Let's Make A Deal
Stocks are cheap. So why is the deal business dead?
Just as individual investors are slow to buy during down markets, corporations, too, tend to be cautious acquirers. The reason for their reticence is similar. Both individuals and corporations become risk-averse in uncertain market environments.
Still, merger-and-acquisition activity in 2009 is likely to be stronger than that seen in 2008. Here are four reasons to expect more deals this year:
A sustained upward move in stock prices could spark panic buying by acquirers. Just as individuals tend to rush to buy during market rebounds, so, too, do corporations. Corporate buyers, fearful that cheap deals will disappear, may start to jump back in this year.
Looser credit and equity markets will ease funding restraints. While a return to the easy-money days of 2003 to 2007 is not around the corner, credit and equity markets are likely to loosen this year. As investors’ appetite for risk grows, companies’ ability to issue debt and equity should increase, while the cost of such issuance should decline. And that’s good news for companies that require outside financing to do deals.
Government regulation will drive consolidation in many sectors. The costs of doing business in some sectors — banking, financial services, natural resources, health care, and utilities, for example — are likely to go up as a result of increased regulation. Those increased costs could drive many companies to boost their scale. And that means more deals.
Distressed companies will look more attractive. Acquirers should become more willing to buy distressed assets in 2009 as they gain confidence in an economic rebound later this year and especially in 2010.
Of course, just because deal activity will increase this year doesn’t mean that investors should put money on a stock based on takeover rumors. In fact, we advise against buying a stock simply because of the potential for a takeover. A better approach is to seek stocks with strong fundamentals, sound balance sheets, and solid growth prospects — in addition to appeal as takeover plays.
The table below highlights 14 stocks that exemplify the features that attract corporate buyers — modest debt levels, lots of cash, and exposure to industries where deal activity has demonstrated a pulse. The table includes the “enterprise ratio.”
Enterprise ratio considers a company’s profits before interest, taxes, depreciation, and amortization (EBITDA) relative to enterprise value. Enterprise value is market capitalization (the number of outstanding shares times the per-share stock price) plus debt, minus total cash and cash equivalents. Enterprise value reflects a firm’s theoretical takeover value because it takes into account both the debt that an acquirer would inherit and the cash a buyer would pocket.
Among the stocks on the list, Dolby Laboratories ($38; DLB) has particular appeal. The company provides encoding technology for movie soundtracks as well as audio technology used in many DVD players and personal computers. Dolby has a low enterprise ratio of 3.6 and almost no long-term debt. But the founder still controls 91% of the voting power, so any takeover deal must be friendly.
Long-term debt is a scant 1% of total capital, while cash represents 15% of the stock’s market value. And the stock’s enterprise ratio ranks in the top quintile of all stocks in the Quadrix universe. A Focus List Buy, Dolby represents one of our top selections for year-ahead capital gains even without a takeover.