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| How
to Find Probable Takeover Targets |
Published: February 1, 2007
Last summer, the largest owner of office real estate in the U.S. -- Equity Office Properties (NYSE: EOP) -- was trading around $35 per share. As rumors began surfacing that the company was looking for a buyer, the stock started rallying. Finally, in mid-November, private equity firm Blackstone Group emerged with a $36 billion deal and the stock shot to about $48 per share, a solid +37% return in just a few short months.
Within a matter of weeks, though, there began a bidding war. Rival real estate investment trust (REIT) Vornado (NYSE: VNO) offered a significant premium to the Blackstone deal. And just a few weeks after the Vornado alternative hit the news, Blackstone was back in the game with a sweeter offer worth around $40 billion. The result: shares of Equity Office Properties are now trading around $55 -- close to +60% higher than last summer. Better still, there's a possibility the company could attract an even higher bid.
Private equity firms like Blackstone have become increasingly active in recent years. These firms are nothing more than private investment vehicles. Typically, investors place capital into a private equity fund, and those funds are then augmented by debt capital when the firm decides to make an acquisition. Private equity firms generally either take over or buy a major stake in private or publicly traded companies.
If Equity Office Properties ultimately accepts the Blackstone bid, then it will rank as the largest leveraged buyout (LBO) ever, anywhere in the world. In an LBO, a private investment firm, group of individuals, or company issues bonds or takes on bank loans to finance the takeover of another firm, known as the target. Typically in an LBO, 70% or more of the transaction is financed by debt capital, but most LBOs involve a ratio closer to 90% debt and 10% investors' equity. Usually that debt is collateralized by the assets of the firm being acquired -- the target company. Investors often use LBOs to take a company private.
But while the Equity Office deal might be the largest LBO ever, it wasn't all that unusual in the context of a record-breaking year for mergers, acquisitions, and buyouts in 2006. Globally, the total value of M&A deals consummated in 2006 was $3.8 trillion -- up from $2.75 trillion in 2005 and an annualized level of about $1.2 trillion in 2002 and 2003. In fact, 2006 was the biggest year ever globally for M&A activity, surpassing the prior record of $3.38 trillion in deals set back in 2000. In total, around 35,000 deals were announced globally last year.
Many of these deals -- as many as one quarter in the U.S. alone -- were private equity transactions similar to the Blackstone/Equity Office deal. Private equity funds raised a record $404 billion in equity capital in 2006, with another $12.5 billion in the first three weeks of January alone. These firms routinely borrow five to ten times their equity in the form of debt capital; that represents trillions in buying capacity. It's no wonder most analysts see another record year for private equity deals and LBOs in 2007.
And thanks to strong global growth over the past few years, corporate balance sheets are healthy. In other words, most big companies are awash in cash and have paid down significant debt. That cash also represents plenty of potential buying power to finance takeovers.
For even better news, check out our chart, which covers just a few of last year's largest deals. If you were a shareholder in one of last year's target companies, then you probably saw the value of your investment skyrocket in a very short period of time.
This is typical for mergers, LBOs, and takeovers -- shareholders in the target company usually receive a premium price for their shares. That's because 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. This can be even more lucrative in the event of a bidding war -- a situation where more than one bidder is competing for shareholders' approval. To make a long story short, if you can identify stocks that are likely takeover candidates, then you stand to post big gains when a merger deal is ultimately announced.
In fact, Ernst and Young states 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, with much of that gain coming in the first few days after a takeover is announced. With this in mind, many investors have found it extremely worthwhile to look for companies with solid businesses that might make attractive takeover candidates in the future.
Think it sounds impossible to identify takeover targets before deals are actually announced? Well, think again. We highlighted three takeover candidates back in a 2005 issue of the
Market Advisor. Of those three stocks, two -- oil explorer Unocal and footwear maker Saucony -- were ultimately acquired by Chevron (NYSE: CVX) and Stride Rite (NYSE: SRR), respectively.
While there are clearly no guarantees, our previous track record proves that it's possible to identify and profit from takeover bids.
How to Find Probable Takeover Targets
My staff and I look for a few key criteria when searching for takeover plays. Here's a brief rundown:
Fundamentally Strong Firms
Sometimes, companies or private equity firms will take over another firm that has weak fundamentals. After all, companies with weak fundamentals often see their share prices decline in value -- a decline in price makes them cheaper and easier to purchase.
At first glance, such a deal might look nonsensical -- after all, why take over a firm that's performing poorly? But there are several possible motivations for such a deal. For example, the acquirer may believe that current management isn't making the right decisions and that by replacing management, the company's prospects could improve. Alternatively, the acquirer may feel that the company doesn't have adequate access to the cash needed to fund growth. In this case, there's an opportunity to improve prospects by infusing capital.
Nonetheless, the problem with buying a fundamentally weak firm is that you could wait months for a bid, or a bid might never emerge. Stock in the potential target firm could continue sliding while you wait for a deal. After all, picking takeover targets is never an exact science; if a deal doesn't emerge, then you don't want to get stuck holding a stock that won't perform well on its own.
Industries with Deal-Making Activity
Often, particular industry groups will see an unusually large amount of deal-making activity over a period of time -- deal binges of this sort can last for several years.
A classic example over the past few years is the casino industry. Profits for casino operators have been booming as Las Vegas and Atlantic City gaming revenues have been solid. In addition, several new districts have passed laws allowing gambling, and revenues outside the U.S. also have picked up. For instance, Macau, near China, has now surpassed Vegas in terms of total annual revenues. Since the casino business is extraordinarily cash generative, it's an ideal target for a leveraged buyout deal -- those solid cash flows can support a large debt burden. In addition, in the casino business location is everything. On the Vegas Strip, for example, popular casinos like the Bellagio, MGM, and Mandalay Bay enjoy plenty of foot traffic and are extremely valuable assets.
With these points in mind, it's hardly surprising that Harrah's (NYSE: HET) board recently approved a $90 per share deal led by two private equity firms. And Harrah's itself acquired Caesar's Entertainment in a $9.4 billion deal in 2004. Another big-ticket deal was MGM's (NYSE: MGM) buyout of Mandalay Resorts Group nearly three years ago. With all that activity, it's only logical to take a closer look at the casino industry when searching for potential takeover targets.
Low Debt Levels
When a company is acquired, the acquiring firm must assume all the target's debt obligations. In other words, the acquirer has to buy out both shareholders and bondholders, or at least continue to make interest and principal repayments on bonds.
Companies with a great deal of debt are harder to take over -- all that debt leads to additional expenses for the acquirer. This isn't a big deal if the acquiring firm is much bigger and can assume all the obligations easily. However, it may be a much bigger impediment to a private equity deal. Private equity acquirers typically use a great deal of debt to fund transactions, and potential bond investors may balk at the large debt burdens this entails.
Strong Cash Flows
As noted earlier, bondholders and bank lenders typically prefer to lend money to companies that generate copious free cash flows. Reliably cash-generative businesses can carry higher debt loads than more cyclical businesses; potential debt investors are more willing to finance such firms.
This is particularly true when it comes to private equity acquirers. Private equity firms can use the strong cash flows of the target firm to support the large debt burden needed to complete the transaction.
Valuable Assets
Sometimes, acquirers are more interested in a company's assets than in the business itself. A classic example of this phenomenon at work was K-Mart's (Nasdaq: SHLD) 2004 takeover of Sears Roebuck & Co. K-Mart was not particularly interested in Sears' retailing business, but was instead attracted by the company's vast real estate holdings and strong brand recognition. K-Mart was able to sell off Sears' underperforming stores to generate cash and then run the remaining stores to generate strong cash flows.
Today's Potential Takeover Targets
With all of these points in mind, my staff and I recently searched far and wide for a handful of firms that could soon become takeover targets. In the text below, we'll profile a few of the more promising candidates . . .
Important Note: Throughout the remainder of this article, editor Paul Tracy and our research staff provide
an in-depth look at six companies ripe for a takeover. However, in order to view the remainder of this article, you'll need to subscribe to our premium newsletter --
Market Advisor. After you subscribe you'll receive immediate access to this full article, as well as our monthly
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Good investing!
-- Paul Tracy
Editor
StreetAuthority
Market Advisor
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Paul Tracy
founded StreetAuthority and became Chief Investment Strategist in 2001. Prior to
that he spent several years as Managing Editor at a multi-million dollar
financial publishing firm with over 150,000 subscribers. In addition to
his role as managing editor and lead financial writer, he was also
responsible for equity research and managing a team of seasoned
professional financial writers, researchers and market commentators.
Paul's previous experience
includes a position at Robert W. Baird & Co.'s full-service
brokerage operations as well as economic research work on a Money and
Banking project funded by the National Bureau of Economic Research. He
has also spent time doing outside consulting and research for the
University of Virginia, has appeared as a guest expert on several
prominent financial radio shows, and has been a featured speaker at
various investment conferences across the U.S.
Paul graduated with a B.S.
in Finance and Management from the McIntire School of Commerce at the
University of Virginia.
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