Tuesday, November 03, 2009

Takeover Temptations

The 2008 credit crisis and the ensuing economic recession have put nearly every company to the test. Even if there is still disagreement on whether a full economic recovery is underway, there is one thing third quarter earnings results have demonstrated with clarity. Public companies are awash in cash.

Financial officers and purchasing managers appear to have gone into a hyper- conservative state - slashing operating budgets and holding back on capital spending. A year ago, when it appeared business would never see credit again, such drastic action made sense. Today, as we work toward normalcy, business looks under invested.

Consequently, there may be a unique convergence of circumstances upon us that could trigger one of the busiest mergers and acquisition periods in U.S. history. First consider the situation most conducive to mergers in an economic period. Highly fragmented industries populated by both large and small players, the latter which often hold the most innovative product lines.

Then look at where capital is aggregated. New found discipline by hedge fund managers coupled with tightened credit means private equity buyouts are - well out of fashion. This leaves room for strategic investors. Guess what? Many more than usual have the cash and the motivation to make deals. Furthermore, many smaller companies are more open than ever to deal talk as capital for expansion is harder to come by in the current environment.

Takeovers often entail premiums to the prevailing market price of the stock. Is it possible for the minority investor to profit from the current M&M environment?

It makes sense to look for the same attributes an acquirer. Look for companies with viable product lines and the potential for large scale growth. Alternatively a solid distribution channel that is underutilized is also a strong strategic play. A clean capital structure with no convertible bonds and only one class of common stock presents fewest obstacles to closing a deal. A clean operating history with only the most ordinary litigation is best. Look also at the potential for margin expansion either through elimination of duplicative functions or higher utilization of assets after the deal.

What if no offer comes along or a deal falls through? Make certain your “takeover” criteria includes improving fundamentals and under valued assets. If no deal comes along there is at least one other driver of value in the stock.

In the next post we apply a set of selection criteria to this approach and come up with a list of 200 public companies that we think are more likely than no to get a phone call (or an e-mail).

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