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The Art of Predicting Takeover Targets

September 4th, 2012

I think we’ve all heard about the Best Buy (NYSE:BBY) takeover attempt by now. The story goes that Founder Richard Schulze offered to buy the company somewhere in the range of $24 to $26 per share. When the announcement was made a few weeks ago, Best Buy shares shot up around 13%. That’s because if the proposed deal was to go through, a Best Buy shareholder stood to earn a premium of around 47% from the previous week’s close.

That’s a nice little return in such a short period of time.

And it got me wondering… “Wouldn’t it be nice to get in on an acquisitioned stock before the takeover bid was ever announced?”

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Obviously, you could gamble and possibly get stuck with a dog of a company. That’s risky business.

Just because a company seems to be the right price for a takeover doesn’t mean you should automatically dabble. There are a lot of companies out there that are cheap for a reason – it’s because they have problems that no one wants to take on. So the important question is: Which companies are worth the risk?

So, how do you go about this?

Is there a market crystal ball or some special formula known only to market insiders? Not necessarily…

But what I did find is that Morningstar will make the decision for you, and then show you how they came up with their decision.

Morningstar’s Merger and Acquisition Insights Report for 2012

In 2011, Morningstar began to release their predictions on takeover targets. Potential targets were placed in categories like size, leverage, cash flow and by other industry specific quantitative and qualitative factors. More importantly, they went through their list and refined it to highlight the companies that appear undervalued so that everyday investors could get in on the action.

The merger and acquisition insights report for 2012, titled Economic Headwinds Shift Catalysts for Takeover Activity, is an in-depth look at investment ideas among a possible list of potential takeover candidates. It also gives merger and acquisition analysis by sector, credit implications of M&A activity and presents investing prospects for options investors.

According to Morningstar, this is how they came up with their list of potential targets:

  • Morningstar equity analysts identified 87 possible takeover targets spanning nine sectors: basic materials, consumer, energy, financial services, healthcare, industrials, technology/communication services and utilities.
  • The potential takeover targets for each of these sectors were determined by what Morningstar calls a “unique and proprietary scoring system” for each sector.
  • The system is based on industry-specific drivers of merger and acquisition activity, as well as factors such as free cash flow, management and capital structure.
  • Morningstar then examined its list of potential takeover candidates across all nine sectors and found 20 that stick out the most.
  • In their own words, Morningstar selected companies that are “the most attractively priced based on their price/fair value ratio and ranking in their respective, sector-specific potential takeover candidate list.”

A Strong Track Record So Far…

A good number of companies that Morningstar labeled as targets in 2011 accepted acquisition offers.

Some of those identified in the 2011 list of likely targets like BJ’s Wholesale (NYSE: BJ), Constellation Energy (NYSE: CEP), Massey Energy (NYSE: MEE), Petrohawk Energy (NYSE: HK), Pride International (NYSE: PDE) and Temple-Inland (NYSE: TIN) had all announced deals by year’s end. Each company experienced an increase in share price of at least 17% from the time Morningstar put them on the list to the time they accepted their offers.

If we look a little deeper, there were some really big winners. Constellation Energy was bought at a premium of 22% while Petrohawk Energy was taken over at a 96% premium.

From 2012’s initial crop of potentials, Amerigroup (NYSE: AGP) and Collective Brands (NYSE: PSS) were already purchased with premiums of 31% and 49% respectively.

This Year’s Updated List

So, here’s the deal. As investors, we want value stocks that other companies actually find attractive, and it seems like Morningstar is doing a pretty good job of picking them. Last month they took another look at the 2012 list and highlighted the following 16 companies:

  • Charles River Laboratories (NYSE: CRL)
  • Chico’s (NYSE: CHS)
  • Guess? (NYSE: GES)
  • ICON plc (Nasdaq: ICLR)
  • iRobot (Nasdaq: IRBT)
  • Leap Wireless (Nasdaq: LEAP)
  • Mosaic (NYSE: MOS)
  • Myriad Genetics (Nasdaq: MYGN)
  • Nasdaq OMX Group (Nasdaq: NDAQ)
  • NII Holdings (Nasdaq: NIHD)
  • Range Resources (NYSE: RRC)
  • Riverbed Technology (Nasdaq: RVBD)
  • Rockwell Automation (NYSE: ROK)
  • SandRidge Energy (NYSE: SD)
  • Stoneridge (NYSE: SRI)
  • Ultra Petroleum (NYSE: UPL)

What Else to Look For

I know some of you out there are “do-it-yourselfers.” You don’t have time to set up your own unique scoring system. But here’s something that might be helpful.

A popular ratio used by merger analysts to value deals is called the “Enterprise Multiple”- also referred to as EV/EBITDA. Let’s break it down…

The “EV” part of the equation is the enterprise value. It’s how much you would pay for all of a company’s shares and pay off its debt holders. Then you apply the company’s cash to the deal. “EBITDA” is an acronym for the company’s earnings before interest, taxes, depreciation and amortization. It’s mostly useful for making comparisons among companies. Luckily for those who aren’t so gifted with numbers, you can access the EV/EBITDA for most companies on their Yahoo! Finance page under “Key Statistics.”

The reason the enterprise multiple is so useful for this application is that it takes into account debt that other popular valuation ratios do not. And debt is certainly something a company taking over another company factors in…

Low EV/EBITDA ratios, say below eight, may signal an undervalued company. But be mindful that enterprise multiples can be different across industries so high growth industries will have larger multiples and expect lower multiples in industries with slow growth.

Good Investing,

by Jason Jenkins, Investment U Research


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