Three Solid Acquisition Candidates

	Paul Tracy Street Authority.com
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Merger mania hit Wall Street in the late 1990's, and at that point in time those investors who were wise enough to load up on shares of prime acquisition targets did extremely well. The tech sector was hot back then, and it seemed as though just about every month Cisco Systems (CSCO) was taking over another small networking company or EMC (EMC) was buying another storage concern. According to Ernst & Young, the average premium for takeovers between 1996 and 2000 was between 40% and 50% -- that means that acquirers paid more than +40% above the pre-takeover price to buy other firms. As this statistic clearly shows, merger and acquisition deals can be a bonanza for those who invest in the target company's stock.

Although deal making has waned somewhat from the frenetic pace of the tech boom, mergers and acquisition (M&A) activity wasn't unique to the market's halcyon days. The 1980's, for example, brought a wave of hostile takeovers in the U.S. -- takeovers in which the target company's management fought the deal -- and, more recently, we've seen a mini boom in deals in the telecom and retail groups.

To give you an idea of just how profitable mergers can be, let's consider a few recent deals. As you can see in our chart, we've outlined four deals consummated over the past year in four different industries, all for significant premiums.

Some of these deals were friendly and others were hostile. As an example of the latter, PeopleSoft fought hard against software giant Oracle's (ORCL) proposed takeover; management even tried to introduce so-called poison pills to make it more expensive for PeopleSoft to be acquired. This deal, which was first announced in June 2003 wasn't finalized until January 10, 2005. Of course, the merger also offered one of the richest premiums of any takeover of the past few years -- nearly an 80% gain for shareholders that owned PeopleSoft prior to June 2003.

By contrast, General Electric's (GE) takeover of X-ray security firm InVision was friendly. However, the government took months to approve the deal on antitrust fears. Because G.E. is such a giant in many industries, the government feared that it would hold a monopolistic control over x-ray scanning equipment used at airports. That deal took about nine months to consummate.

Regardless of these potential setbacks and delays, Ernst and Young suggests that the average takeover premium in the U.S. over the long run is around 24%. That means investors in the takeover target make an average profit of nearly 25% by the time the deal closes, much of that gain coming in the first few days after a takeover is announced. With this in mind, many investors have found it extremely worthwhile to look for companies with solid businesses that might make attractive takeover candidates in the future.

So why, one might ask, does the acquiring company offer a premium at all? The answer is rather simple: all mergers must be approved by the owners of a company -- the shareholders -- and those owners need to be tempted by an acquirer to sell their stake. The premium is more or less a profit incentive for shareholders to approve a deal. Of course, the acquiring company also hopes to make money out of the transaction. After all, that acquirer will need to make enough out of an acquisition to cover the takeover premium, otherwise the deal simply wouldn't make sense.

There are a number of reasons why a company might find it financially viable and profitable to acquire another firm. Sometimes, the answer is money and capital. This was the case with many late-1990's tech mergers. Basically, small upstart companies with some valuable patents or a promising technology simply didn't have the cash to reach their full potential -- they were unable to commercialize their technologies.

Meanwhile, largecap companies like Cisco and IBM usually have piles of cash lying around, just waiting for promising technologies to invest in. What's more, companies like Cisco have huge sales forces that are able to put new technology products in front of likely buyers, adding to the commercial value of the transaction. Such deals can be highly successful if the acquiring firm can make a commercial success of its target's technology.

Other mergers are defensive in nature. Sometimes, management sees little growth out of its business and little opportunity for expansion, so they simply try to milk that business as a "cash cow." Such companies can be tempting targets if an acquirer sees value in the target company's assets. For example, many analysts believe that K-Mart's motivation to take over Sears related to the value of Sears' real estate and brand name. Sears was also a cheap stock when that deal was announced -- the stock had been declining for years, losing about half its value between 1998 and the autumn of 2004. The deal makes some sense -- after all, Sears has a profitable business and some of the best retail locations in the country, but it's basically a stagnant enterprise. Meanwhile, K-Mart has plenty of cash, little debt and a rich stock price -- the firm may be able to better finance expansion and leverage the venerable Sears brand name.

My staff and I look for a few key features in selecting potential takeover plays. First, we're careful to ignore potential takeover targets that look shaky or unlikely to succeed if a merger doesn't materialize. Clearly, picking takeover targets isn't an exact science. Sometimes expected deals fail to materialize. Meanwhile, in other cases the target company's stock slides sharply prior to the merger announcement due to weak fundamentals. If a deal doesn't materialize, we don't want to be stuck holding a stock that can't make a go of its business alone.

Second, we like to look for smaller companies in industries with plenty of potential acquirers. In other words, we look for industries with a major, cash-rich company like GE waiting in the wings. Companies like GE have no problem digesting small-cap stocks and can afford to pay big premiums. In addition, over the years this firm has proven to be an aggressive acquirer.

Third, it's a good idea to look for groups that are hotbeds of M&A activity. In the 1980s consumer goods ruled, and in the 1990s it was tech. Going forward, merger activity in this decade is likely to be dominated by financial, energy, telecom and technology firms.

Finally, we also like to look for stocks in industries where a recent deal has been proposed or finalized. That often raises the odds that further acquisitions will take place.

With these points in mind, below you'll find a table of likely takeover candidates. In today's article, my staff and I will review three of our favorites from this list. We believe that all three are likely to be bought up over the next few years. However, even if a deal never materializes, these companies should still be strong enough to deliver impressive gains as standalone entities.

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THESTREET.COM (TSCM, $4.46)

Business Overview

TheStreet.com operates two main businesses -- electronic publishing and research/brokerage services. The publishing business consists of a series of websites and online financial advisory products. The list includes monthly subscription services like RealMoney.com, a financial information website that's updated during the day and is aimed at more active traders.

The company sells about 16 products aimed at various financial specialties, ranging from technical analysis to short selling. Revenues from this division come from subscription fees and paid advertising. In total, the company has nearly 70,000 subscribers to its services.

The brokerage research division is aimed at institutional clients. TSCM offers research on companies and also charges commissions to execute trades.

Competitive Advantages

TSCM's main competitive advantage lies in the popularity of some of its main contributors. Jim Cramer, one of the firm's primary founders, is a well-known television personality who hosts a nightly program, Cramer & Kudlow, on business-TV heavyweight CNBC. He is also a regular contributor (several times daily) to the company's websites and publishes a premium-priced service known as Actions Alert Plus.

Other well-known contributors include Gary B. Smith, a technical analyst with regular TV appearances on the Fox News Channel and, of course, Doug Kass, a well-known hedge fund manager.

While some of TSCM's staff could certainly defect to a competing electronic publisher, we believe that's unlikely. Jim Cramer, for example, is a founding investor in the company and other contributors like Gary B. Smith have long histories with the firm. While other websites have popular commentators, few boast the breadth of well-known celebrities that TheStreet.com employs. It would be difficult for competitors to build an equally successful brand.

Growth Drivers

My staff and I see two main long-term growth drivers for TSCM. First, we like the company's new Independent Research Group (IRG) division, which offers independent stock research and a brokerage service. There has been significant interest in recent quarters in independent research; this interest is driven by recent scandals on Wall Street where bigger brokers allegedly used positive research to pump up the shares of their investment banking clients. Secondly, TSCM is leveraging its brand name to drum up brokerage business -- commission revenues have almost tripled in the past year alone.

But while its research and brokerage business holds a great deal of promise, publishing remains the firm's bread-and-butter business. In this division, TSCM has started to distribute its content via popular outside news portals like Yahoo!. That has dramatically added to the firm's brand name exposure, and we believe this move will help drive new paid subscribers to the company's website.

Acquisition Target?

TSCM strikes us as an appealing takeover target. In addition, the company recently announced that it is considering "strategic alternatives" for its business -- that's often Wall Street code that the company is putting itself up for sale. In fact, TSCM has already retained the services of an investment bank, Allen & Company, to help it identify valuable alternatives for its business model.

Even better yet, one of the company's biggest rivals in the online publishing world, MarketWatch, was recently acquired by publishing giant Dow Jones (DJ). Dow Jones, publisher of well-known periodicals like The Wall Street Journal and Barron's, purchased Marketwatch for about $18 per share -- a premium of nearly +40% to its pre-takeover price.

The final attraction of TSCM's shares is that the company's balance sheet is in good shape. Although the company is losing money on a net income basis, the firm has produced positive free cash flow over the past 12 months. In addition, TSCM has almost no debt and over $1 per share in cash. An acquirer wouldn't need to assume a host of financial obligations to take over TSCM.

There are a number of companies that might be interested in TSCM. The New York Times Company (NYT) has been building its online presence -- growth in print products has stagnated, yet the online world offers growth. TSCM would offer NYT an instant turnkey online presence. Meanwhile, Yahoo! (YHOO) already offers TSCM content on its free website but has been trying to expand its subscription business -- the company might well be interested in TSCM's paid offerings.

Outside of other publishing firms, it would be a mistake to rule out a big discount brokerage company like Schwab (SCH), Ameritrade (AMTD) or E*Trade Financial (ET). Given that all three companies have been expanding the online research they offer their brokerage customers, TSCM's research business would be an attractive fit.

Valuation and Outlook

TSCM has no earnings at this time and analysts expect the firm to deliver EPS (earnings per share) of just 13 cents in 2005. This makes the stock hard to value on either a trailing or forward P/E basis. However, we can look at price-to-sales (P/S) to get an idea how the market is valuing the stock.

TSCM is currently trading at 3.4 times sales. By contrast, MKTW was acquired at roughly 6.6 times sales. Some might argue that MKTW is a more established company and, therefore, deserves to trade at a premium. However, even applying a 30% discount to MKTW's takeover valuation, TSCM could easily trade at over $6 per share -- a significant premium to its current price.

And even if TSCM remains a standalone entity, the firm's outlook remains bright. The company produced nearly $1 million in free cash flow in the trailing 12-month period, up from negative territory in 2003. This year the firm is expected to earn about 13 cents per share, and the company's long-term growth is pegged at +30%. At that growth rate, TSCM could be earning around 50 cents per share within the next five years. Based on current prices, the stock is trading at only about 9X those earnings, very cheap given the quality of TheStreet.com's online brand.

SAUCONY (SCNYB, $27.87)

Business Overview

Saucony designs and sells footwear and athletic apparel under four main brand names: Saucony, Saucony Originals, Hind and Spot-Bilt. Although the company sells some casual footwear, its main focus is clearly on athletics and, in particular, running and walking shoes for both men and women. That includes shoes with highly specialized features, such as arch and ankle support for runners experiencing foot pain.

Outside the running shoe business, Saucony also produces specialized shoe products like soccer and football cleats. Meanwhile, through its Hind brand name the company sells athletic apparel such as sports bras and sweat-resistant shirts.

Competitive Advantages

The shoe and athletic apparel business is loaded with competitors, many of which are much larger than Saucony -- Nike and Reebok, among others, spring to mind. Despite this, however, Saucony's competitive moat is a lot wider than you might at first imagine.

More specifically, the company has garnered a solid reputation and a loyal, almost cult-like following among a core base of devoted running fans. This highly profitable niche business isn't fully exploited by the big athletic shoe manufacturers. And because reputation and brand loyalty among the most committed athletes is high, it would be very difficult for the likes of Nike to attack this niche effectively.

One of the easiest ways to gauge the strength of a consumer brand franchise is to watch trends at the retail level. Specifically, watch how many retailers stock a particular brand and what a retailer's perception of the brand is. On both measures, Saucony scores well.

A poll conducted by Sports Marketing Survey at the end of 2004 showed that 62% of the retailers surveyed had decided to carry Saucony's running shoe brands, up +11% from 2003 levels. That represented the largest jump in retail penetration among any running shoe brand. Even better, most retailers reported that they planned to stock more of Saucony's products in 2005.

As for brand perception, the same survey was enlightening. Over 90% of retailers characterized Saucony's brands as "performance" running shoes. That number was up well over +30% from what the same survey revealed in 2000. These strong numbers are a testament to Saucony's strong brand reputation in the high-performance athletic shoe business.

Growth Drivers

Going forward, Saucony's growth will be fueled by two main factors: an improving product mix and increased retail store penetration.

On the retail side, as we explained above, it's clear that more retailers are stocking Saucony brands. Simply put, that means that the company is putting its products in front of more and more consumers every year. And this trend could carry on for some time. Although over 60% of retailers carried Saucony products in 2004, it's not difficult to imagine that figure eventually jumping up to over 90%, especially given the popularity of the firm's brands. This increased exposure should result in higher sales in the years ahead.

But equally important is the company's changing product mix. Specifically, throughout 2004, Saucony experienced greater demand for its specialized running shoes than its more traditional cross-trainer lines, which it markets mainly under its "Saucony Originals" line. The company also boasts a sizeable backlog of orders for 2005, and most of that backlog is for more advanced, high-performance shoes.

High-performance lines carry fatter profit margins than simple cross-trainers. That should come as little surprise, as there is far more competition in the cross-trainer business than in the more specialized niche running shoe business. The fact that the company is seeing its fastest sales growth from higher-margins shoes is a major positive, and this change in mix has been behind Saucony's consistent margin expansion over the past several quarters.

Bottom line: Saucony is set to experience higher sales growth due to better exposure. And because the company's business mix is shifting toward more lucrative running shoes, each dollar in incremental sales will result in greater profits for shareholders.

Acquisition Target?

In August 2004, Saucony retained an investment bank, Chesnut Securities, to explore the possibility of selling the company. Although no reported bidders have emerged since that time, we believe the company will likely be taken over in the future.

There are several potential suitors for Saucony. Sporting products group K2 (KTO) has a nice stable of brand names targeted at more serious athletes in a number of different sports. That includes Rawlings baseball equipment, Phlueger fishing rods and a line of ski equipment. Saucony's running shoes might well be a logical fit in this empire, and given that KTO is about 3 times Saucony's size by market capitalization, the firm could probably afford SCNYB. KTO has also been a very aggressive acquirer of high-end sporting brands in recent years, so we know the company's management is on the prowl for acquisitions.

Even more obvious candidates include Nike (NKE) and Reebok (RBK), two multi-billion dollar shoe giants with plenty of cash to buy a small-cap name like Saucony. Both Nike and Reebok have tried to break into the high-end shoe market and have product offerings in that segment. Saucony's brand name would be a valuable addition. What's more, NKE and RBK have the scale and distribution network to ensure prominent placement of Saucony's products in major retail outlets around the country.

Valuation and Outlook

Wall Street analyst coverage of Saucony is virtually nonexistent. In fact, there are no published earnings estimates for this relatively unknown firm. As a result, institutional players own less than 15% of the company's outstanding shares -- an unusually low figure, even for a small-cap stock like Saucony. This should be a huge positive for the stock in the years ahead -- as institutions catch on to the company's impressive growth story, they're likely to start buying up shares.

My staff and I believe that Saucony can post earnings growth in the +20% to +25% range throughout the next several years. Although that's slightly below the growth rate the company has experienced over the past few years, it's considerably higher than the industry average. By comparison, analysts expect Reebok (RBK) to post long-term growth of around +14% and for Nike (NKE) to deliver annual earnings gains of closer to +13.5% --fully 10 percentage points less than Saucony.

Despite the firm's much stronger growth profile, however, Saucony has tended to trade at a steep discount to the likes of Nike and Reebok. On a price-to-earnings basis (P/E) that discount has been as high as 50% over the last few years. We think this valuation disparity will disappear in the years ahead as Wall Street finally gives Saucony the exposure and recognition that it deserves. In the meantime, investors have a great opportunity to snap up a high-growth stock at a bargain price. And in the event of a takeover, we feel Saucony could earn a multiple of about 25X earnings, in-line with its long-term growth rate. That implies a valuation north of $40 per share.

UNOCAL (UCL, $46.71)

Business Overview

Unocal is primarily an oil and natural gas exploration and production (E&P) company. The company explores for and produces gas and oil fields primarily in the Gulf of Mexico and Asia, near Thailand, Myanmar and Indonesia. Although the company pumps both oil and gas, natural gas accounts for about 70% of its total production. In total, roughly 60% of UCL's reserves are located outside the United States.

Competitive Advantages

The E&P business is highly competitive and it's hard to gain a defensible edge in this market. However, UCL's large presence in Asia represents a key advantage.

Much of the recent spike in oil and gas prices has been due to surging demand from Asia and, in particular, China and India. Consider that as Japan industrialized rapidly between 1950 and 1990 the nation's consumption of oil skyrocketed from 1 to 2 barrels per person per year in 1950 to about 18 in 1990. The U.S. saw a similar growth in demand between 1900 and 1980. With over 2.5 billion in combined population, my staff and I believe that China and India will be the primary drivers of energy demand over the next few decades.

Many of UCL's fields are located very close to this key demand center and the company has already grabbed some of the region's key locations. Although several major oil conglomerates also have exposure here, UCL has an enviable position very close to its key future market, namely Asia.

Growth Drivers

As we mentioned above, a sustained rise in oil prices should be a key growth driver for UCL in the years ahead. Specifically, the world has seen only very slight growth in oil and gas production since 1990. Meanwhile, demand has skyrocketed. China, once a net exporter of oil and gas, now imports both products. India is in a similar boat.

That makes existing oil reserves all that much more valuable. UCL should be able to continue to sell its oil and gas reserves at relatively high prices. Most of those profits will flow right to the bottom line -- over the trailing 12-month period, UCL generated nearly $2 billion in operating cash flows, almost 20% of its total market capitalization.

Acquisition Target?

Two factors drive UCL's attractiveness as a takeover target. First, the stock, like most in the oil exploration and production group, is relatively cheap. Analysts estimate the company will earn over $4 in 2004, giving the stock a P/E of less than 12. Long-term growth estimates have been ticking higher in recent months, with some analysts calling for long-term growth of as high as +15%, assuming oil prices remain above $30 per barrel over the next few years. The stock's cheap valuation makes it a logical target.

Secondly, the company's Asian exposure is a big plus. Firms like ExxonMobil (XOM) and Royal-Dutch Shell (RD) have been trying to find new reserves in Asia to feed growing regional demand. UCL's sizable reserves in the region would be a mouth-watering asset.

There has been rampant speculation in recent months that the Chinese National Offshore Oil Company (CEO) is interested in acquiring UCL. In our view, that deal would make considerable sense financially. CEO is China's dominant producer of oil and natural gas offshore of that nation; in fact, it's the only company licensed to explore many of these reserves. UCL's reserves in the same region would be a logical add-on to CEO's business.

Global integrated oil companies like ChevronTexaco (CVX), ExxonMobil and Royal-Dutch Shell might also be interested in UCL. All of these companies are many times UCL's size in terms of revenue and market cap, so the company would be fairly easy to acquire. Although these major integrated names have been using profits generated by high oil prices to pay down debt in recent years, this de-leveraging process is largely complete. As such, these companies are likely to use their cash in other ways over the next few years, making M&A activity that much more likely.

Valuation and Outlook

With a P/E of less than 12, UCL's valuation has plenty of room for to expand. Although Wall Street has been very slow to ratchet up earnings estimates for E&P stocks, there's a growing realization that estimates are too low and are likely to continue rising. Given long-term growth of about +15% and solid cash flow generation, UCL could trade north of 15 times earnings this year, putting the stock at about $60.

In the event of a takeover, most analysts are looking for UCL to sell its Asian operations separately from the rest of the business. Most estimates suggest UCL could get about $12 to $15 billion for the Asian assets with another $5 billion from the U.S. operations. Taking the low end of that range, $17 billion, UCL stock would be worth about $65 per share.

In the meantime, UCL's management team is likely to continue reducing the company's debt burden and we wouldn't be surprised to see a dividend hike or share buyback program. These steps will make the shares even more attractive for an acquirer.

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We sincerely hope you've enjoyed today's look at three high-quality acquisition targets. Please stay tuned for our next full issue, which we'll publish on Monday, February 7th. In it, my staff and I will bring you a closer look at five promising stocks that we haven't covered extensively before, but that we're now considering adding to our various model portfolios. Good investing in the week ahead!

Paul Tracy will be available for questions until Friday, February 11. Don't miss this chance to ask your questions using the below form.