These 5 Undervalued Stocks are Screaming “Takeover”

“Strike while the iron is hot,” is the new catchphrase in Private Equity (PE) circles. Conditions are perfectly in place to do deals, and you can expect to hear of many more this winter. Just this week, Yahoo! (Nasdaq: YHOO), Wendy’s/Arby’s (NYSE: WEN) and Seagate (NYSE: STX) are surging on word that PE investors are sniffing around. This frenzy of potential deal-making comes as many public companies are cash-rich but undervalued.

[See: “This Sector’s Mountain of Cash Could Soon Line Your Pocket”]

To pull off a deal the size of Yahoo! is no mean feat. The company’s market value already exceeds $20 billion. Seagate, which is now valued at around $6 billion, is typically more in line with an ideal size for PE investors, several of whom got burned in the last decade from deals that were simply too large to digest. PE firms also made the mistake back then of ignoring balance sheets, instead identifying debt-laden targets upon which they heaped even more debt. These days, PE buyers prefer to see lots of cash on the books so they can easily talk a bank into lending them the money to finance a deal. With interest rates quite low, the economics of deal-making are very compelling.

These PE firms hope to take companies private while they’re cheap and then bring them public (or find another buyer) when valuations improve. But buyers beware: by the time that a company goes public again, debt levels can be alarmingly high. For example, Hertz Global Holdings (NYSE: HTZ) was taken private in 2003 and then brought back public in 2006 through an IPO. Shares plunged below $5 in 2008 when a massive debt load suddenly became a scary prospect in an economic downturn.

To be sure, many potential PE candidates have already surged and would be risky to buy at this point. Names such as CommVault (Nasdaq: CVLT), Isilion Systems (Nasdaq: ISLN) and NetScout Systems (Nasdaq: NTCT) have already seen considerable buyout buzz.

With all that in mind, here is a quick list of five companies that appear to be attractive targets for the PE crowd, yet still appear undervalued.

1. Symantec (Nasdaq: SYMC) — Shares of this data security and storage vendor started to rebound after Intel (Nasdaq: INTC) bought rival McAfee (NYSE: MFE). My colleague Ryan Fuhrmann made a clear case for considerable upside for shareholders, if a PE offer emerged. [Read Ryan’s take here]

2. Integrated Silicon Solutions (Nasdaq: ISSI) — This company checks all the boxes that PE firms look for. It sports a reasonable $236 million market value, has roughly $90 million in net cash, is nicely profitable — trading at less than six times earnings, and is utterly unloved. Semiconductor stocks are far out of favor right now, and this maker of embedded chips that go into a wide range of applications could be acquired and combined with another PE holding to make a larger chip company.

3. Novellus Systems (Nasdaq: NVLS) — This company, along with Lam Research (Nasdaq: LRCX), trails behind industry leader Applied Materials (Nasdaq: AMAT) in the market for semiconductor manufacturing equipment. They all toil in a highly cyclical industry, which means they are occasionally stuck with low price-to-earnings (P/E) ratios– right now they all trade for less than 10 times next year’s projected profits. Yet these types of stocks are often attractive to PE firms that can buy them, extract the cash, and take them public again when the sector is back in vogue.

4. Huntsman Corp. (NYSE: HUN) — This chemicals maker routinely traded in the high teens and the low $20s prior to the financial crisis and now trades for around $12. As I noted in this article, a buyer was prepared to pay $28 a share in 2007 before financing dried up.

The chemicals business is highly cyclical, and Huntsman’s profits are just starting to rebound. The company is likely to earn $0.50 a share this year and perhaps twice as much next year. But PE buyers will note that EPS exceeded $2 in 2008, when economic conditions were better. Shares trade for just six times that peak cycle profit. Of course, Huntsman still carries a lot of debt, even as it has built up a hefty load of cash, so PE buyers would likely use Huntsman’s $1 billion in annual free cash flow to help secure financing for the deal.

5. Ciena (Nasdaq: CIEN) — When Tyco International (NYSE: TYC) announced plans in July to acquire ADC Telecom (Nasdaq: ADCT), investors quickly surveyed the landscape to see what rivals may be up for sale. ADTRAN (Nasdaq: ADTN) seemed to some as the most obvious target, and its shares have risen about +20% since then. But I think Ciena is more likely to find interest. That’s because Ciena was able to pick up Nortel’s telecom equipment business at a cheap price in bankruptcy court earlier in 2010, and now has an even broader product platform and deeper array of customers.

That newfound heft should help Ciena to secure rising market share in the telecom equipment market, whose demise has been greatly exaggerated. Europe now represents 35% of sales for Ciena, which currently represents a drag but will be a tailwind when the European economy rebounds and European telecom service providers need to catch up on lagging infrastructure investments.

Action to Take –> This list could go on and other names such as JetBlue (Nasdaq: JBLU), AMR (NYSE: AMR), Weatherford Industries (NYSE: WFT), Blue Coat Systems (Nasdaq: BCSI) — all are digestibly-sized and operate in consolidating industries. Of course, many of these deals will never happen, so you should buy these stocks for their fundamentals, and not because you expect a buyout offer to emerge. But make no mistake, the PE buyout frenzy is clearly underway and will remain in place as long as borrowing costs and current equity valuations are low.

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