How to Know Which Mergers Will Be Winners

Millions of investors find mergers to be complicated and murky undertakings, best left to Wall Street's "Armani Army."

I look at 'em differently and think you should, too.

That's because mergers are one of the single greatest profit generators out there.

Today, we're going to talk about why and how you could play along for big potential profits...

Why Free Cash Flow Is Your Key to Big Profits

Take the all-stock merger between Harris Corp. (NYSE: HRS) and L3 Technologies Inc. (NYSE: LLL) that was announced, for example.

The deal is a transaction between "equals" – meaning neither company is assuming a dominant position over the other. Instead, you're getting a single, far larger, integrated defense contractor.

The new and aptly named "L3 Harris Technologies Inc." will generate something on the order of $16 billion a year in sales that should translate into profits of around $2.5 billion, according to company representatives.

That's good by any stretch of the imagination.

But I'm into GREAT.

That's why I started Total Wealth and why we're in this together.

It's a well-proven formula... line up with one or more of the Six Unstoppable Trends, identify the world's best companies, then buy the ones making "must-have" products and services the world cannot live without.

That's what this merger is.

The newly formed contractor will instantly become the nation's sixth-largest defense contractor and a top-ten global defense supplier with 48,000 employees and customers in 100+ countries around the world.

Critically, this will also produce an estimated $1.9 billion in "free cash flow."

That's the key to life-changing profits, especially today, and especially when it comes to a transaction like this one.

Free cash flow – if you've never heard the term before – is the cash a company produces after it pays for operations, less the cost of capital expenditures.

That's a mouthful of very technical terminology, but there's a reason I want you to understand the term.

Free cash flow is a metric not unlike the cash you have in your pocket. Plan efficiently, and you've got more of it... after you've paid for your gas, your food, and other living expenses.

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Companies use free cash flow as a barometer for potential business expansion.

Sadly, most investors don't pay a lot of attention to it, and the mainstream news outlets almost never discuss it.

They should.

Free cash flow is the one metric capable of sorting out the winners from the losers objectively, especially when it comes to big mergers and acquisitions like the L3-Harris deal.

You see, unlike most opinions, which are completely subjective, free cash flow is an objective measure that can provide great insight into things like operational efficiency, potential profitability, how much money is left over for buybacks or dividends, and more.

But I also like it for another reason.

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Free cash flow is often a significant prelude to increased earnings, cost reductions, dividends, and share buybacks – all of which are great for your money.

It's also one of the very few metrics that can give you a decidedly accurate view of the future.

Companies with large and growing free cash flow are the ones that will reward investors handsomely tomorrow for the risks they take in buying shares today.

You can run these numbers yourself, if you're so inclined.

All you need is a simple balance sheet and income statement drawn from a company's annual report or the online investor resources page most publicly traded companies maintain.

  1. Grab the net income figure. Add back depreciation and amortization.
  2. Subtract current liabilities from current assets to adjust for working capital.
  3. Then, subtract capital expenditures (some companies list these as plant and equipment), and
  4. Voila!

Or, you can simply find a website that does all the calculations for you.

Interpreting the results is simple.

  • Companies with rising free cash flow typically signal improved earnings and higher share prices ahead. That's the case with L3 Harris Technologies Inc.
  • Companies with falling free cash flow are usually a precursor to falling share prices ahead, because a decline in free cash flow means they're going to have a hard time keeping the doors open. Sears Holdings Corp. (Nasdaq: SHLD) has been in this boat for years.

There is one important caveat, though.

Because of the way it's calculated, free cash flow is a "snapshot" in time.

To really make it valuable, what you want to do is look at how it changes over time. I typically look at three to five years.

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At the same time, you'll want to make sure you understand how various industries use and abuse cash so you can draw as accurate a conclusion as possible when it comes to any company that interests you. Inc. (Nasdaq: AMZN), for example, is constantly investing in growth, so there's typically lower free cash flow available than there would be in Walmart Inc. (NYSE: WMT), for example. Tesla Inc. (Nasdaq: TSLA) may be accelerating receivables to boost revenue recognition, and presumably, share prices, which suggests there may not be as much cash flow as everyone thinks.

Back to L3 Harris Technologies Inc.

The L3-Harris deal comes at a time when the president is ramping up spending, so there are bigger, more significant projects on tap. Everything from missile defense to capital ships to badly outdated computer systems is up for grabs.

Stuff that is literally so big and so complicated that very few single contractors can tackle 'em.

Unless, of course, they team up.

I recommended Harris in April 2015 to paid members of the Money Map Report family, and it's up a healthy 127.24%, versus only 30.5% from the S&P 500 – which means everyone who is following along has a big, fat Cheshire Cat-like grin on their face.

If you missed out, don't worry.

Mergers are almost always a sign of "the strong getting stronger," which means there is undoubtedly further industry consolidation ahead.

Take as an example the healthcare industry in 2017, which saw a giant $69 billion merger between CVS Corp. (Nasdaq: CVS) and Aetna. The largest healthcare ETF, tracking the entire industry – the Health Care Select Sector SPDR Fund (NYSE: XLV) – appreciated a whopping 31.19% that year as lesser companies fell in line and more valuable ones plowed ahead.

Or the energy and power sector in 2010. The big play that year was FirstEnergy Corp. (NYSE: FE)'s buying of Allegheny Energy. The largest ETF for that sector – the Energy Select Sector SPDR ETF (NYSE: XLE) – jumped 19.72%.

Now it's the defense sector's turn.

The easiest way to play it is a defense-centric ETF like the iShares U.S. Aerospace & Defense ETF (NYSE: ITA).

The largest holdings in the ITA portfolio include The Boeing Co. (NYSE: BA), United Technologies Corp. (NYSE: UTX), and Lockheed Martin Corp. (NYSE: LMT), which come in at weights of 11.72%, 8.20%, and 7.70%, respectively.

The newly created L3 Harris Technologies Inc. represents a combined 7.52% weighting at today's prices, which is important because of the profit potential that a stunning $1.9 billion in free cash flow represents.

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The post How to Know Which Mergers Will Be Winners appeared first on Total Wealth.

About the Author

Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

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