Friday, August 20, 2010

Takeover Temptations

An object in possession seldom retains the same charm that it had in pursuit.
Pliny the Younger, Letters


Pliny might have had some insight into why as many as 80% of business acquisitions turn sour. Despite the rather dismal track record, it appears U.S. companies are positioning for a great buyout spree. Reportedly over $3 billion in excess cash is sitting in corporate bank accounts. Having chosen not to grow by developing new products and adding new personnel, companies must acquire to build revenue and earnings.

Look at the deal between Intel, Inc. (INTC: Nasdaq) and McAfee, Inc. (MFE: NYSE). The chip maker agreed to pay $7.7 billion for the computer security firm ostensibly as part of its strategy to penetrate the building market for personal computers that rely on web-based software applications. Intel offered a 60% premium to the prevailing market price for MFE shares before the deal was announced.

What could the Intel people be seeing in McAfee that would lead to what many are already calling a foolish move?

We thought it might be instructive to look at what makes an attractive takeover target. The criteria could be just as valid for selecting stocks in a buy and hold strategy.

First, find a company with a niche product or service. Alternatively one with great brand strength is a good candidate. Check that for McAfee.

Second, look for compatibility in the distribution channels and geographic proximity or compatibility. Check this item as well, since Intel and McAfee products both end up on personal computers around the world. Indeed, the two companies may have considerable strategic fit in the cloud computing world.

Number three, look for potential for profit margin expansion through economies of scale or operating leverage. No doubt the combination will afford some operating expense savings. However, that is not enough. Intel needs to use the McAfee knowledge base to build its line of chips for net computing with chip-based security solutions.

Number four, look for a clean capital structure with no preferred stock and no convertible bonds. If there is debt, the ability to refinance that debt at lower rates would be a plus. The appearance of inadequate capital to invest for future growth or to meet the challenges of new competition is also a cue to potentially motivated management. In this case, it is really Intel that may have problems in securing future growth. McAfee has no debt and has $788 million in its own cash kitty. Perhaps this relative positioning is why Intel is “paying up” for McAfee.

Five on our list relates to the management team. Successful integration of an acquired operation is sometimes facilitated by management staying on board. McAfee’s current CEO, David DeWalt, has been with the company for three years and has been relatively successful in steadying McAfee after a series of accounting problems and management changes in the past.

Number six but not necessarily sixth in importance is a clean operating history and profitability. McAfee earned a 8.4% net profit margin on $2.0 billion in sales in the trailing twelve months ending June 2010. McAfee has not reported a loss since 2000.

The last takeover criteria is under-valuation in the public markets. McAfee had been trading near 30.0 times trailing earnings ($1.06) and 11.7 times the consensus estimate for 2010 ($2.57 according to Thomson-Reuters). Intel’s offer represents a multiple near 19.0 times the consensus estimate. The question is whether Intel can extract more than 20% growth out of the deal - the threshold growth rate that would justify the valuation.

Most corporate buyers will consider the ratio of enterprise value to EBITDA (earnings before interest, taxes, depreciation and amortization). McAfee EBITDA was $430.2 million for the twelve months ending June 2010, representing a 16.1 ratio of Enterprise Value to EBITDA for Intel’s offer. The ratio was approximately 8.8 at the price level MFE shares had been trading before the Intel deal was announced.

Let’s hope McAfee is able to retain its charm after the deal is closed. Otherwise Intel is like to rue giving in to this takeover temptation.


Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.
$INTC $MFE

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