8/2/2011 12:17 PM ET|
5 big names ripe for takeover
Despite a hard economy, it looks as if the market’s corporate raiders are getting back to work. Here’s why names like Whirlpool, SkyWest and Aetna could be takeover targets -- and how to profit if they are.
You don't need a rip-roaring economy to bring out the market's raiders and barbarians.
Wall Street's takeover artists typically thrive during booming economies and bull markets -- perhaps most famously during the late 1980s, when they knocked at the gates of high-profile companies like RJR Nabisco in notorious takeover battles.
But despite anemic economic growth, conditions right now could be leading us into another wave of leveraged buyouts, the experts say.
These buyouts specialists have tons of cash on hand, and money is cheap now anyway. And many solid public companies are suffering with weak profits and fallen stock prices.
In fact, any number of household names could have targets on their backs -- including, according to a recent Deutsche Bank report, Whirlpool (WHR, news), SkyWest (SKYW, news), Xerox (XRX, news), Tyson Foods (TSN, news) and Aetna (AET, news).
"We think conditions are very supportive of an up-cycle in LBOs," says Binky Chadha, co-author of that report, "On the Cusp of Another LBO Upcycle."
In fact, a new round of takeover fever may have already begun. Worldwide, takeovers by private equity shops averaged 725 per quarter in 2009. This rose to 942 per quarter last year and hit a pace of 1,024 per quarter during the first half of this year, according to Thomson Reuters.
How to profit from takeovers
The big money in LBOs, of course, is made by the artists who buy businesses and then take them private, using large amounts of leverage, or debt -- often borrowed against the assets of the target company.
In private hands, companies can get a makeover as managers implement strategic plans that gradually improve business, often slashing costs, cutting jobs and selling assets in the process. "They're not caught in the quarterly earnings treadmill," says Andrew Corn, the chief investment officer of E5A Funds. "That allows managers to cut costs, figure out where companies are profitable and start to drive revenue again."
When they're done, raiders typically spin out the company to the public again, collecting hefty profits and fees -- usually 20% of any upside. "Everyone makes a ton of money when they sell the company or go public again. That's where the big payday is," says Corn.
On example: Blackstone Group (BX, news) recently took Kosmos Energy (KOS, news) public in an initial public offering at a value that was six times what it originally paid for the company, says Blackstone.
But average investors can make money here as well if they can spot targets early on -- before news of a takeover try surfaces. Such news can juice stocks nicely.
Shares of Clorox (CLX, news), for example, moved to $75 in July from lows of $67 that month, on news that shareholder activist Carl Icahn was offering $80 a share, a bid the Clorox board rejected. By the way, I've noticed that Icahn has also built big positions in Hain Celestial (HAIN, news) and Oshkosh (OSK, news), suggesting something's going on at those two as well.
And shares of 99 Cents Only Stores (NDN, news) moved up sharply to almost $20 from below $17 in March when the discount chain announced it had received a buyout offer from its founding family and an investment firm to take the company private. Late last year, shares of J. Crew and Jo-Ann Stores also jumped nicely on news they were being bought out.
The big money in LBOs
There are several reasons to believe the time is right for more takeover activity:
- Private equity funds have "extraordinary amounts of dry powder," says Deutsche Bank. They have $500 billion in unused capital, which works out to $1.5 trillion in purchasing power when you add in the potential leverage on those funds. "Private equity funds are loaded with cash, and they don't get paid to sit on cash," says Timothy Ghriskey, the chief investment officer at Solaris Group, which manages $2 billion. "We invest in private equity for clients, and we don't want funds sitting on cash because it makes us wonder, 'What are we paying them for?'"
- Money is cheap. Interest rates and yields on corporate debt are extremely low. This means takeover artists can readily borrow more to leverage deals.
- Many stocks are also cheap, despite strong underlying fundamentals like solid free cash flow and relatively good earnings growth. This makes them attractive targets -- especially when they have some fixable defect like below-average profit margins, and a brand name with continuing value.
But the hard part is finding the actual targets before the rest of the market catches on.
So the analysts at Deutsche Bank I mentioned figured out a way to hunt for specific targets. They analyzed 500 buyouts since 1986 to identify the key attributes of LBO targets.
Here's what they had in common: lots of free cash flow to support additional debt; below-average profit margins, which suggests plenty of room for cost cutting; and relatively cheap stocks, based on historic levels of stock prices compared with earnings for the company and its group. LBO targets also had below-average growth in corporate assets. (This sounds technical but simply suggests that it won't take a lot of capital to turn them around.)
Deutsche then screened the markets for companies with similar attributes to produce a short list of potential takeover targets. Here's a look at why five of the most prominent names made the list:
This iconic maker of home appliances looks cheap -- trading at just seven times expected earnings and 1.2 times book value, the value of its tangible assets. The company's brand could be valuable to a buyer as well. "It's a quality name it, just needs to be utilized better," says Ghriskey. Meanwhile, the company produces a nice $674 million in operating cash flow, and it pays a 2.9% dividend yield -- payouts that could be cut to support borrowing to finance a takeover.
At about $12.60 a share, regional carrier SkyWest trades at a price-to-earnings ratio of 10.2, well below its historic average of 11.5. It also has a price-to-book ratio of 0 .5, or less than a third of other regional airlines like Alaska Air (ALK, news). Its operating-profit margins of 5.6% are also well below those at Alaska Air. All of this suggests room for improvement at SkyWest in an LBO. SkyWest does have $1.8 billion in debt, which makes it less desirable as an LBO candidate. But that's offset in part by $684 million in cash and $280 million in annual operating cash flow. SkyWest cited high labor costs when it guided down on earnings last month. But unlike many other airlines, its labor force is nonunion -- suggesting room to maneuver here.
Despite its powerful brand, Xerox shares have lagged the markets significantly over the past five years. Its price-to-earnings ratio of 13, on the previous 12 months' earnings, is well below its historic five-year average of 20, according to Morningstar data. Xerox has been carrying out a restructuring. But net profit margins of 4.2% on a trailing 12-month basis, compared with 6% to 7.4% during 2005-2007, suggest a lot more can be done -- maybe after an LBO. The company produces $2 billion a year in operating cash flow, has $1 billion in cash and pays a 1.8% dividend, which could be cut to support a transaction. All of this makes the company look like a good potential target. "The brand is valuable and underused," says Ghriskey.
Tyson Foods is the world's largest meat company. It has 22% of the U.S. markets for beef and chicken. But even this huge market share cannot shield earnings from the volatility in the costs of the grain it needs to raise animals. This makes earnings tough to predict, and they shift around a lot, which turns off investors. That's one reason Tyson trades for a price-to-earnings multiple of 8.7, compared with around 13 for the S&P 500, despite the company's powerful brand and leading market position. Tyson is taking steps to boost profits, like renegotiating debt and reducing costs. But the stock's multiple suggests the company still doesn't get the respect it deserves. That, plus solid annual cash flow of $1.2 billion and a cash treasure trove of $794 million to help support an LBO, make it a potential target.
Aetna is the third-largest health insurer in the U.S. So it has the kind of size that gives it an edge over smaller rivals. But the numbers show it's not really doing that well, for the big leagues. Aetna carries a price-to-earnings ratio of 8.6, compared with an industry average of 12.1, according to Morningstar. That's also well below the company's five-year average of 11.9. Sure, health insurers are being held back by uncertainties about Obamacare. But Aetna's operating margins of 8.3% for the past year are well below the 10.1% to 11.9% it posted during 2004-2007 -- suggesting room for improvement in private hands. Its big operating cash flow -- $1.41 billion last year -- would help support an LBO.
Another play: the artists
At about $9.40 a share recently, KKR Financial was trading at book value, and paying a 6.8% dividend yield. Besides buyouts, the private equity shop invests in high-yield corporate debt and lots of energy plays, among other things. Insiders have been buying this year, around current levels.
Apollo Global Management looks even better, because at below $17 a share it's cheaper now than it was when it came up as a buy in April, at $18.20, in the stock selection systems I use for my newsletter.
Apollo Global Management is a value-oriented private equity and hedge fund with a contrarian bent and an excellent record. It favors distressed assets, which can pay off big for investors who have the patience to wait. The company has generated average annual returns of 26% since its inception in 1990. Managing partners Leon Black, Joshua Harris and Marc Rowan have worked together for more than 20 years, so if you buy shares now, you are still getting the same management that produced those excellent results.
Employees have put about $1 billion of their own money into Apollo funds, and insiders put $20 million into the stock when it went public in an IPO earlier this year -- one of the main reasons I like this stock. If you can't orchestrate LBOs or spot the raiders at work, investing with their cousins isn't a bad way to go.
At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column.
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
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How much longer are we willing to put up with it, people? Can we change the status quo -- or is it too late?
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