Do You Own These Potential Buffett Targets?

Although most companies appear largely focused on dividends and buybacks these days, some still see the merits of a growth-inducing acquisition.

In a slow-growth economy, dealmaking can lead to sales synergies and better operating leverage. And that can boost earnings per share (EPS) even more quickly than buybacks can.#-ad_banner-#

That was precisely the rationale behind Packaging Corp. of America’s (NYSE: PKG) just-announced $2 billion (in cash and assumed debt) acquisition of rival Boise (NYSE: BZ). The deal will create a $6 billion (in sales) behemoth in the cardboard box industry.

Cardboard boxes? Why should anyone care about such a low-tech old-line industry? The answer: e-commerce. That UPS (NYSE: UPS) package at your doorstep explains why this industry isn’t going anywhere.

Investors loved the deal, bidding up shares of Boise nearly 40% and even the acquirer, PKG, by nearly 10%. The deal was attractively priced, at 6.7 times trailing earnings before interest, taxes, depreciation and amortization (EBITDA), or just five times EBITDA when planned synergies are taken into account.

That’s a price Warren Buffett would love. In fact, everything about this deal would appeal to the Oracle of Omaha.

The combined entity will have:

  • An opportunity to boost market share beyond the pro forma 9% (7% for PKG and 2% for Boise) in what is still a fragmented industry.
  • Robust projected EBITDA: more than $1.1 billion annually on that $6 billion revenue base.
  • An opportunity to earn more than $4 a share in 2014, according to DA Davidson. That’s up from $2 a share in 2012. 

Don’t be surprised if Buffett eventually pounces on this company, as it has the key characteristics he looks for. In the interim, with the ink already dry on a deal early this year to acquire H.J. Heinz, Buffett is likely still on the prowl in search of his next prey.

Berkshire Hathaway’s Recent Acquisitions

The process of studying Buffett-style businesses is extremely worthwhile. It can lead you to great companies that represent solid intrinsic value, even if they are never acquired. 

As a quick recap, Buffett likes businesses that have:

  • A strong global brand name (Heinz)
  • A history of consistent, stable cash flow (all of them)
  • An industry that can earn greater returns through infrastructure investment (BNSF)

Frankly, it’s the absence of recent major insurance acquisitions that is a bit curious. After all, Buffett built his initial fortune by acquiring insurance companies before he ventured into other industries.

Insurance companies are some of the best deals on the market right now, as many of them still trade below tangible book value. And considering that book value will rise more quickly as interest rates (and interest income) move higher in coming years, Buffett’s Berkshire Hathaway (NYSE: BRK) could afford to pay up to 1.25 times book value and still garner excellent long-term returns. Here’s a quick list of insurers that fit the bill:

Below Book Insurers

My favorite insurers: AIG (NYSE: AIG) (which I discussed a few months ago), Protective Life (NYSE: PL) and Reinsurance Group of America (NYSE: RGA).

The other fertile area for value investors: high free cash flow. If you’re looking to mimic Buffett, then you need to exclude companies he would never buy anyway, such as airlines.

Notably, a handful or regional banks make the list. The appeal of these banks is in the projected consolidation of the banking industry. The major banks are now too large (in the eyes of regulators) to make more acquisitions. And the smallest banks are being squeezed by a rising tide of regulatory and capital compliance. That puts the mid-size regional banks in the sweet spot, and they will likely look to make accretive acquisitions that bolster their franchises.

Would Buffett look to acquire regional banks? He’s a huge fan (and a major shareholder) of Wells Fargo (NYSE: WFC), but he’s shown little interest in smaller banks thus far.

The remaining group of companies look perfect for Buffett.

In fact, Buffett had been building a growing position in agricultural giant Archer Daniels Midland (NYSE: ADM), as I noted in this article.

He subsequently closed that position with a nice profit, and he should now check out rival Bunge (NYSE: BG), which in my view, holds better value. (I’ll have more to say about Bunge in a separate column in coming weeks). 

Lastly, you’ll note that both Reinsurance Group of America and Genworth Financial (NYSE: GNW) appear on two separate tables here, as they both sport high free cash flow yields and trade below tangible book value. Those deep value metrics have surely caught the eye of Buffett and his research team. 

Risks to Consider: It’s unwise to buy a stock simply on hopes of a buyout, and the company should instead have appeal on its own intrinsic value. 

Action To Take –> Value never goes out of style. Although the current bull market has been especially kind to high-growth stocks, it is value stocks that tend to deliver the steadiest gains for risk-averse long-term investors. These companies all have proven track records, and sport impressive valuations. 

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