Scanning for More Takeover Targets

 | Jul 26, 2012 | 4:00 PM EDT
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On Wednesday, we looked at companies that could be potential takeover candidates because of low debt levels and high free cash flow relative to market capitalization. This type of company makes sense for financial buyers.

A private-equity firm or LBO firm has room on its balance sheet to add debt, and the target company's operations are producing enough cash to service the debt. Much of the return for financial buyers in the past few years has come in the form of takeout dividends and strong free cash flow, and low debt means the target can be levered substantially and cash taken out for the partners.

The other type of buyer is strategic. A strategic buyer is a company in the same or similar industry that is looking to add earnings and revenue growth by acquiring other companies. In a slow-growth economy, acquisition is the best way to add to your product and service offerings and grow the company. If you do not overpay for the target company, growth-by-deal is cheaper to achieve than organic growth in many cases.

Today I want to take a look at some companies that might make sense for strategic buyers in today's market by screening for growing companies that are reasonably priced.

I ran a simple screen and came up with a few interesting ideas. One company has been the subject of takeover rumors at several points during my career, and I expect it will be again soon. Weakness in the iron ore and coal markets has weighed on the share price of Cliffs Natural Resources (CLF) all year. Although earnings have fallen this year as the economy slowed down again, over the past five years earnings have grown by about 35% a year, and revenue has risen by 28% annually. A good deal of that has been the result of merger activity as the company acquired ore and coal mines, but it also benefited from growth in the Asia Pacific markets.

Cliffs is very dependent of the level of economic activity, but if the world does not end, the shares are worth a lot more than the current quote to a strategic buyer. Cliffs currently trades at just 5x earnings and less than 7x free cash flow. As a bonus, the stock yields over 6% at today's price. If the stock falls to a discount to tangible book value, it will be an outright buy, even aside from takeover speculation.

Quanex Building Products (NX) has also been hurt by weakness in its major market. This company makes windows, doors, wood flooring and molding and offers aluminum sheet products. We all know what has happened in the building industry. The stock has recovered from the bottom of 2009 and has actually held up nicely. In spite of industry weakness, the company has been growing nicely the past five years. Sales and earnings have both grown about 19% annually. Analysts expect earnings to decline in the second half of the year, and that could create an opportunity for a strategic buyer to acquire the company on the cheap.

Quanex dominates its marketplace, controlling about 70% of the market. All of the major window companies, such as Anderson and Pella, buy from Quanex. A patient building-products company could see enormous growth by buying the company while business is weak. Insiders own fewer than 5% of the shares, so they could not block an attractive offer.

There are some stocks on the list that I believe may eventually be taken over, but it is far too soon to bet on them. Many of the education stocks are on the list, but until the business model is fixed, it makes no sense to combine two companies in an uncertain industry. GameStop (GME) is cheap enough on the numbers, but I am not sure who would benefit from buying it. When looking at potential takeover candidates, a useful question to ask is, who would buy it and why? A lot of the companies on my list do not pass this basic test.

The next takeover wave may be slower to develop than some might think. But this is a good time to start thinking about potential candidates and look for opportunities to buy them at bargain levels.

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