Chasing the Bid

Wall Street adores the art of the deal. An acquisition announcement means it’s time to redraw competitive maps and weigh the odds that any of the companies remaining will be the next to go. The prospect of motivated buyers at the bargaining table lifts both sentiment and valuations as once-marginal players that had been unlikely to thrive on their own suddenly become viable as components of a conglomerate in the making.

Even just the rumors of a deal can be powerful. Once management announces that it’s even contemplating a merger or acquisition offer, long-dormant value can emerge very quickly as traders chase the premium and push the market price closer to what they believe a strategic buyer is willing to pay.

While collecting all that appreciation in one quick burst is thrilling, it can be difficult to predict with total accuracy which stocks will get taken out in a given time period. Negotiations are confidential, and even when we know management is at the table, the deals come when they come.

The good news is that if we think like a strategic buyer, we can get the likeliest targets on our screen well in advance of the deal announcement – and position ourselves to be among the sellers when the bid comes.

Better Than a Buyback

While share buyback programs are getting a lot of buzz lately, the corporate urge to merge is actually a bigger factor keeping stock prices humming.

Global M&A activity topped more than $1.3 trillion in 2014 – more than twice the level we saw just two years ago. Meanwhile, companies have acquired maybe $250 billion worth of their own shares. Given that gap in relative scale, it’s a little shocking that the commentators are spending so much time marveling at how buybacks are reshaping the market.

It’s true that M&A is a form of “financial engineering” designed to generate satisfying shareholder returns on capital through market activities instead of conventional corporate operations. But the core concept here is that management is using corporate currency – cash or stock – as an investor would. In fact, we can think of M&A as a slightly more complex version of the simple-yet-sexy buyback program.

To get a better understanding of the differences, let’s take a closer look at the fundamentals for each type. Low interest rates are helping fuel each, as companies can borrow money cheaply to either buy their stock or make an acquisition.

If management believes their stock is the best investment available, a buyback program is the logical choice. The company pays cash to acquire the shares on the open market and then retires the stock, reducing the effective float available to other traders. As the theory goes, reducing supply as demand for these shares remains relatively constant drives the price higher and creates value. Fewer shares also increases earnings per share.

At its most basic, M&A takes place when management discovers that another company presents better long-term value than a simple buyback could generate. The logic here tends to revolve around scale (bigger enterprise, bigger margins) and strategic capabilities. Will the combination open up previously untapped possibilities or bolt more business onto the company?

A share exchange eliminates the stock of the acquired company, but the overall supply of equity does not decline because the acquiring company often issues new shares to fund the deal. If anything, the premium built into the exchange generally inflates the value of the shares acquired and then retired, leaving a larger pool of diluted stock behind.

Legacy shareholders in the acquiring company may feel the bite until the deal starts feeding the bottom line and boosting results. Those who owned the acquired shares are usually the short-term winners thanks to the premium a motivated buyer is willing to pay as an incentive. As long as that incentive is tempting enough to satisfy the sellers, the deal provides a quick and relatively risk-free exit.

Cash transactions are even more interesting because the net impact on the market is share destruction (as in the buyback) but while the primary beneficiary is still the selling shareholder (who now no longer even has to sell a new lot of shares in order to book profits), the buying shareholders don’t face immediate dilution when the deal closes. It’s as though a new and extremely focused institutional investor has emerged with deep enough pockets to take a single stock off the market.

And while the cash deals are flowing, it’s good for equity investors on a level that’s deeper than corporate strategy and whether buying growth now is easier than building it. Remember that $1.3 trillion in deal flow so far this year? Balance it against what would otherwise be considered a blockbuster $67 billion year in the IPO market and it’s obvious that the net supply of equity is shrinking fast.

Fewer shares across the equity universe means more robust demand per share, which in turn supports prices. It’s more than just froth keeping the investor channels busy on Monday mornings. The more cash comes to the table, the more of a tailwind the stock market gets.

Corporate cash hoards are still in the $3.6 trillion range, so there’s still enough dry powder around to keep the wind blowing for at least another couple of years without forcing any would-be buyer to issue a single additional share of stock. Only $900 billion has been allocated to future buyback programs. The rest is available for companies willing to look outside their own treasury at the opportunities the market provides.

One other thing to note: simply knowing that corporate management finds it cheaper to buy than build should give you a little confidence in asset prices right now. Even counting the 30%-40% premiums that a lot of offers carry to sweeten the deal, these stocks look cheap enough to present a bargain to strategic buyers.

When premiums come in and M&A activity tapers off, it may be time to worry that valuations have stretched too far. But before that happens, I think we’ll see what is now a steady flow of multi-billion-dollar deals turn into a flood. There haven’t been many true blockbusters in this cycle. Once records start breaking, it will be time to get nervous about overheating.

Right now, regulatory issues seem to be a brighter red flag than valuations. Tougher talk about cross-border “inversion” M&A may keep tapping the brake on activity, but that’s not an issue of stocks being too expensive on a pre-tax basis. Management knows how much it would cost them to build their way to growth. They’ve already run the numbers. If they still think it’s cheaper to buy another company’s shares, the math works in our favor as investors as well.

Sizing Up the Deal

So what type of deals are we looking for? We want to buy into the kinds of companies that strategic investors want to own, so we will be in position to sell them our shares and collect that premium. That requires thinking like a strategic investor, which is a good thing because the overall mentality is very similar to our own approach in many ways.

A strategic investor wants hard assets and sustainable cash flow. The book value of the business (cash and other assets minus debt) creates a foundation for any acquisition and the operational cash flows demonstrate how quickly management is generating value on those assets. At a minimum, this underlying value adjusted for cash flow more or less tells us what the enterprise is worth on a bolt-on or fold-in basis.

Look for slim differences in valuations compared to competitors and companies that occupy similar roles in other industries. Is this company the cheapest in its ecological niche according to earnings, assets, capital efficiency? If so, it may be the first one to field merger offers when a bigger player gets hungry. Remember, corporate M&A consultants, private equity managers and investment bankers primarily draw on the same information we have. They are running the same screens we do before they draw up their list of targets.

Market fluctuations sometimes create chances to buy cash flow (P/E), hard assets or both at a relative discount. These stocks are obvious investment opportunities for traders as well as strategic investors, but I would not dig too deeply into vulture territory here.

While M&A is not forever, most deals are structured to pay out over a relatively long term – turning a failure around adds time, effort and cost to the calculations. Relatively few corporate executives want to buy a deeply troubled organization as anything more than spare parts, and if they buy scrap they’ll pay scrap prices for it. Even then, the odds are good that the seller will be at least as highly motivated as the buyer, so premiums will be low or even negative on a per-share basis.

The critical metric to watch on the terms we’ve covered so far is EV/EBITDA, which is short for “enterprise value” to “earnings before interest, taxes, depreciation and amortization.” This ratio represents the rate at which an enterprise is generating cash on its assets. A lower result indicates that cash is flowing relatively quickly through the company given its size, while a higher number reveals that even though the numbers may be large, efficiency is actually on the low side. The more efficient the enterprise, the better a bolt-on acquisition it will make at the right price.

What is that price? In many industries, deals between relatively mature companies have gravitated toward around 2X-4X annual revenue, scaling up toward the stratosphere for more growth-oriented or speculative ventures. Odds are good that if you are looking at publicly-traded companies outside the frothiest biotech and high-tech groups, the strike price will probably top out around 10X revenue.

Because profit margins vary widely even among companies in a similar space, converting that revenue-oriented target back to EV/EBITDA can be difficult, but ultimately the exercise can be very rewarding when estimating how high the premiums can sanely go. Once you have a sense of revenue multiples in a given industry, you know how much a motivated buyer would pay for the companies in your universe with the lowest (best) EV/EBITDA scores. Divide by current share count and you have a rough per-share offer target.

Once you know what a particular company might be worth as a bolt-on acquisition, you can set out to find the companies with the lowest EV/EBITDA scores at the lowest price you can get. A deal might come fast, slow or never, but if a potential buyer is out there, you can rest assured that your company will be on the acquisition screens.

Needless to say, a true strategic buyer will look for a good synergistic fit. This is where unique technological capabilities feed into the calculations: Does a potential target have a drug or computing patent that will fill a hole in the acquiring company’s pipeline, product line or platform? Can the companies address new markets in combination that would have eluded them separately?

While fascinating to consider, in many cases the motivations here are so idiosyncratic that they truly do rely more on visionary insight than hard math. Synergy is in the eye of the beholder. As such, these announcements will often come as a complete surprise and carry premiums that initially seem completely irrational to outsiders – sometimes you have to be in the right place at the right time to catch the lightning.

The one place you can look for synergistic M&A opportunities is in terms of companies with low management effectiveness scores like return on capital, return on equity and return on assets. Even a buyer looking primarily for added scale will scour an acquisition’s organization chart, consolidating support functions and otherwise reorienting the company in order to add value and make the deal accretive that much faster. This is one reason deals are priced in revenue, not earnings: the new owners will take every opportunity they can to improve margins.

Unusually low revenue per employee compared to competitors also signals a place where a buyer can quickly create “synergy” simply by shifting the acquisition to what is presumably a stronger corporate culture.

However, once again, if you are hunting companies where a more aggressive management team that can add value, you are not simply looking for a stock that’s likely to get taken out. You are looking for a job with Carl Icahn or another activist investor.

10 Names to Get You Started

Many of the stocks I recommend across my investing services have buyout potential. Let me be clear that I always look for other reasons to invest beyond the possibility that a company will be acquired. I’ve been pretty good at profiting from acquisitions through the years, but ideally you want to find a stock that is attractive in its own right and is a good candidate to be bought.

Several such stocks have earned us fast and huge exits. Names like InterMune (ITMN), ExactTarget (ET) and SHFL Entertainment (SHFL) gave us 32%-56% profits after they were taken out within five months of my recommendation.

Medical Action Industries (MDCI) is one of our biggest winners. MDCI was a relatively small vendor of custom procedure instrument kits for surgical and other medical environments. Owens & Minor (OMI) was the company’s major customer, accounting for 45% of sales. Once the relationship got deep enough, it became cheaper for OMI to simply buy MDCI and take that side of the supply chain inside.

The deal was signed for a relatively cheap 0.72X trailing sales or $13.80 per share in cash, which still created an enormous windfall for a company that previously traded at barely $7. We got in a month before the deal was announced at $6.49 for a net one-month return close to 108%.

I’m highlighting these past winners to give you the sense of what’s possible, and also to illustrate a key point: Only a handful of M&A trades may pay off in any particular time frame, but those that do will reward your time.

With that in mind, the more shots on goal you can take, the more likely you are to catch the lightning. Here are 10 stocks that strike me as catching the eye of strategic buyers hungry for buried value.

1. Akebia Therapeutics (AKBA)
A classic biotech takeout candidate, AKBA went public only last year. While the company is still basically a start-up with no earnings or revenue on the books, its lead drug candidate is at a relatively advanced stage in the clinical process and targets potentially huge kidney disease markets. Now that the first Phase II trial has begun, “Big Biotech” can finally take this technology a bit more seriously. Even if no outright acquisition emerges, AKBA could be entertaining partnership offers even as we speak, and those announcements can move stocks sharply as well. About half the enterprise value is cash, but the drug itself may be worth a good price to a buyer willing to let current operational burn go a few quarters before swooping in. If so, biotech valuations are so scattered that the offer could end up anywhere.

2. Eastman Kodak (KODK)
Sad to say, this is largely a “spare parts” scenario, but the sum of those parts could be huge for a buyer willing to finally put an end to one of the world’s great corporate legacies. KODK has $12.59 in cash and another $16.30 in receivables, inventory and other current assets. Although debt wipes out a lot of that value, the fact that the business still generates $2 billion a year in revenue and significant operating income creates an interesting opportunity. As the balance sheet clears up, this looks more and more like an eventual takeout – several private equity firms would be interested in the cash flow, while the imbalance between market cap and enterprise value could produce an initially staggering premium.

3. Old Second Bancorp (OSBC)
Based in Chicago, this small (27-branch) community bank is a classic bolt-on opportunity for any larger financial institution looking to buy relationships, locations and a good if not great balance sheet at book value. Well over $3 of OSBC’s current share price around $4.80 is cash, which zeroes out of any M&A negotiations, so even at 1X trailing sales a reasonable offer might be worth a 25% premium on the low end. Remember, M&A is about cash flow; a buyer bolting on deposits would simply apply its own operating margins to see how accretive the deal would be.

4. Entravision Communications (EVC)
A few of you may recognize this name from earlier discussions. At this price, EVC’s 58 Spanish-language TV stations and 49 radio stations represent a real prize for a broadcaster in any language eager to fill out a national footprint. Getting institutional shareholders to sell may require a little sweetening, but simply offering to take over a daunting $364 million in debt should be enough to get management to pay attention. The longer EVC continues to pay down that debt, the better it looks.

5. Alaska Communications (ALSK)
Telecom M&A has been huge, accounting for well over $200 billion in U.S. deal flow in 2014. Much of that action has been close to the mega-cap top of the market, but ALSK’s unique footprint may put it in play as smaller carriers look for lines to fold into their networks. With this stock so beat up last year, it wouldn’t cost too much to roll up the entire operation – and with management confident that they’ve turned the business around, now might be the time to move.

6. ITT Educational Services (ESI)
A casualty of the “for profit” education crash, this battered stock would make an extremely tempting target for a larger rival desperate for scale or even a private equity firm intrigued with the prospect of cutting the operation back to profitability. At 1X revenue minus $280 million in assumed debt, this could easily be a $30 company in better times, nearly three times where it is currently trading. In the near term, anyone with $500 million to spare could take it off the market.

7. Renewable Energy Group (REGI)
When the biodiesel industry comes back around, REGI will still be sitting on close to $16 in assets per share – assuming of course that it hasn’t accepted a merger offer by then to conserve its strength. Annual revenue is still in the $1.4 billion range, so given the current market cap a full 70% below that level, management may feel justified in asking for a significant premium in exchange for making a deal happen.

8. Atlas Air Worldwide (AAWW)
Charter passenger and especially freight services will always be in demand for any logistics giant looking to grow a little faster than what the organic trend allows. Cargo rates are up again, and while a new management team may be unwilling to consider selling themselves to a rival in their first month on the job, they may get an offer they can’t refuse. A 100% premium would probably do the trick, while giving a would-be buyer roughly $1.3 billion in assets at par as well as an effective P/E of 18X forward earnings.

9. Voya Financial (VOYA)
On the big side of the banking world, this company was formerly Dutch giant ING’s U.S. unit before spinning out early last year. Now independent and struggling to divorce itself from its former parent’s highly successful branding, this company may end up presenting another global institution with a $10 billion toehold in North America. Debt inherited in the spinout could be an issue; the bidding here would need to start at $15 billion, but with a stunning $58 per share in assets on the books, a merger might still be cheaper than building a presence from the ground up.

10. Kelly Services (KELYA)
Let’s wrap up the list with one last classic private equity play. KELYA is one of the biggest independent staffing firms based in North America with a fairly narrow float – 19% insiders, 72% institutions – and a significant discount to book value. Liberating the assets at par would translate into nearly a 40% premium on the current share price. Although margins are necessarily slim, offering as little as 0.20X revenue would leave shareholders ecstatic.

There you have it – an in-depth look at what goes into an M&A deal, what we as investors pay attention to, and 10 of the stocks currently on my radar for a potential buyout. I hope you’ve found this report helpful as you navigate what is an exciting aspect to the market right now! As we get closer to the Federal Reserve starting to actually raise interest rates this year, we may see even more activity if companies race to get deals done as cheaply as possible. I’ll keep you posted in the various investing services, and I expect we’ll have some M&A driven winners as well.

Sincerely,

Hilary Kramer
Editor, GameChangers