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Shareholders of hospital owner HCA (HCA, news, msgs) and graphics chipmaker ATI Technologies (ATYT, news, msgs) were pleasantly surprised last week when buyout offers triggered healthy price jumps for their stocks.
The lesson: Even in a lackluster market, you will usually make money if you hold a stock when someone says they want to buy the company.
Is there a way for investors to identify buyout targets in advance? There is. First, though, it's important to understand how the HCA and ATI deals are different.
Advanced Micro Devices (AMD, news, msgs) bought ATI for strategic reasons. It felt it needed ATI's products and expertise to better compete with archrival Intel (INTC, news, msgs).
By contrast, a group of private investment firms bought HCA solely for its profit potential. In two or three years they'll probably cash out by taking HCA public again. In the meantime, they'll arrange for HCA to pay them generous management and consulting fees, and possibly even fat dividends.
The HCA transaction is typical of most acquisitions these days. Many private investment firms are awash in cash, and their pace of acquisitions is accelerating. In recent months, they've taken over familiar names such as Neiman Marcus, Linens 'n Things, Metro-Goldwyn-Mayer and Univision Communications (UVN, news, msgs).
To try and identify the companies ready to join that list, I researched recent acquisitions to see if they share some common traits. And they do. Most were small to midsized corporations that were profitable, but somewhat out of favor. I'll explain those terms in detail as I describe the screen I devised for identifying potential buyout candidates.
Not too small, not too big
For starters, acquisition candidates must be small enough so that private investment firms can raise the cash needed to buy the shares. Market capitalization is the dollar amount required to buy all of a company's shares. Most acquisition targets' market caps were in the $1 billion to $5 billion range (HCA, with a $20 billion market cap, was an exception).- Screening parameter: Market Capitalization >= 1,000,000,000
- Screening Parameter: Market Capitalization <= 5,000,000,000
Profitable
Private investment firms like to start pulling cash out of their targets as soon as possible. So the last thing they want is an unprofitable company that will require additional cash transfusions to keep it going.Checking return on equity, or ROE (12 months' profits divided by shareholders equity), is a quick way to gauge profitability.
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- Screening parameter: Return on Equity >= 5
Count the cash
Cash flow measures the actual cash that flowed into, or out of, a company's bank accounts from its activities. Sometimes a company reports positive earnings, but isn't really profitable when you count the cash. Buyout firms want companies where the cash is flowing in, not out.While you can't screen for cash flow directly, checking the price-to-cash-flow ratio (share price divided by 12 months' cash flow) accomplishes the same thing. If the ratio is a positive number, cash is flowing in, not out.
- Screening parameter: Price/Cash Flow Ratio >= 1
The price-to-cash-flow ratio also tells you how much you're paying for each cash flow dollar. Buyout firms apparently pay attention to that figure. Most recently acquired companies had ratios below 20.
- Screening parameter: Price/Cash Flow Ratio <= 20
Bargain hunters
Buyout firms take the old axiom about buying low and selling high seriously. They prefer stocks trading well below earlier highs, but not if they've fallen too far. Most of their recent targets were trading 30% to 60% off their five-year highs when the buyout was announced.So, to find stocks within that range, I added the following two screening parameters.
- Screening parameter: Last Price <= 0.7 * Five-Year High Price
Passing stocks must be trading at least 30% off their Five-Year Highs.
- Screening parameter: Last Price >= 0.40 * Five-Year High Price
Precludes stocks that have dropped more than 60%.
The price-to-sales ratio is the recent share price divided by the past 12 months' sales per share. It's a steadier valuation gauge than the more familiar price-earnings ratio, because quarterly sales don't fluctuate nearly as much as quarterly earnings.
Value-priced stocks usually trade at ratios below 2 and almost all of the buyout targets that I checked were trading below that level when their acquisitions were announced.
- Screening parameter: Price/Sales Ratio <=2
In some industries, most stocks trade at ratios consistently below 2. So, in addition to setting the maximum P/S at 2, I found it helpful to also rule out stocks trading above their industry average.
- Screening parameter: Price/Sales Ratio <= Industry Average P/S
Moderate expectations
Judging by analysts' buy and sell ratings and long-term earnings forecasts prior to the buyout announcement, private investment firms prefer moderately out-of-favor companies with modest earnings-growth expectations.For instance, in terms of buy/sell ratings, most takeover targets were rated between "moderate buy" and "hold," when the buyouts were announced (many market players interpret "hold" as meaning "sell").
Here's how I pinpoint stocks in that range.
- Screening parameter: Mean Recommendation <= Moderate Buy
- Screening parameter: Mean Recommendation >= Hold
(Taken together, the two parameters require that qualifying stocks must be rated between moderate buy and hold)
Looking at analysts' long-term forecasts, buyout firms look for stocks with only moderate growth prospects, typically in the 10% to 15% annual earnings growth range (analysts usually forecast 20% and higher growth rates for hot growth stocks).
- Screening parameter: EPS Growth Next Five Years >= 10
- Screening parameter: EPS Growth Next Five Years <= 15
Strong balance sheet
Since their goal is to take cash out, buyout firms typically avoid high-debt takeover targets.The debt/equity ratio measures debt by comparing long-term debt to shareholders equity (book value). A zero D/E ratio signals no long-term debt, and the higher the ratio, the higher the debt. Companies with D/E ratios above 1 are considered high-debt, and most of the acquired companies that I checked had D/E ratios below 0.8.
- Screening Parameter: Debt to Equity Ratio <= 0.5
My screen turned up 17 potential buyout candidates. Four were retail stocks, which isn't unreasonable when you consider that retail stalwarts such as Toys 'R' Us, Neiman Marcus, Linens 'n Things and Petco (PETC, news, msgs) have either already been taken private or recently agreed to do so.
| Identifying buyout targets | |||
|---|---|---|---|
Company Name | Last Price | Industry Name | Market Capitalization |
17.96 | Restaurants | 1,351,786,000 | |
18.11 | Electronics Wholesale | 2,555,825,000 | |
28.36 | Discount, Variety Stores | 1,849,402,000 | |
19.07 | Specialty Retail, Other | 1,185,161,000 | |
29.53 | Sporting Goods | 2,743,104,000 | |
13.33 | Discount, Variety Stores | 4,077,777,000 | |
22.48 | Discount, Variety Stores | 3,345,052,000 | |
48.45 | Medical Equipment Wholesale | 4,188,778,000 | |
22.34 | Management Services | 2,432,889,000 | |
20.82 | Trucking | 3,022,292,000 | |
18.53 | Farm & Construction Machinery | 1,899,343,000 | |
38.15 | Data Storage Devices | 1,155,739,000 | |
42.43 | Trucking | 2,363,242,000 | |
27.63 | Restaurants | 2,134,835,000 | |
28.49 | Diversified Machinery | 2,808,153,000 | |
13.52 | Information Technology Services | 1,587,286,000 | |
37.15 | Recreational Vehicles | 1,579,633,000 |
While many of these stocks look like viable acquisition targets, only time will tell how accurate my screen is at predicting takeovers. So do your due diligence and only buy stocks that look like good investments, even if they're not acquired.
At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article. Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.
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