The Next Buyout Stock

After a torrid first half in which announced leveraged buyouts (LBOs) totaled $616 billion, the pace of buyouts came to a halt in August due to a seize-up in the credit markets.

Since then, some of the bellwether megadeals, such as TXU and First Data, have been completed, but other deals have fallen through. Cerberus Capital Management decided to walk away from its proposed buyout of United Rentals (NYSE: URI) only days before the deal was set to close on Nov. 16. The volume of new activity remains depressed, at least compared to the recent boom time; according to research firm Dealogic, the value of announced U.S. mergers and acquisitions fell to $58.1 billion in November, down 71% from the prior year.

I now expect buyout activity to resume next year, albeit at a slower pace than in the first half and with fewer megacap targets. LBO firms are still flush with cash that needs to find a home (Dow Jones Private Equity Analyst estimates that LBO and corporate finance shops raised $108 billion in the first half of this year alone!). Also, expect cash-rich sovereign funds to take up some of the slack; Citigroup (NYSE: C) recently announced that it had sold a $7.5 billion equity-linked participation to the Abu Dhabi Investment Authority.

Naturally, many investors are curious to know which company will be snatched up by private equity investors. If I wanted to sleuth the public markets in search of the next buyout target, I'd take a step back and ask myself the following question:

What types of companies do private equity firms tend to invest in?

These are four primary characteristics of firms that private equity firms seek out in potential targets:

1. Steady and predictable cash flows
LBOs are financed by large amounts of debt (that "L" does stand for "leveraged"). Investors look for companies that will be able to make the associated interest payments by generating healthy, steady cash flows from their operations.

2. Clean balance sheet with little debt
Debt boosts the returns of private equity investor returns in an LBO. If a company already has a lot of debt on its balance sheet, it's not a viable candidate.

3. Strong, defensible market position
No surprise here! A defensible market position is attractive for a couple of reasons: First, it is a key determinant of a firm's ability to generate steady cash flows year in and year out. Second, firms with a defensible competitive position are those that are most likely to compound their intrinsic value. Increases in intrinsic value are another source of LBO investor returns.

4. Minimum future capital requirements
Capital expenditures required to maintain a firm's operations consume cash flow that could otherwise be allocated to other uses. The priority of a company that has been taken private through an LBO is the payment of interest or principal payments on the new debt. All other things equal, companies with low maintenance capital expenditures can dedicate more cash to servicing their debt.

Do these four criteria sound familiar? If, like me, you're a value investor, they might as well be a mantra. That's not a coincidence: Value investors believe in adopting the mindset of a control investor -- we approach every stock purchase as if we were acquiring the entire company, and these are the hallmarks of superior companies. Stocks represent ownership interests in businesses -- a quaint notion, to be sure, but one value investors are still fond of.

My potential buyout screen
To try to find potential buyout candidates, I created a stock screen based on criteria that try to capture the characteristics I discussed above. These are the criteria I used:

• Free cash flow margin greater than 15% over the trailing 12 months and for the years 2004 through 2006.
• Total debt-to-capital ratio less than 20%.
• Capital expenditures to revenues less than 8%.

No investor worth his salt wants to overpay, even for a high-quality company, so I added a valuation criterion:

• Enterprise value-to-EBITDA less than 11 (EV/EBITDA is a valuation ratio that is widely used by LBO investors).

Here are four companies that showed up in my screen:

	Industry	TTM FCF Margin	Return on Capital	EV/ EBITDA
Coach (NYSE: COH)	Apparel -- footwear and accessories	25%	41%	11.0
Federated Investors (NYSE: FII)	Asset management	29%	32%	11.1
Getty Images (NYSE: GYI)	Business services	23%	8%	5.9
The Travelers Companies (NYSE: TRV)	P&C insurance	26%	13%	5.6

Source: Standard & Poor's Capital IQ.

These aren't recommendations, but they might be worthy of further investigation. Of course, you might be wondering why I bothered to leave Travelers on the list. At nearly $36 billion in market capitalization, it's too large to be the object of a LBO in this environment.

Don't bet on buyouts
As an individual investor, you shouldn't be buying stocks purely in the hope that they'll get bought out. While you'll get a nice short-term gain, you're also leaving future gains on the table. Remember: Private equity will buy out a company only if it thinks it can get gains far in excess of the buyout price.

So instead of trying to guess where private equity will be stepping next -- an approach that is unlikely to prove financially rewarding -- focus on finding outstanding companies trading at bargain prices. That's what we do at the Inside Value service I just mentioned. You can take a look at all of our research and value recommendations by clicking here to join free for 30 days.

After all, if you find enough outstanding companies trading on the cheap, private equity will find you.

This article was first published on June 21, 2007. It has been updated.

Alex Dumortier, CFA has a beneficial interest in Federated Investors. Federated Investors is a Motley Fool Inside Value recommendation. The Fool's disclosure policy can be found here.