Three Simple Steps to Predicting Takeover Targets

by Louis Basenese Wisdom of Wealth Wisdom of Wealth

Three Simple Steps to Predicting Takeover Targets

by Louis Basenese, Chief Investment Strategist, Wall Street Daily

Friday, June 3, 2011: Issue #1527

Global merger and acquisitions activity volume just surpassed the $1-trillion mark.

Not only that, but the market also hit that milestone six weeks earlier than it did last year.

Why should we care?

I'll let National Semiconductor Corp. (NYSE: NSM) do the talking for me.

On April 4, Texas Instruments (NYSE: TXN) announced it was buying National Semiconductor for $25 a share - a 75 percent premium to the share price at the time. And look what happened...

National Semi Share Price Skyrockets After News of Takeover

Since nobody invests for sport. The reason to care about an uptick in mergers and acquisitions activity is easy: greed.

We're in the market to make money - pure and simple - and nothing jolts a stock higher than an unsolicited takeover offer.

So far this year, the average takeover premium paid checks in at a solid 23 percent. But it's not uncommon for individual premiums to check in at 50, 60, or even 75 percent, like with National Semiconductor.

And I'm sure you wouldn't argue with single-day returns like that...

A Three-Pronged Approach to Identifying Takeovers Targets

The tricky part, of course, is knowing how to identify takeover targets before a deal is announced.

Tricky... but not impossible. And we can dramatically improve our odds of success by following three simple steps for predicting takeovers...

  • Consolidation is Your Friend

Consolidation trends are a powerful predictive tool because they tend to persist.

Think about it. When your biggest competitor buys a fellow firm and doubles in size overnight, there's only one way to respond: Find a suitable acquisition of your own to remain competitive. Thus, by focusing on those industries and sectors undergoing the most rapid consolidation, we can isolate high probability targets.

  • Focus on Companies With Valuable (and Undervalued) Assets

Whether it's a new drug, a mammoth oil discovery, key market share, distribution channels, or a few promising patents, the real reason a company is acquired is because it owns a particular asset of value to the acquirer. So it stands to reason that we should only invest in companies with such "must-have" assets.

  • Insist on Improving Fundamentals

Takeovers take time. In fact, a buyer might spend as much as nine months conducting due diligence on a takeover target. Even then, there's nothing stopping them from walking away from a deal (Microsoft and Yahoo! ring a bell?).

As a result, I recommend buying an "insurance policy" that'll protect against such unprofitable breakups. By that, I mean that you should only buy companies with improving fundamentals - whether it's strong earnings growth, new product launches, increasing market share and so on. That way, you'll be in good shape, even if a takeover never materializes.

So, let's take a look at a company sitting in the takeover crosshairs...

AboveNet: A Perfect Internet Infrastructure Takeover Candidate

With web traffic expected to triple, internet infrastructure continues to be a critical area for businesses and consumers alike.

And a takeover candidate in this space could be AboveNet, Inc. (Nasdaq: ABVT). It fits perfectly into the three-step screen I mentioned above...

  • Consolidation: The internet infrastructure industry is narrowing. Last month, Level 3 Communications (Nasdaq: LVLT) scooped up one of AboveNet's competitors, Global Crossing Ltd. (Nasdaq: GLBC) for a 57 percent premium.
  • Assets: AboveNet possesses "must-have" assets - fiber-optic networks in more than a dozen American cities. And given the expected rise in traffic, the need to increase bandwidth and provide faster connection speeds is urgent.
  • Fundamentals: Since AboveNet emerged from bankruptcy in 2003, the company's numbers are clearly improving. It boasts more cash than debt and is enjoying solid growth, with revenue up 86 percent over the last five years. Not to mention, the company's turning a profit, while most of its competitors struggle to do the same.

And now, credible rumors have surfaced that AboveNet is exploring a possible sale. Multiple suitors exist, including leading telecommunications companies AT&T (NYSE: T) and Verizon (NYSE: VZ). Level 3 Communications is another possible buyer.

And the more the merrier, as it increases the likelihood of a bidding war and increases the profit potential for early investors.

As Colby Synesael at Cowen said, "Whoever is going to buy AboveNet would have to write a very big check."

I agree. Based on the 57 percent premium paid for Global Crossing, AboveNet could easily fetch $100 or more in a deal. That would be a 35 percent premium to the current price, which is pretty tidy, considering that the S&P 500 is only up six percent this year.

Bottom line: With takeover activity heating up, it's time to start looking for potential targets. And AboveNet certainly represents a solid first addition.

Good investing,

Louis Basenese

Note: This article originally ran on Wall Street Daily on May 30, 2011.

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