How to Spot a Takeover Target

Let’s step back from day-to-day volatility to look at corporate mergers and acquisitions (M&As), an area that still confers the potential for outsized gains, even in this frustrating bear market.

For insights into the current state of M&A, I interviewed my colleague Nathan Slaughter (pictured), chief investment strategist of Takeover Trader. The following is a condensed transcript of our discussion.

After a tough first half of 2022, it seems that M&As are gathering momentum again.

M&A activity in the first half of this year slowed from the sizzling pace in 2021. The Russia-Ukraine war, rising inflation, climbing interest rates, and a bearish stock market all created headwinds for deal-making.

However, as the second half of the year progresses, the appetite for making deals seems to have rebounded, according to a recent KPMG survey of 360 U.S. business leaders. Nearly 80% of respondents reported that their desire to pursue M&As is as strong or even stronger than in 2021.

And as we know, whenever a large fish swallows a smaller one, shareholders in the target company often walk away with quick gains of 30%, 40%, or more.

Is it possible to “reverse engineer” the deal-making process, to get ahead of the curve?

Yes, that’s exactly what I do. I’ve examined countless takeovers over the years, looking for commonalities. I’ve also been in on more than my fair share of these deals. And while there is no such thing as a crystal ball in the investment world, I’ve noticed a few recurring patterns.

Just as meteorologists are trained to spot wind shear and other telltale signs of an imminent tornado, there is a specific set of conditions that often precede a takeover announcement.

What are the criteria with the most predictive power? I assume that visible growth prospects are near the top the list.

Yes, it takes growth to placate investors. Companies that don’t deliver often see their shares languish. Unfortunately, finding new growth avenues isn’t always easy, particularly for mature businesses, and especially in this bear market.

Acquisitions can be the surest growth catalyst, and there are a lot of larger, older companies out there in need of propulsion.

I also look for achievable synergies. In fact, synergy is what justifies the sometimes exorbitant price tag to make these deals happen. That’s how management sells it to voting shareholders.

When two businesses get married, they no longer need separate headquarters. Combining into one organization provides an opportunity to eliminate or downsize overlapping administrative functions, sell off redundant assets, and take other steps to streamline expenses.

Those cost savings are called synergies. And the bigger the scale, the more they add up. In most cases, the two companies joining will become more profitable together than they were apart. It’s a classic case of 2 + 2 = 5.

Mergers can bring about other benefits, such as supply chain efficiencies or debt refinancing. Supply chain streamlining is all the more important these days, as we witness bottlenecks in global distribution networks caused by the Russia-Ukraine war and the pandemic.

These efficiencies can expand margins and squeeze more profit from every dollar of sales. But the most impactful mergers can boost sales as well, delivering synergies on both the top and bottom lines.

When an innovative company with great ideas joins forces with a more established player with global distribution capabilities, it can be a beautiful thing. The greater the potential synergies, the more accretive a takeover can be to cash flows, and thus the more attractive to acquirers.

Enhanced pricing power is probably a big plus, especially during this era of soaring inflation.

That’s true. Corporate profit margins right now are under enormous pressure from rising inflation and supply chain hassles.

But even in the best of times, every business wants to increase product prices and boost profit margins. It’s a calculated trade-off, because doing so can scare away customers, shrink market share, and bite into volume.

The grocery business, for example, is known for being cutthroat. Kroger (NYSE: KR) has a net operating margin of just 1.8%, pocketing less than two pennies for every dollar of sales. By contrast, Microsoft (NSDQ: MSFT) boasts an operating margin of 40%, or 40 cents per dollar of revenue.

Of course, these are two starkly different industries. But it’s much easier for Microsoft to raise prices for its software and services without suffering a sharp dent in demand.

How does competitiveness factor into your equation?

If you’re a Star Trek fan, you’re probably familiar with the Borg, the fearsome cybernetic creatures that take over entire races. With every assimilation, the Borg not only remove a potential enemy, but they also absorb the unique strengths of that conquered race.

Over time, they become increasingly formidable. The Borg’s motto is: “Resistance is futile.” The business world is no different.

Microsoft didn’t reach $140 billion in annual sales all on its own. PowerPoint, for instance, came from the purchase of a company called Forethought back in the 1980s. Over the years, Microsoft has gobbled up more than 200 smaller competitors, absorbing their assets (and their customers). More recently, it has hunted down Nuance for $20 billion and ZeniMax for $7.6 billion.

The same dynamic applies to other tech juggernauts such as Apple (NSDQ: AAPL) and Google parent Alphabet (NSDQ: GOOGL). It always pays to be on the lookout for situations where deep-pocketed companies can turn dangerous potential enemies into valuable allies.

Editor’s Note: Despite bearish conditions in the overall stock market, companies are flush with cash and eager to fuel growth. That means we’re likely to see a wave of deals in the coming months.

Even the whisper of a “mega-merger” can lead to enormous returns. At Takeover Trader, my colleague Nathan Slaughter just pinpointed a potential takeover deal that could dwarf them all. Want to get in on his next big trade? Click here for details.

John Persinos is the editorial director of Investing Daily.

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