Go!
How to Find Probable Takeover Targets
Published:  July 16, 2007

We've all seen it many times before. A stock moves quietly along for months, drifting with the ebbs and flows of the broader market, when boom! All of a sudden, the shares rocket higher, often to a new multi-year peak. 

What is it that catapults a stock so abruptly? Increasingly, such sharp moves are the result of a proposed takeover.

Takeovers have long been an important part of Wall Street, where big fish frequently swallow the assets of their smaller rivals. In recent years, though, this deal-making has stepped-up to a frenetic pace -- and the dollar amounts involved have reached astronomical heights. And these days, it is no longer just the small fry that is getting gobbled up -- even corporate giants like Home Depot (NYSE: HD) and Anheuser-Busch (NYSE: BUD) have been mentioned as possible targets.

As an investor, you stand to post big gains if one of your holdings gets bought out by another firm. In fact, Ernst and Young states that the average takeover premium in recent years has been around +24%. That means investors in the takeover target make an average profit of nearly +25% from the time a deal is announced to the time the deal closes.

With this in mind, it's worthwhile to search for companies with solid businesses that might make attractive takeover candidates. When doing so, here's a list of characteristics to look for...

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.

Nonetheless, the problem with buying a fundamentally weak firm is that you could wait months for a bid, or a bid might never emerge. Meanwhile, 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 doesn't emerge, then you don't want to get stuck holding a stock that won't perform well on its own. Therefore, it's best to focus on fundamentally strong firms.

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. Since the casino business is extraordinarily cash generative, it's an ideal target for leveraged buyout deals -- those solid cash flows can support a large debt burden.

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 at least 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 isn't 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 -- 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.

Valuable Assets -- Sometimes, acquirers are more interested in a company's assets than in the business itself. A classic example of this phenomenon at work was K-Mart's (Nasdaq: SHLD) 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.

After examining each of the factors above, as well as a host of other considerations, Editor Nathan Slaughter recently uncovered two firms that he feels are ripe for a possible takeover. The first is a world leader in the highly profitable video game market, and in recent months its management team has hinted that it could place itself on the auction block. Meanwhile, Nathan's other favorite is involved in the casino industry. After watching most of its rivals either get bought out or get taken private in recent years, this cash-generating machine (the firm brought in over $400 million in free cash flow last year) looks like the next logical takeover target. 

To learn the names and ticker symbols of these promising takeover candidates, you'll need to subscribe to Nathan's premium newsletter -- Half-Priced Stocks. To learn more about this monthly value investing service, please visit this link.



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