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Takeover Targets
In the summer of 2006, the largest
owner of office real estate in the U.S. -- Equity Office Properties -- 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,
then-private equity firm The Blackstone Group emerged with a $36 billion
deal, and the stock shot up to about $48 per share -- a solid +37% return in
just a few short months.
But within a matter of weeks, a bidding war began. Rival real
estate investment trust (REIT) Vornado (NYSE: VNO) offered a significant
premium to the Blackstone deal. And just a few weeks after the |
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Vornado alternative hit the
news, Blackstone was back in the game with a sweeter offer worth around $40
billion.
The result: Equity Office Properties agreed
in February 2007 to be bought by Blackstone for $55.50 per share -- giving
investors who bought in the summer of 2006 a gain of close to +60% in just a
few short months.
The
Equity Office Properties/Blackstone deal now ranks as one of the largest leveraged
buyouts (LBO) ever. A LBO is when 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, 70% or more of
the transaction is financed by debt, but most involve a ratio closer to 90%
debt and 10% investors' equity.
Gains of this magnitude are common for mergers, LBOs, and takeovers, because
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.
Check out our chart, which
covers a few of the largest
recent deals. If you were a shareholder in one of these target
companies, then you probably saw your investment skyrocket in a very
short time.
Ernst and Young states that the average takeover premium in
the U.S. over the long run is around +25%. That means
investors in the takeover target make an average profit of
+25% by the time the deal closes, with much of that gain
coming in the first few days after a takeover is announced. |
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This can be even more
lucrative in the event of a bidding war as evidenced by the
Equity Office deal. The buyout price quickly increases if several companies
are interested. But 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 deal is
ultimately announced.
Now is a good time to begin looking for possible buyout candidates.
Globally, the total value of M&A deals announced in 2007 was $4.4 trillion
-- up from $3.8 trillion in 2006 (the previous record) and more than triple
triple the deals done in 2003. Many of these deals -- about one quarter of
all acquisitions in the U.S. -- are private equity transactions. At the time
of the Equity Office Properties deal, Blackstone was one of the largest
private equity funds in the world (it has since gone public.) These funds
typically borrow five to ten times their equity. Last year, private equity
raised a record $302 billion. That represents trillions in buying capacity.
And thanks to strong global growth over the past few years, corporate
balance sheets are healthy. 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. Additionally, with the
global sell off, there are plenty of cheap companies on the market.
Think it sounds impossible to identify takeover targets before deals are
actually announced? Well, think again. We highlighted three takeover
candidates back in recent issue of
our premium investing newsletter, the
StreetAuthority 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.
Unocal rose nearly +42% from the announcement date until the deal was finalized. Saucony generated a loss despite the takeover bid; the company's fundamentals deteriorated somewhat prior to the buyout. Our final pick -- TheStreet.com (Nasdaq: TSCM) -- remains an independent firm but continues to be rumored as a target.
While there are clearly no guarantees, our previous track record proves that it's possible to identify and profit from takeover bids.
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And this is not just some lucky strike. Out of the last 30
positions held, 27 were closed for a profit, with an average
gain of +65.7%. So, if your portfolio isn't doubling the S&P, then you need to subscribe to
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Characteristics of 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? There are several possible
motivations for such a deal. The acquirer may believe that
current management is not 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 and there is 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
does not emerge, then you do not want to get stuck holding a stock that will
not 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, a special administrative region of China, has now surpassed Vegas in terms of total
annual revenues. Since the casino business is extraordinarily cash
generative, it is 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 approved a $90 per share deal in late 2006 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 several years ago. With all that activity, it is 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 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 is not 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 was K-Mart's 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.
END OF FREE
CONTENT
The
remainder of this report is available exclusively to our Market Advisor
subscribers.
In it, our research staff provides an in-depth look at several firms that
like prime takeover candidates. Better yet, should no offer arise, these
companies make a valuable addition to your portfolio on their own merits.
Thanks for reading
today's special report -- Takeover Targets.
Good investing!
-- Research Staff
StreetAuthority.com
http://www.StreetAuthority.com
StreetAuthority LLC
839-K Quince Orchard Blvd.
Gaithersburg, MD 20878-1614
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