Most people are familiar with the phrase, “There ain’t no such thing as a free lunch.” Basically it means you can’t get something from nothing.
Investors may have a basis for refuting that adage though. Enter the corporate takeover.
A takeover is when one company purchases, or takes over, another company, usually after extensive negotiations and financing. The acquiring company becomes responsible for the target company’s debt obligations, holdings, and assets. In many cases, this transaction results in a significant price appreciation for the company that’s being taken over making it one of the most sought after events an investor can hope to be a part of.
Even the possibility of a takeover can have drastic effects on a stock’s price. If a company is interested in another, they may tender an offer to buy the other out at a specific price, often higher than that company’s current stock price. The rumor is enough to lift a stock’s price by ten, twenty, thirty percent or more overnight.
You can see why such an event is worth chasing after. Of course, like the mythological unicorn, actually owning a stock when it becomes a takeover target is something you almost never get to actually see.
Even so, there are ways to spot takeover targets before they receive an offer. A word of warning – a stock should never be bought solely for the purpose of being taken over. It should be bought for solid fundamental reasons with the possibility of a takeover as an added bonus at most.
The Key Elements Of A Takeover Target
Identifying a takeover target isn’t as difficult as you might think. There are several commonalities these stocks have that make it easier to own an undervalued company that another company may have an interest in.
The good news for investors is that merger and acquisition (M&A) activity for 2014 is at its highest level since 2007. As of June, more than $1.75 trillion worth of deals have happened globally. The total value of M&A deals compared to the same time period last year is up 44% with mega-mergers (deals between two multi-billion dollar companies) leading the way.
Obviously cost is the most important variable when it comes to buying out a competitor. You can figure out a rough estimate of how much a company costs to acquire by figuring out its enterprise value (EV).
EV = Total Market Capitalization + Long Term Debt + Preferred Shares – Cash and Cash Equivalents
This formula basically shows you what an acquiring company would be purchasing. It would have to buy out any and all debt but can subtract the cost of the purchase with the targets cash holdings to discount the deal.
There are five main characteristics to look for when searching for potential takeover targets:
- Company Size
The size of a company has a lot to do with its affordability. Larger companies worth billions may have a harder time finding other, larger competitors that could afford to buy them out. A smaller company will have a bigger pool to work from.
Ideally, the best target companies will have a market capitalization of less than $2 billion making small caps the best category to search through. These stocks often have few, if any, analyst coverage as well giving rise to more undervalued opportunities overlooked by Wall Street.
- Cash Holdings
A company with a large cash reserve will find itself a target for buy-outs far more quickly than its competitors without cash. The reasoning is simple. From our valuation formula above, we can see that cash can be used by the acquiring company and subtracted from the total buy-out cost making it cheaper to purchase.
Companies with cash on hand usually have fewer debt obligations as well. If they have little or no interest payments, the company can afford to stockpile reserves to use for capital investments or even acquisitions of their own.
Undervalued stocks will find themselves targets of acquiring companies because their inherent value is already built into the company. The best metric to find undervalued stocks that might be taken over is the price-to-book ratio.
Book value tells you what a company would be worth if it declared bankruptcy and had to liquidate all assets. Companies look for targets with a price-to-book ratio of 1 or less because it represents value that’s already priced into the stock.
- Insider Ownership
A company that has a lot of insider ownership goes a long way in facilitating potential buyouts. Acquiring companies like buying target companies with a lot of insider representation because it means that getting the voting majority is a much easier task to accomplish. In addition, a lot of insider ownership means that they will likely have more incentive to sell their shares and realize a profit.
- Sector Activity
Some sectors are more amenable to M&A activity than others. Utilities for example rarely merge or buy out other companies due to their geographically limited business base, large debt loads, and low cash flows. Other sectors are experiencing heavy growth and consolidation like healthcare, telecommunications, technology, and industrials.
Healthcare, technology, and industrials hold almost $735 billion in corporate cash – 2/3rds of all corporate cash holdings in the market. Currently, healthcare is leading the way for M&A activity this year with around $319 billion in deals. 4% of stocks in the sector receive some kind of merger or buyout offer – more than double the amount of any other sector. Telecommunications has been a popular place for activity this year as well. There’s been almost $261 billion in deals with the largest being AT&T’s $69.8 billion* buyout of DirecTV.
Let’s take a look at a real world example that hasn’t yet closed. Dollar General (DG) has tendered an offer to buy Family Dollar (FDO) for $9.1 billion which equates to $80 a share. Dollar General’s original offer of $7.1 billion back in July caused Family Dollar’s stock to jump nearly 25% over the weekend. Investors that owned Family Dollar immediately realized a significant gain on just the possibility of a takeover.
That kind of action makes rigorous research of other potential takeover targets well worth the trouble. But it does no good to dwell on past buyouts; let’s take a look at 3 companies that could be primed for a takeover based on the variables we’ve mentioned above.
3 Potential Takeover Targets For Investors
Quality Systems Inc. (QSII)
This company engages in healthcare information systems and electronic health records, an industry that has been experiencing rapid changes since the roll-out of the Affordable Care Act. It provides for more than 85,000 physicians and dentists and could be a target for Siemens AG (SIEGY) or McKesson Corp. (MCK).
- Market Cap: $921.4 million
- Cash Holdings: $116.4 million
- Long Term Debt-to-Equity: 0
- Price-to-Book: 3.2
- Insider Ownership: 26.81%
SodaStream International (SODA)
This innovative small cap company has popularized the idea of making soda at home instead of purchasing it at a retailer. They are the world’s largest manufacturer of home carbonation systems sold in over 60,000 stores in 45 different countries. They could be a potential pick-up for Pepsico (PEP) or Coca-Cola (KO).
- Market Cap: $699.2 million
- Cash Holdings: $36.2 million
- Long Term Debt-to-Equity: 0
- Price-to-Book: 2.01
- Insider Ownership: 15.1%
Vitamin Shoppe (VSI)
This specialty retailer provides products and solutions for healthcare and healthy living with a strong focus on its online segment. The unique branding of this company and consolidation could be a reason for GNC Holdings (GNC) to buy it out.
- Market Capitalization: $1.25 billion
- Cash Holdings: $15.03 million
- Long Term Debt-to-Equity: 0
- Price-to-Book: 2.16
- Insider Ownership: 3.21%
Only time will tell if these companies become targets of a takeover, but these companies tick off most of the requirements that make up a good takeover target and are all currently undervalued. A take-over target doesn’t have to necessarily fall in line with every category to make it a possibility. Mega-mergers like Comcast’s (CMCSA) $45 billion acquisition of Time Warner Cable (TWC) clearly ignores the rule about small caps, but still resulted in a buyout.
There are plenty of benefits in M&A’s. The acquiring company can expand its customer base and grow its business immediately instead of spending millions trying to attract new customers. Consolidation can result in a slimmer balance sheet and increase margins as well.
In order for these deals to occur, shareholders must vote to approve it. For that reason, the company propositioning the target company generally offers a premium in order to incentivize shareholders. This premium comes in the form of a price pop that you see when an offer comes through on a stock and creates instant value for shareholders. Value investing is a strategy that can take months or even years until the market realizes a stocks intrinsic value. In a takeover, that value is created instantly which not only eliminates opportunity cost, but also provides a “free lunch” for investors.
*Since the AT&T buyout of DirecTV is a cash plus stock transaction, the actual total transaction value will likely have changed since the time of this writing.
CEO, Elite Wealth Management
Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions on the companies mentioned through stocks, options or other securities.