Who doesn't love having their company bought out at a fair price? It's a refreshing feeling to check your stocks and see a stock up 30% to 40%. It makes your week.
So below I'm highlighting three stocks that I think would be very attractive to private-equity buyers. Here's the usual P/E drill: Take a company private, lard it up with debt, pay yourself a dividend, and finally do an IPO that sells the debt-riddled company back to the public. I explain the whole process here.
To that end, private equity firms like companies with the following characteristics:
- Clean (if not pristine) balance sheet.
- Reliable cash generation.
- Low earnings multiples (i.e., cheap).
The three companies below have these qualities in spades, making them great additions to your portfolio. Above all in looking for great companies, avoid those that don't have some combination of the above qualities, that is, don't pay a high price for lackluster cash generation and a dirty balance sheet. While some investors grow ravenous when they see the potential of penny darling Sirius XM Radio
1. Aeropostale
The perennial little retailer that could, Aeropostale resides in the sweet spot here and has many of the same qualities that made J. Crew a recent buyout. Aeropostale is sitting on an ideal balance sheet, with no debt and 11% of its market cap in cash. Unbelievably, the stock trades for less than 10 times earnings, and in the year ending in July, operating cash flow was 4.5 times the company's capital investment. While flat same-store sales in the recent quarter made Aeropostale look human, its performance throughout the recession has been admirable and its comps have otherwise been consistently good.
2. Gap
Recent takeouts of Gymboree and J. Crew show that private equity thinks retailing is attractively priced now, and retail sits within the consumer discretionary sector, which is the top-performing sector this year. So my next pick is not as counterintuitive as it might seem at first. Gap has been written off by many as a has-been retailer, but its performance has been reasonable, if not stellar, and the balance sheet looks quite attractive.
Gap is also pristine: It has $1.65 billion in cash and short-term investments and no debt. Over the past year, Gap extracted more than three times as much cash as it put into its business. And it's already taken steps to make its business efficient: closing underperforming stores and reducing inventory. Better still, the company has invested in its fast-growing online and international operations. As evidence, the company's operating margin sits at the highest level in a decade.
And the recent logo gaffe that made Gap the laughingstock of the interwebs? I think you should read that in the same vein as the New Coke fiasco that fizzled out on Coca-Cola back in the '80s. As it did for the soda company then, the outrage over Gap's logo shows just how beloved the company is. Coca-Cola used the outrage as a wake-up call, and Gap should do that, too.
The stock trades at less than 12 times earnings, so it's cheap. The one downside (though not insurmountable) is that the company, at a $13 billion market cap, is bigger than the usual bite-size $3 billion to $5 billion deals that private equity often does. But even if there's no buyout, you still are treated to Gap's 1.9% dividend, which has increased at a 19.5% clip over the past five years.
3. NeuStar
I've made an extensive case for why NeuStar is an undiscovered monopoly that mints money. To recap, this small cap provides essential services that connect telecoms of all types, from wireless operators to wireline. By sitting at the nexus of these companies, it's able to generate 20% net profit margins consistently. But it also stands to benefit from the move to digital distribution of movies via the Web through a huge initiative called Ultraviolet. As part of the initiative, NeuStar will manage the registry database that allows you to watch any purchased movie on any device. So NeuStar is poised to ride the coattails of media giants such as Netflix
NeuStar has a P/E of less than 18 and a balance sheet with virtually no debt. And it has nearly 19% of its market cap in net cash, and its ability to generate more is stellar: Over the past three fiscal years, the company has pulled nearly six times as much cash out of the business as it has invested.
Foolish takeaway
So those are three stocks that I think are poised for great gains, whether or not a private-equity buyer steps in to make me an offer I can't refuse. Look for those three criteria I mentioned at the top: cash generation, low multiple to earnings, and a clean balance sheet. That will steer you away from potential dogs like Sirius. Do you have any other stocks that are poised for greatness?
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