5 Retail Buyout Candidates

Mergers and acquisitions are back, and they're getting investors pumped up. Late last month, Unilever (NYSE: UL) agreed to buy Alberto-Culver; earlier this week, Bain Capital said that it's buying Gymboree; and now there are rumors that L'Oreal may be sniffing around Avon Products (NYSE: AVP).

The appeal of being along for the ride is pretty obvious. Both Gymboree and Alberto-Culver were bought at around a 20% premium to the closing price prior to the buyout announcement, and many deals end up sending the target's stock up even more. Therefore, any investor who owns the stock prior to the buyout announcement stands to bag quick and easy riches when the acquirer agrees to pay a big price. Right?

Not so fast
"Quick and easy riches" may be the way some folks look at being on the target end of a buyout, but reality isn't always so rosy.

While buyers generally do pay a premium over a company's market price to make an acquisition, the premium isn't always particularly attractive. And when buyout rumors start pushing up a stock's price, disappointment and losses can easily follow if no deal materializes.

In other words, buying a stock because you think a buyout offer is on the way is not usually a great strategy.

On the other hand ...
Buyouts happen for a reason. When a private equity company like Bain or KKR moves in, it's often because the potential acquisition has a reasonable underlying business, a solid balance sheet, and good cash flow, but has been ignored or beaten down by Mr. Market. Strategic acquirers focus more on how the target would fit into the acquirer's business, but financial strength and valuation will certainly be part of their math as well.

Why is this important? Because in many cases the companies that may be on the buyout radar are simply good investments and can be worthwhile even if a buyout never materializes.

Digging in
Consistent with what I noted above, in picking out companies that could be buyout targets I looked for balance sheets with little or no debt, solid free cash flow, a business that's not at risk of extinction, and a reasonable valuation.

Source: Capital IQ (a Standard & Poor's company) and author calculations.

This may seem like a set of some pretty boring retailers, and to some extent they are. We've got arts and crafts retailer Jo-Ann Stores, moderately priced women's clothing retailer Dress Barn, footwear peddler Shoe Carnival, and general off-price apparel and home accessories merchant Ross Stores.

Aeropostale may be the most "exciting" of the bunch as it focuses on delivering fashion to teenagers, but the company keeps its nose from tipping up like other teen fashion retailers. As my fellow Fool Alyce Lomax noted back in August when she recommended the stock for our 11 O'Clock Stock series, Aeropostale has kept a keen focus on what its customers can actually afford in these tough times. So even Aeropostale concerns itself with boring concepts like being affordable.

All in all, this is a group of companies that's far more likely to elicit yawns than wows.

But all of the companies in this group are also cash machines, pumping out the green stuff year in and year out. They also have extremely clean balance sheets -- meaning that there's plenty of room for a financial buyer to juice returns by adding debt into the equation.

More importantly, though, I think all five of these companies are currently undervalued and could be good investments whether or not an acquirer ever gives them a second look. It's a win-if-they-do and win-if-they-don't kind of situation. I'll take that any day over crossing my fingers and relying on a takeover bid to secure my returns.

Of course these are far from the only companies in this "win-win" boat. Have a favorite of your own that could be a winner with or without a takeover? Head down to the comments section and share your thoughts.

When it comes to retailing, could Wal-Mart soon look like a dinosaur? Check out this free special report to find out about the new "cash kings" of retail.