Free lunch? 4 cash flow takeover targets

With high free cash flow yields, these stocks would be an attractive fit for an acquirer.

By TheStockAdvisors Sep 4, 2012 10:32AM

Jose Luis Pelaez Inc Blend Images Getty ImagesBy  Stephen Leeb, The Complete Investor

 

If fears about the economy recede somewhat, the market is likely to see a spurt of takeovers. Companies with high free cash flow yield will be the ones to benefit in a big way. IBM, for example, has a free cash flow yield above 7% and recently borrowed money for 10 years at around 2% interest.

 

This means that IBM can acquire other companies that are similarly blessed with high free cash flow yields and essentially get additional growth and profits for free. Wow! And many other companies are in comparably happy positions. In other words, sometimes there really is a free lunch.

 

So why haven't we seen a massive flurry of acquisitions? The only reason is the prevailing economic uncertainty. The one hidden assumption in our analysis is that free cash flow won't decline.

 

And given the looming fiscal cliff, ongoing problems with Europe, and continuing uncertainty over oil prices, you can't blame companies for hesitating about taking on debt that would have to be paid back.

 

Our analysis suggests, however, that if such worries recede, the market could explode on the upside. And even small gains in confidence could propel a stream of takeovers.

 

The likeliest initial takeover candidates are companies that have high free cash flow yields and that sailed relatively easily through the past five very turbulent years, their free cash flow growing or at least holding steady.

 

Here's a look at four such cash paragons -- picked literally out of hundreds -- that were selected because they could be great fits with many other companies.

 

BMC Software (BMC) is already pushed by a major hedge fund to put itself up for sale. Even if a sale or merger doesn't happen, though, BMC has the fundamentals and growth characteristics to be a strong performer regardless.

 

The company is a leader in mainframe management software, which thanks to the ever growing need for storage is a rapidly growing software area.

 

A pickup in the enterprise management division, which we think likely, would keep growth in all metrics, including free cash flow, above 15%.

 

BMC's upside potential far exceeds the risks, and indeed any sign of slackening growth would likely prompt intense pressure for the company to seek an acquirer.

 

St. Jude Medical (STJ), a medical device company specializing in cardiac products, is poised for accelerating growth (it already is growing faster than its competitors).

 

Not only does it have a pipeline full of new products, its multiple should expand as fears about an existing product ease. (A wiring problem in one of its devices had led investors to sell the stock in June, but all evidence suggests the failure was a one-off event.)

 

The company's leading new product aims to protect patients with heart anomalies from suffering strokes: it could propel growth into double digits. By next year St. Jude's free cash flow yield should exceed 10%.

 

The stock is sharply undervalued by every metric and presents a very tempting takeover candidate for larger more slowly growing companies in the same field.

 

Without a buyout we expect the shares will continue to return cash to shareholders through share repurchases and rising dividends.

 

NVIDIA (NVDA) is a leading producer of graphic and video semiconductors for computers and related products.

 

A licensing arrangement with Intel generates a lot of free cash flow and also points to Intel as a possible suitor. Without the licensing agreement NVDA is still one of the most innovative graphics players in the world.

 

Its balance sheet is exceptional, with only nominal long-term debt. NVDIA may be the most speculative of our picks in that future growth will depend largely on its gaining a stake in the rapidly growing tablet and phone markets.

 

Without notable success in these areas, growth will hang on the stodgier PC market. Still downside is well protected by a book value that will approach double digits in the next year or so and by continuing high free cash flow.

 

Food processors, which are among the most defensive stocks, have been bid to high levels in this uncertain economy. For most of them free cash flow yields are too low to suggest a strong takeover possibility.

 

JM Smucker (SJM), well known for its jams but also the maker of such deeply entrenched brands as Folger's and Pillsbury, is an exception.

 

The better than 5% free cash flow yield is complemented by five- year and 10-year growth rates of about 10% in virtually all metrics.

 

The roadblock to a takeover is that management belongs to the Smucker family. However, Smucker would be a gem for larger food producers.

 

Even without a takeover the company should generate ample total returns. The dividend has risen for at least 15 consecutive years.

 

With a current dividend yield of 2.5% this is one of the surest bets to provide inflation-beating income for many years to come. Capital appreciation consistent with long-term growth points to a stock likely to satisfy investors of all ages and goals.

 

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