With merger & acquisition activity intensifying and remaining strong this year, the situation may arise where a company you invest in may be involved in a takeover deal. There are several issues that shareholders should consider, to get the best value from M&A activity and offers. Investing in potential takeover targets can also be very profitable. There are a few items to consider when attempting to find and invest in stocks that could be potential takeover targets. In most cases, the following considerations can apply to both public and private companies. They are not an exhaustive list, but cover a variety of issues that one should consider.
Considerations if you are looking to invest in potential takeover targets:
• Some management teams openly announce that they are looking for a buyer. Consider if those companies good investments to begin with, or if there are underlying concerns which may explain why management wishes to sell the company. If it is not a good investment to begin with, other companies may also see the same issues, and it may not be worth your investment dollars. Some management teams feel their companies are extremely undervalued, and large shareholders may want to see the true value reflected in the stock’s price. A buyout will sometimes increase the market price of an undervalued company, bringing it closer to its fair value, especially when a premium over the market price is offered.
• Are the larger players in the industry looking to grow from takeovers more so than organic growth? If so, how many smaller players are there? If there are too many, there will be a lot of choice for the larger companies. With a large number of choices, finding a company that has a high likelihood of being acquired will be more difficult. Consider looking for companies with higher quality assets, profitability, and growth prospects (a business worth taking over!). Avoid investing into companies just because they may be trading below their intrinsic values, or (even worse) just because their stock price may be small (for example a $0.50 stock). A market price that is below intrinsic value, and a small market price are two different things. It is also important to note, that not all takeover targets are small cap companies (as can be seen from the price of many of the takeovers listed above). However, small caps often have favorable takeover qualities (growth prospects, lower price, smaller size, easier to assimilate, etc).
• How do you know if any of the large companies are interested in looking for acquisitions? One of the easiest ways to find out is to look in quarterly reports, at the management discussion & analysis section. A company’s various strategies going forward are usually discussed in that section. In addition, the quarterly conference calls are invaluable sources of information. They discuss many issues in depth, especially items such as strategy (something that cannot be easily foretold with numbers on the financial statements alone). Many financial websites (Morningstar, etc) and a company’s own website, often have transcripts that you can read. To save time, you can perform a text search for keywords such as “merge”, “buyout”, “acquisition”, “acquire”, etc. They may sometimes indicate the type of company, size (market cap or size of operations), business, operations, assets, etc. that they may be looking to acquire.
• By looking at the qualities acquiring companies might be targeting, you can find and invest in businesses with those qualities. Although, I prefer investing in a extremely attractive small cap company because they are good investments themselves, not because they could be potential takeovers. In my experience, really great small cap companies have become attractive investments, not just for me, but for larger companies as well. I also prefer investing in companies, not for the sake of investing in potential takeover targets, but because I believe better value can be unlocked from the company’s own growth. An acquiring company may not pay the shareholders, the true intrinsic value of the business (usually only a small premium above current market price).
Considerations if the company you have invested in is acquiring another business:
• Does the take over make sense? Does the acquisition help with growth, or strengthen core capabilities? If not you may need to vote against the deal, if it is taken to the shareholders for approval. Is the company being acquired a good fit with the organization (corporate culture, values, etc).
• Does the purchase represent the best interests of shareholders? We can find examples of takeovers that put the CEO in the spotlight (fame, status, etc) for completing large takeovers, but such deals may not always be beneficial.
• Is the offer price fair or too high? Is management paying more than the intrinsic value to acquire the business? Many companies have low stock holdings by executives. In such cases, the management team is essentially using your money, and not their own to make the purchase. On many occasions, companies end up over paying for a business, especially when its not their money. In companies where the CEO may be a major shareholder, their decisions are likely in the best interests of both the company and the shareholder.
• How will the company fund acquisition? In some transactions, companies need to issue new shares (shareholder dilution). In other transactions, new bonds (increase debt obligations), or borrow money (new debt, or draw on lines of credit). If the company is funding the purchase with debt, capital strength is somewhat diminished. In such cases the deal had better create significant net benefits (growth, market strength, core capabilities, etc). and worth reducing financial strength. Some transactions are also funded via stock swaps/exchanges. Is the ratio of the exchange fair?
Considerations if the company you have invested in is the subject of a takeover:
• Is the offering price fair or too low? This question should often be considered along with the deal’s net benefit to the company. If the price offered is below the intrinsic value, consider if the deal creates new growth prospects & opportunities (that would otherwise be difficult to reach on its own). A price below the intrinsic value may be acceptable, if it creates new growth prospects (increases the intrinsic value of the business after being merged). This question also becomes more complicated, if a share swap or exchange is involved instead of cash, as it involves considering the intrinsic value of the new merged company with the new synergies or cost savings. The ratio of the exchange would also be important in calculating the net return to the investor..
• If shares of the acquiring company are being offered in exchange for the business, do you want to keep it or immediately sell it? The acquiring company may be a business or include businesses that you don’t necessarily want to own. Reasons may include different core operations, corporate culture, strategy, vision, etc. The purchasing company may be experiencing poor profitability, or low overall growth prospects (may offset growth of company being acquired). This would ultimately dilute profitability to the original shareholders of the company being acquired. For example, a biotech company that is being taken over by a larger diversified healthcare company, and is offered shares of the acquiring corporation. The profit at the merged company attributed to the original biotech unit may be eaten up (offset) by expenses or costs from other areas of the company as financial results are merged. In such a case, the shareholders would have benefited more directly from its profit if it were a stand alone company that continued to grow on its own. Its important that investors consider if the original business unit is capable of growing to such a level on its own without the merger. This may be a reason to reject takeover deals. Perhaps a merger with a different company would be more beneficial? However, if a takeover occurs where share are exchanged, keeping the merged shares may not give the same returns to the investor. One should consider whether its more profitable to sell the merged stock to find another investment, or to keep it (better growth prospects, etc, than original unit) due to higher returns.
• Does the take over make sense? Is there a net benefit to being acquired? Or is it just beneficial to the purchasing company? Many times a larger company with low growth prospects, declining profitability, and poor long term outlook may attempt desperately to acquire a smaller business in hopes to revive the company and improve growth, profitability, etc. However, this can be detrimental to the growth, profitability, and even survival of the original unit. During the technology bust, many profitable startups, with good growth prospects were acquired by larger companies. The original unit’s profit would be uploaded (transferred back) to the merged parent company. There were many instances where the smaller startup was eventually destroyed when the larger company that acquired them went bankrupt. The startup’s original products, patents, innovation, and intellectual property would be sold off (in bankruptcy court) and eventually lost to the original shareholders. Shareholder value was ultimately destroyed. However, there are many cases where smaller companies benefit greatly from the acquiring company (access to markets, customer base, financial support, expanded intellectual property access, etc).
• Does the purchase represent the best interests of shareholders or just the management team? We can often find examples of takeovers that reward the management team with large payouts or bonuses. This can be (but not necessarily) an indication that the purchase may not be in the best interests of current shareholders, and may actually be in the best interests of the acquiring shareholders. Is the management team of the acquiring company trustworthy? Do they have strong leadership & vision?
Thanks & Happy Investing! — The Investment Blogger © 2011