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Above-Average Profits by Investing in Potential Acquisition
Targets |
Published: January 26, 2005
Merger mania hit Wall Street in
the late 1990s, and at that point in time those investors who were wise
enough to load up on shares of prime acquisition targets did extremely
well. The tech sector was hot back then, and it seemed as though not a
week went by when Cisco Systems (CSCO) didn't take over another small
networking company or EMC (EMC) didn't purchase another storage concern.
According to Ernst & Young, the average premium for takeovers
between 1996 and 2000 ranged between 40% and 50% -- that means that
acquirers usually paid more than +40% above the pre-takeover price to
buy other firms. As this statistic clearly shows, merger and acquisition
deals can be a bonanza for those who invest in the target company's
stock.
Although deal making has waned
somewhat from the frenetic pace of the tech boom, mergers and
acquisition (M&A) activity wasn't unique to the market's halcyon
days. The 1980s, for example, brought a wave of hostile takeovers in the
U.S. -- takeovers in which the target company's management fought the
deal -- and, more recently, we've seen a mini boom in deals in the
telecom and retail groups, among others.
To
give you an idea of just how profitable mergers can be, let's consider a
few recent deals. As you can see in our chart, we've outlined four deals
consummated over the past year in four different industries, all for
significant premiums.
Looking at an expanded time
horizon, Ernst and Young suggests that the average takeover premium in
the U.S. over the long run is around 24%. That means investors in the
takeover target make an average profit of nearly 25% by the time the
deal closes, much of that gain coming in the first few days after a
takeover is announced. With this in mind, it can be extremely profitable
to look for companies with solid businesses that might make attractive
takeover candidates in the future.
So why, one might ask, does the
acquiring company offer a premium at all? The answer is rather simple:
all mergers must be approved by the owners of a company -- the
shareholders -- and those owners need to be tempted by an acquirer to
sell their stake. The premium is more or less a profit incentive for
shareholders to approve a deal. Of course, the acquiring company also
hopes to make money out of the transaction. After all, the acquirer's
goal is to make enough from an acquisition to more than recoup its
initial cost, otherwise the deal simply wouldn't make sense.
There are a number of reasons
why a company might find it financially viable and profitable to acquire
another firm. Sometimes, the answer is money and capital. This was the
case with many late-1990s tech mergers. Basically, small upstart
companies with some valuable patents or a promising technology simply
didn't have the cash to reach their full potential -- they were unable
to commercialize their technologies.
Meanwhile, largecap companies
like Cisco and IBM usually have piles of cash lying around, just waiting
for promising technologies to invest in. What's more, companies like
Cisco have huge sales forces that are able to put new technology
products in front of likely buyers, adding to the commercial value of
the transaction. Such deals can be highly successful if the acquiring
firm can make a commercial success of its target's technology.
Other mergers are defensive in
nature. Sometimes, management sees little growth out of its business and
little opportunity for expansion. In these cases, their company's
share price might languish -- or even decline -- for several consecutive
years. Such companies can be tempting targets if an acquirer sees value
in the target company's assets. For example, many analysts believe that
K-Mart's motivation to take over Sears related to the value of Sears'
real estate and brand name. Sears was also a cheap stock when that deal
was announced -- the stock had been declining for years, losing about
half its value between 1998 and the autumn of 2004. The deal makes some
sense -- after all, Sears has a profitable business and some of the best
retail locations in the country, but it's basically a stagnant
enterprise. Meanwhile, K-Mart has plenty of cash, little debt and a rich
stock price -- the firm may be able to better finance expansion and
leverage the venerable Sears brand name.
My staff and I look for a few
key features in selecting potential takeover plays. First, we're careful
to ignore potential takeover targets that look shaky or unlikely to
succeed if a merger doesn't materialize. Clearly, picking takeover
targets isn't an exact science. Sometimes expected deals fail to
materialize. Meanwhile, in other cases the target company's stock slides
sharply prior to the merger announcement due to weak fundamentals. If a
deal doesn't materialize, then we don't want to be stuck holding shares
of a company that can't deliver solid gains on its own.
Second, we like to look for
smaller companies in industries with plenty of potential acquirers. In
other words, we look for industries with a major, cash-rich company like
GE waiting in the wings. Companies like GE have no problem digesting
small-cap stocks and can afford to pay hefty premiums. In addition, over
the years this firm has proven to be an aggressive acquirer.
Third, it's a good idea to look
for groups that are hotbeds of M&A activity. In the 1980s consumer
goods ruled, and in the 1990s it was tech. Going forward, merger
activity in this decade is likely to be dominated by financial, energy,
telecom and technology firms.
Finally, we also like to look
for stocks in industries where a recent deal has been proposed or
finalized. That often raises the odds that further similar acquisitions
will take place.
With these points in mind,
below you'll find a table of roughly a dozen companies that we feel are
likely to be bought out at significant premiums in the coming years. My
staff and I will then bring you an in-depth analysis of our three
favorite investing ideas from this list. We believe that all three of
these firms are likely to be bought up over the next few years. However,
even if a deal never materializes, these companies should still be
strong enough to deliver impressive gains as standalone entities...
Important: To view the remainder of this article, in which
StreetAuthority.com founder Paul Tracy and his staff provide a table of
likely acquisition targets, as well as an in-depth
analysis of several of their top picks from that table, you'll
need to subscribe to our premium Market Advisor
newsletter. Please visit one of the following links to continue...
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