Buy This M&A Machine Before The Market Catches On

Rock-bottom interest rates and huge cash stockpiles have led to a rebirth in the market for mergers and acquisitions (M&A) over the past few years. Faced with a weak economic recovery and a lack of organic growth opportunities, companies have used acquisitions to increase sales by gobbling up competitors and firms in related industries. 

#-ad_banner-#As enterprise values creep up and this external growth strategy becomes expensive, we may be entering a new stage for the market. This next stage could be defined by internal reviews by companies looking for ways to improve the bottom line through cost-cutting and integration of acquisitions. 

It’s these transformational companies that you should be watching for now.

Potential transformational targets are companies that have seen sales jump after a series of acquisitions but that may still have operating margins and profitability that trail well behind their peers. These companies’ shares may perform well enough, but management is leaving money on the table due to poor efficiency. 

Once leadership decides to make a change, that’s when the real opportunity starts.

I’ve found just such a company. In a bid to change its industry focus, this manufacturer has acquired 21 other companies over the past three years alone, increasing its assets by 54%. 

However, its shares lagged the S&P 500 by more than 50% in the four years to the beginning of 2013. Operating margins plummeted 3.6 percentage points, to 7.7%, between 2007 and 2012, and investors wondered whether the company could integrate its acquisitions effectively.

Management began shifting the company into its next stage last year. The move paid off as the company’s operating margin improved to 9.3% and its shares jumped nearly 80% during the year. 

CW Chart

CW data by YCharts

But the company is still in a transformational stage and could go much higher.

Curtiss-Wright Corp. (NYSE: CW) is a $3 billion maker of engineered industrial products. Until just the past few years, the company primarily operated as a defense contractor with nearly half of its revenue coming from the sector. 

Threats to defense projects throughout the recession prompted management to embark on a massive acquisition program, diversifying the company’s revenue base through more than $845 million in deals over the past three years. 

Until just last year, Curtiss-Wright traded with the stigma of a defense manufacturer — and a price multiple well below other industrial manufacturers. According to Morningstar data, CW traded at an average trailing price-to-earnings (P/E) ratio of 14.6 from 2008 to 2012. That’s closer to the multiple on defense companies than industrial manufacturers. 

Management’s cost-cutting and integration initiatives look like they’re paying off. The company’s first-quarter operating margin of 9.3% was well above the 6.4% margin in the same quarter last year. Management is targeting a margin of at least 14% as it integrates acquisitions and lowers costs through 2018. An operating margin of 10.5% this year (an improvement of 1.2 percentage points from last year), combined with an expected 8% increase in sales, could drive a 22% increase in earnings to $3.50 per share.

Improving margins are continuing to drive the company’s forecasts even higher: Management recently increased its guidance for operating income and free cash flow by 2.6% and 6%, respectively.

Curtiss-Wright’s commercial aerospace unit should benefit from the production ramp-up at Boeing (NYSE: BA) and Airbus (OTC: EADSF) for both legacy and new programs. The energy division saw strong sales growth of 12% in 2013, with expectations of 9% average growth through 2017. Management also expects the energy division’s operating margins to double to 14% from 7% last year.

CW now trades at a trailing P/E of 19.6, still below the average of 21 for diversified industrials. While the share price has increased significantly, earnings are expected to rise 19% this year, to $3.44 per share, and 17% next year. 

Risks to Consider: Shares have shot up over the past year and could level off for a period before moving higher. While management has demonstrated its ability to integrate acquisitions with an improvement in margins over the past year, threats to operational efficiency remain.

Action to Take –> Curtiss-Wright is moving into a new era as a diversified manufacturer. Even after a tremendous run, the shares are still only at the industry average and higher margins in the future could drive strong returns. I have a price target of $71.60 on higher than expected earnings and a P/E of 20. That target represents a 16% increase from current levels with strong upside over the next several years on sales growth and improving margins. CW entered oversold territory this month with a Relative Strength Indicator (RSI) of 29.8, and I am recommending a buy-under price of $64 per share.