538
310
46
86
Energy
Orthofix Int'l
($42; OFIX)
695
5.4
11.1
99
207
245
91
Health Care
RPC ($13; RES)
3,105
4.3
8.7
517
166
319
99
Energy
Saia ($22; SAIA)
452
5
7.4
98
396
108
96
Industrials
Notes: Quadrix scores are percentile ranks, with 100 the best.     NM Not meaningful because company has little or no debt.

Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com