The Next Buyout Stock

After a torrid first half of the year in which announced leveraged buyouts (LBOs) totaled $616 billion, the pace of buyouts came to a halt in August because of concerns that investment banks wouldn't be able to sell on the $300 billion to $350 billion backlog of leveraged loans they had taken on to finance the transactions.

September was to be the month of reckoning, as investors waited for the outcome of planned debt sales on some megadeals. So far, private-equity firms such as the Blackstone Group (NYSE:BX) and investment banks have played nice to get the deals done -- renegotiating loan covenants and/or raising the interest rate on the loans. Meanwhile, Lehman Brothers (NYSE:LEH) was first to prove the business isn't without risk (contrary to widespread belief) by taking a charge in excess of $1 billion on approximately $30 billion in loans in its fiscal third quarter.

I now expect buyout activity to resume this year and next, albeit at a slower pace than in the first half of this year, 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!) Naturally, many investors are curious to know which company the private-equity investors will snatch up next. If I wanted to sleuth the public markets in search of the next buyout target, I'd take a step back and ask myself: What types of companies do private-equity firms tend to invest in?

Well, they look for four primary characteristics:

1. Steady and predictable cash flows
LBOs -- the "L" stands for leveraged -- are financed by large amounts of debt. 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, year out. Second, firms with a defensible competitive position are the 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 that are required to maintain the firm's operations consume cash flow from operations that could otherwise be allocated to other uses. In a company that has been taken private through an LBO, the priority 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 that 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 of less than 5%.

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

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

Here are three companies that showed up in my screen.

These aren't recommendations, but they might be worthy of further investigation.

Don't bet on buyouts
But 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 IV 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 no beneficial interest in any of the companies mentioned in this article. The Motley Fool has a disclosure policy.