The Next Buyout Stock

For leveraged buyout (LBO) funds, 2007 was a tale of two halves. After a torrid first six months, the subprime crisis prompted a dry up in credit, putting the brakes on dealmaking activity. For the full year, private equity accounted for 19.5% of mergers and acquisitions volume, but its contribution in the fourth quarter was less than half that, just 9% -- the lowest since the first quarter of 2004, according to Thomson Financial and the Financial Times.

I expect buyout activity to resume in 2008, albeit at a slower pace than in the first half, with fewer megacap deals and lower levels of debt financing. Private equity is 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 2007 alone!). Also, cash-rich sovereign funds from the Middle East and Asia may continue to take up some of the slack. In the past quarter, they invested $20 billion in financial firms, including a who's-who of banks and broker-dealers: Morgan Stanley (NYSE: MS), Merrill Lynch (NYSE: MER), and Bear Stearns (NYSE: BSC).

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:

Steady and predictable cash flows
LBOs -- remember, 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.

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.

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 those that are most likely to compound their intrinsic value. Increases in intrinsic value are another source of LBO investor returns.

Minimum future capital requirements
Capital expenditures 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 mind-set 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 10% 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 investors worth their salt want 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 is widely used by LBO investors].

Here are four companies that showed up in my screen:

These aren't recommendations, but they might be worthy of further investigation. Of course, you might be wondering why I bothered to leave Applied Materials on the list. At $23 billion in market capitalization, it's unlikely to be the object of an 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 Inside Value; in fact, two of the companies in the table above are already recommendations (Nasdaq Stock Market and Symantec). 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 June 21, 2007. It has been updated.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Nasdaq and Symantec are Motley Fool Inside Value recommendations. The Fool has a disclosure policy.