Excess Cash Could Drive Takeover Spike

4/5/2010


Shares of Genentech, a former Forecasts Long-Term Buy, rose 16% between mid-July 2008 and early March 2009, a stretch during which the S&P 500 Index shed more than 20% of its value. How did Genentech stay afloat while others sank? The biotech company was taken over by Swiss drugmaker Roche.

Takeovers can enrich investors in both bull and bear markets, but such opportunities were difficult to find in 2009. The volume of full acquisitions of U.S. companies — this excludes deals such as the one above because Roche was already a Genentech shareholder — declined more than 34% last year, according to FactSet Mergers. Only 35 deals topped $1 billion, compared to 144 in 2007.

Financing proved troublesome, as it became much more difficult to borrow. Only 55% of 2009’s announced acquisitions were funded entirely in cash, the lowest proportion since 2004. The remaining deals were financed partly or entirely with stock.

Cash takeovers are likely to pick up in 2010. The 1,244 nonfinancial companies in the S&P 1500 Index are sitting on $1.18 trillion in cash, 27% more than a year ago. Long-term debt levels have risen only 6% in the past year.

As companies become less worried about the future, they become more willing to put their cash hoards to work. Dividends and stock buybacks are on the rise, and takeover activity appears to be picking up.

Companies flush with cash can become takeover targets themselves. At the time of Roche’s initial offer in July 2008, Genentech had stockpiled $5.29 billion in cash and investments, more than double its $2.48 billion in long-term debt.

Another tool for identifying takeover candidates is the enterprise ratio, which estimates a company’s total takeover price relative to its earnings power. The ratio equals enterprise value (stock-market value and long-term debt, minus cash) divided by EBITDA (earnings before interest, taxes, depreciation, and amortization).

Historically, the cheapest stocks based on enterprise ratio have tended to outperform the market. So seeking out stocks with low enterprise ratios represents a useful investing strategy even if the company continues to operate on its own.

You should never buy a stock solely because of its takeover potential. But if you can find a stock with strong fundamentals and an attractive valuation that also has takeover appeal, so much the better. Listed in the table below and reviewed below are companies with strong cash flow, below-average enterprise ratios, and solid stand-alone growth prospects. Three of those companies are reviewed below:

DirecTV ($33; DTV) and AT&T ($26; T) already team up for the popular “triple play” packages that offer television, Internet, and phone service. As telecommunication companies try to push further into television, many expect AT&T to consider buying DirecTV. Verizon Communications ($31; VZ) has also been mentioned as a potential acquirer.

Either suitor would gain a satellite provider with 18.6 million U.S. subscribers, the second-largest pay-TV provider in the country. Revenue for the U.S. cable-TV industry is expected to advance at an annual rate of 3% to 5% through 2011. DirecTV should grow at a faster rate over that period as it takes market share from cable.

DirecTV shares trade at 15 times the year-ahead profit estimate, 15% below the five-year average forward P/E ratio. The stock’s market capitalization is $31.40 billion, less than 40% the size of Verizon and about 20% the size of AT&T. DirecTV is a Focus List Buy and a Long-Term Buy.


GameStop ($22; GME), the world’s largest retailer of video games, operates about 6,450 stores spread across 17 countries. The company generates most of its revenue from new video games and hardware (60% of fiscal 2010 sales, 27% of gross profit). But it thrives in the profitable realm of used games and equipment (26%, 47%), a business even the strongest rivals have had a hard time cracking. Wal-Mart Stores ($56; WMT) and Best Buy ($43; BBY) experimented with used-game kiosks but failed to make the model work.

GameStop’s stock-market value of $3.65 billion would make it a digestible meal for a big rival — or even a private-equity buyout if financing conditions continue to improve. Cash assets total $905 million, or $5.39 per share, versus $447 million of long-term debt.

At just 9.6 times trailing earnings, the stock trades 58% below its five-year average P/E ratio. The stock seems capable of reaching $25 over the next six months. GameStop, with a Qudrix Value score of 100, is a Buy.


NII Holdings ($41; NIHD) provides wireless-communications services to small and midsized businesses in Latin America. This market niche and NII’s appealing portfolio of assets could attract potential suitors as telecommunication companies look to expand their presence in a growing market.

Mexico’s spectrum auction has attracted major telecom players from within its borders and across the Atlantic. Seeking an edge, Grupo Televisa ($21; TV) agreed to purchase a 30% stake in NII’s Nextel Mexico unit for $1.44 billion in cash, though the deal hinges on the unit acquiring spectrum. Auction results should be announced in May. NII may also participate in similar auctions in Argentina and Brazil.

If a telecom giant misses out on an auction, it could choose to take market share through acquisitions. Terms of the deal with Grupo Televisa imply that Nextel Mexico (42% of NII’s 2009 sales and 55% of operating income) is worth more than $4 billion. NII’s stock-market value is just $6.97 billion, so the stock could get a big lift should all or part of the company be sold. Shares trade at 18 times trailing earnings, 34% below their five-year average P/E ratio. NII is a Focus List Buy.

STOCKS WITH TAKEOVER APPEAL

All 10 of the recommended stocks below earn Quadrix scores of at least 70 in enterprise ratio (enterprise value divided by EBITDA) and look cheaper than the average for their sector and industry based on that ratio. All possess assets that would appeal to rivals large enough to acquire the companies.

We do not advise purchasing stocks based on takeover possibilities, and in fact we are not projecting that any of the companies below will be acquired over the next year. However, all of the companies look like solid choices on their own merits. Investors should consider the takeover appeal a kicker.

—————— Enterprise Ratio ——————
– Quadrix Score * –
Company (Price; Ticker)
Enterprise
Value
($Mil.)
Enterprise
Value/
EBITDA
Quadrix
Rank
Sector
Average
Industry
Average
Trailing
12-Month
Cash Flow
($Mil.)
LT Debt
to Total
Capital
(%)
Cash and
Equivalents
($Mil.)
Value
Overall
Advance Auto Parts
($42; AAP)
3,997
6.6
74
9.1
9.3
700
14
100
88
83
DirecTV Group
($33; DTV)
36,891
6.9
70
9.1
6.9
4,431
68
2,621
65
75
GameStop ($22; GME)
2,376
3.0
96
9.1
3.8
644
14
905
100
82
National Oilwell Varco
($40; NOV)
16,451
5.4
85
11.2
10.5
2,095
6
2,622
93
85
NII Holdings
($41; NIHD)
7,200
6.5
75
6.5
6.7
865
52
2,620
73
90
Questar ($43; STR)
9,640
5.9
81
8.4
8.8
1,578
38
31
62
64
Raytheon ($57; RTN)
21,007
6.1
79
10.0
8.2
2,725
19
2,642
91
95
TJX ($43; TJX)
16,721
6.9
71
9.1
7.7
2,272
15
1,745
79
98
Transocean ($83; RIG)
36,221
5.7
82
11.2
8.9
5,598
32
1,168
96
70
Travelers ($54; TRV)
24,140
4.1
93
15.0
5.3
4,231
18
9,475
94
96
* Quadrix scores are percentile ranks, with 100 the best.

 


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