Outlook 2008: Three Ways to Profit From A Takeover Market That's Alive and Well

Editor's Note: This is the 13th Installment of an Ongoing Series Highlighting the Global Investing Outlook for 2008.

Elvis might be dead. But the mergers and acquisitions (M&A) boom certainly is not. While it's an admittedly Contrarian stance, I'm convinced the deal-making environment will be even better in 2008 than it was in 2007.

That's significant, considering that the latest figures from Thomson Financial confirm that 2007 - despite the gummed-up credit markets - was the best year ever for worldwide M&A deals. Total deal volume checked in at $4.5 trillion, up 24% from the previous high-water mark set in 2006. U.S. deal volume also hit record levels last year, jumping 9% to reach $1.61 trillion.

To understand our optimism, let's examine the catalysts at work in the New Year. There's a strong incentive to tune in and pay attention: If we're right, investing in eventual takeover stocks nets investors an average single-day gain ranging from 43.5% to 53.7%, according to recent data from FactSet MergerStat LLC.

A Closer Look at the "Deal Grease" For 2008

As we all know, last year's frenetic deal making has ignited the kind of easy credit that fuels a "Go-Go" environment for private equity (PE). PE firms accounted for $874.2 billion - or 19.5% - of all announced M&A activity, according to Thomson Financial. Most of that came before the credit crunch sacked the global credit markets in August, as private equity shops only accounted for 9% of the deal volume in the fourth quarter.

But here's the thing - while private equity buyers got benched in late summer, and remain seated thereafter, their absence created an opportunity for strategic buyers to step back in and carry the ball. And this newest group of players isn't wasting any time: They accounted for a majority of the $1 trillion in deals announced in the fourth quarter of last year.

As Mark Pacitti, a partner in the corporate finance division of Deloitte & Touche LLP, noted at the beginning of January: "Corporate deal-makers have often lost out on M&A [in 2006 and 2007] because they've been outbid by private equity firms. Now they're in the position to outbid private equity."

I agree. And I actually made similar comments back in September when I told Takeover Trader subscribers "there's a silver lining to the private-equity slowdown. Their absence is creating a window of opportunity for strategic acquisitions … companies flush with cash can now take advantage of [the] depressed stock prices of competitors without the fear of being outbid by overly aggressive private equity shops."

So expect strategic buyers to keep filling the void, especially since they're sitting on roughly $600 billion in cash, based on the latest tally from Standard & Poor's Corp. These buyers also are flush with another source of M&A currency - treasury stock. Since 2004, corporations have bought back hundreds of billions of dollars of their own stock, which can now be reissued as "currency" to help finance buyout deals.

And don't count private-equity firms out entirely, either. They will return - perhaps as soon as the second quarter. The key factor will be how quickly investment banks can clear their backlogs of leveraged loans.

According to recent study by the Transaction Services Group of PricewaterhouseCoopers LLP, of the $350 billion to $450 billion credit overhang reported early in the second half of last year, approximately $245 billion remains.

But once that clears - and it will - private-equity buyers will be back in full force. And while borrowing costs have increased, they're still about four to five percentage points below the levels that brought the last M&A boom to a grinding halt in 2001. That means that interest rates still have a long way to run before they shut off the financing portion of the takeover market.

In short, financing will be available, but the current credit environment means that for PE firms to access that capital, they'll probably need to focus on small- to mid-sized buyouts.

So far, I've demonstrated that strategic borrowers will continue to be a factor in the takeover market. I've also shown that the all-important private-equity players can be expected to return to the fray. But I'm predicting that the most-powerful catalyst for M&A deal volume this year will be the emergence of cross-border deal making.

Obviously, this is pertinent to Money Morning readers because of our focus on following global money flows and global-investing trends.

Thanks to a greenback that continues to drop in value against other major currencies, U.S. companies are becoming increasingly attractive on a price basis to offshore companies. And as the effective "sticker price" of U.S.-based companies continues to decline, they are also becoming ever more alluring foreign suitors. And the list of potential buyers keeps increasing. As we've noted here before, companies in international and emerging markets are enjoying much stronger earnings growth rates and can now afford to expand operations.

Statistics already support this prediction. The volume of foreign purchases of U.S. companies increased 92.2% year-over-year, according to Thomson Financial. And that trend accelerated in the fourth quarter of last year, with foreign buyers accounting for 46% of U.S. M&A activity, up from the historical average of only 18%, according to Bloomberg Financial. Two such notable deals include the pending takeover of Commerce Bancorp Inc. (CBH) by Toronto-Dominion Bank (TD), and Nokia Corp.'s (NOK) $8.1 bid for Chicago-based Navteq Corp. (NVT), a leading digital mapmaker.

As we outlined in the earlier "Outlook 2008" series installment, "Seven Ways to Profit From the U.S. Dollar's Doldrums," and our research report, "Nine Ways to Profit From the Diving Dollar," several different forces are combining to hold down the dollar, or even to push it lower, meaning that cross-border deals with U.S. companies as the target will only accelerate this year.

And don't forget the newly aggressive sovereign wealth funds. I fully expect that they'll deploy some of the $3 trillion they control into this part of the M&A game. We already witnessed this predisposition when Abu Dhabi provided Citigroup with a $7.5 billion cash injection, and when Singapore's government-run fund invested $4.4 billion in Merrill Lynch.

Now that we've covered the forces at work, let's get to some specific recommendations…

Four Sectors and Three Stocks Ripe For the Picking 

When it comes to M&A investing, I always tell investors to follow the consolidation trend. Long story short, deals in one industry encourage more deals in the same industry. It's a domino effect.

If you think about it, that theory actually makes a lot of sense. If one company in a sector goes out and doubles its size overnight via an acquisition, it ups the ante for the whole sector; the only way its sector rivals can remain competitive is to complete an acquisition of their own. Otherwise, they might as well sell out themselves.

Accordingly, the industries experiencing the most consolidation in 2007 will likely enjoy similarly strong consolidation in 2008. And the three top industries last year were:

  • Financials.
  • Materials.
  • And Energy.

Conditions also point to increased consolidation in the healthcare industry - specifically in the pharmaceutical space, as traditional pharmaceutical companies forgo the long-and-costly route for researching and developing their next "blockbuster" drug, opting to buy it instead.

Three specific stocks to consider include:

  • Ultra Petroleum Corp. (UPL): In early 2004, seven independent natural gas producers operated in the Western Rockies. Today, only UPL remains. Not that the others failed or went belly-up. Reserve-hungry suitors gobbled them up for an average takeover premium of 20%. The last deal, Western Gas Resources, fetched a 44% premium. UPL will likely be next because it finally sold its China drilling sites in late September. This divestiture officially eliminated the 6,000-mile operational divide that previously kept potential suitors at bay. Now, UPL represents one of the lowest-cost producers in the industry. And that makes it a hassle-free way for a suitor to add proven reserves and production. I don't expect it to remain independent much longer.
  • Colonial BancGroup Inc. (CNB). Investors were quick to bail out of this stock because of its focus on real estate lending in Florida. Ironically, CNB dropped no subprime bombs to spark the sell-off. And after a thorough review of the company's financials, it comes up clean.  Thanks to strict underwriting discipline, CNB stopped lending into the overheated Miami condo market almost four years ago. Such foresight wasn't a coincidence. Management consistently demonstrates terrific acumen, and is an excellent judge of its local markets. A net charge-off level equivalent to only 0.25% of total loans for the past 10 years proves it. Put simply, CNB is a classic case of "guilt by association," with investors throwing out the good with the bad - all in the name of "risk management." CNB is an attractive buyout candidate because it represents an easy way to capture the wealth migration of U.S. banking assets into the Southeast, which we're seeing as more baby boomers retire there. Plus, Chairman and CEO Robert E. Lowder is nearing retirement age. With a 4.4% stake in the company, it's highly likely that he wouldn't mind dramatically boosting the value of his retirement package with a sale of the bank.
  • Genzyme Corp. (GENZ). As we noted earlier, major pharmaceutical companies now embrace acquisitions as the easiest way to grow. And GENZ represents an attractive asset. It focuses on rare diseases - a niche that lends itself to less competition and higher margins. Plus, many of Genzyme's drugs possess the ability to treat multiple diseases. And sales for its current drug lineup continue to accelerate. Not to be overlooked, of course, is its loaded pipeline, which includes several drugs in late-stage development, including the oncology drug, Mozobil. It has also worked to extract as much value as possible from its product portfolio by establishing key partnerships. In short, there's a lot of built-in value just waiting to be unlocked and released - enough, in fact, to pique the interest of billionaire activist investor Carl Icahn. And given his track record in the space, specifically with Maryland biotech, MedImmune Inc. [one of the companies that Money Morning Executive Editor Bill Patalon covered back during his business journalist days], a takeover of Genzyme shouldn't be far off.

These are just three examples of the countless takeover targets that exist. If you take the time to unearth others by following the consolidation trends, I'm convinced you won't be disappointed with the results in 2008.

Lou Basenese is the editor of The Takeover Trader news service. For more information on an Oxford Club membership, please click here.
Editor's Note: Money Morning's "Outlook 2008" series last covered The U.S. Housing Market. Next up: Agricultural Commodities.

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