Putting Takeouts to the Test

 | Jul 27, 2012 | 3:00 PM EDT
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I'm going to wrap up my series on potential takeover candidates with my favorite metric. While I never buy a stock based purely on takeover speculation, it never hurts to add this calculation into my stock-picking efforts.

Over the years, roughly a third of my stock picks have become takeover targets within a five-year period. This metric is based on conversations with folks engaged in private equity and leveraged buyout activity and who were generous enough to share their valuation concepts with me. The premise is simple: They want to buy companies with decent returns at a low multiple of earnings before interest, taxes, depreciation and amortization. They are looking for companies where the return on equity is already respectable and strong cash generation adds the possibility of additional leverage.

I ran a screen this morning looking for companies with decent return on equity that trade at less than five times the enterprise value to EBITDA ratio. Enterprise value is a better tool than market value because it takes into consideration the entire capitalization of the company, including outstanding debt. Using EBITDA gives some idea of how much cash the business can generate, regardless of capital structure or chosen financing methods. It is the preferred measurement of most of my PE and LBO friends.

What really stands out when I run the screen are the tech giants. By this measurement, companies such as Cisco (CSCO), Hewlett-Packard (HPQ) and Dell (DELL) would be attractive takeout candidates. The truth is they are too large for anyone to buy them. It would require a premium to the already very high enterprise value that shrinks the pool of potential acquirers to pretty much zero. When valuing companies as potential takeover candidates, it helps to ask yourself who would buy it and how would they pay for it.

As I expected, energy is well represented on the list. Devon Energy (DVN) is the largest, with a total enterprise value of more than $27 billion. It would take one of the major oil and gas giants to buy it but Devon is very attractively priced from a private equity perspective. The ERV/EBITDA ratio is just 3.8 and the return on equity is a comfortable 10.8 -- the lowest ROE Devon has had in the past decade, with the exception of the recessionary years of 2008 and 2009 when the company posted losses. It would be a tough deal to finance right now and there would certainly be antitrust issues, but Devon is a collection of attractive assets at an interesting valuation.

Other onshore-specific energy companies make the list as well. Clayton Williams Energy (CWEI) operates primarily in Texas, Louisiana and New Mexico. It also owns 102 miles of pipeline and three natural gas treating facilities. The stock trades at an EV/EBITDA ratio of just 3.2 and has very high ROE. It has a god deal of debt but $300 million of operating cash flow and EBITDA of $344 million leave room to rework the balance sheet.

Patterson-UTI Energy (PTEN) provides onshore drilling services and is attractively priced for potential acquirers. The stock trades at an EV/EBITDA ratio of less than 3 and has an ROE of 14. Buying energy assets on a financial or strategic basis while asset valuations are low should pay huge dividends when demand begins to increase again and pricing firms. If I were running a private equity firm right now, much of my attention would be focused on onshore drillers and service companies.

 There has been a lot of discussion about the potential for a takeover wave in the second half of 2012. I am skeptical because I believe regulatory and financial uncertainty will keep many companies from acting. As we have seen this week, outside of energy, there are not a lot of companies priced on attractive terms for potential buyers. Looking at takeovers is instructive, however. Takeover value is one of the four valuations I perform on every stock I investigate and is an important tool in the value investor's toolbox.

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