Three Takeover Targets to Take Aim at

Deals are driving prices higher, so making money should be easy—theoretically. Here are stocks (and target prices) that are worth watching.

Acquisition frenzy is upon us. August is on a path to be the second-biggest August ever for corporate takeovers. Making a profit as one of these deals drives a stock's price up ought to be as easy as shooting fish in a barrel.

Except it's not.

Many of the barrels are devoid of deals: Fire away as you like at these sectors, but you won't hit anything. Others are full of minnows: Nothing you hit is going to be worth the ammo.

There is a way to improve the odds, though.

If you understand the reasons behind the surge in acquisitions, you can figure out where the big fish might be hiding. (For more on the acquisition boom, see "Time Is on Investors' Side.")

That can help you eliminate some barrels and prioritize others.

Using that process, I've come up with three acquisition candidates that I think are worth putting in your gun sights.

Why They're Buying

Two motivations are driving this acquisition trend.

For companies and their CEOs, acquisitions mean a shot at higher profits in two ways. First, there's industry consolidation. You're probably familiar with this story; it's the motivation for deals such as BHP Billiton's (NYSE: BHP) $40 billion hostile bid for Potash of Saskatchewan (NYSE: POT).

Consolidation works to increase profits because it eliminates competitors who might have been tempted to cut prices to grab market share, and it produces significant increases in profit margin as companies shutter inefficient facilities, combine redundant operations, and reap efficiencies of scale.

There's also the advantage of vertical integration. A company that can make steel, supply the iron ore and metallurgical coal that making it requires, do the trading to buy these and other necessary raw materials, sell the finished product, and maybe even transport it has the opportunity to capture more of the "value chain" than a company that specializes in just one of those functions.

The effort to add the last piece of this structure—the internal trading operation—is also behind many of the cross-commodity acquisitions of the past year or so. If an iron miner and steelmaker wants to build a trading operation, buying an oil producer makes sense because it increases the company's trading clout in the global markets.

Understanding this motivation won't help much in indentifying barrels full of fish, but once you've selected the barrels to shoot at, any fish you aim at should be an acquisition target that helps an acquirer apply this logic.

But Which Sectors?

To find the barrels themselves, look at motivation number two for acquisitions.

For companies, especially in state-controlled, state-funded, or state-influenced industries, acquisitions are a way to gain access to raw materials in a world where ready supplies of commodities at reasonable prices are by no means guaranteed. Can't run a steel industry without iron ore or metallurgical coal. Can't make a profit in that steel industry if the prices of raw materials—from independent suppliers that want to make a profit themselves—keep rising. Acquiring the supplies and suppliers of the raw materials you need solves these problems.

This is the logic that can help you identify the right barrels to aim at.

And I think it points at three barrels: Iron ore, metallurgical coal (used in turning that iron ore into steel), and thermal coal (the coal used by utility power plants).

NEXT: Quest for Iron Ore; Great Coal Rush

The Quest for Ore

Virtually everybody—from Brazil's Vale (NYSE: VALE) to India's steelmakers to China's state-controlled steel companies—is buying iron ore producers you've never heard of in countries you've never thought of as iron ore producers.

For example, last week Xstrata (OTC: XSRAF) agreed to a $381 million acquisition of Sphere Minerals (OTC: SVESF), an Australian mining company with iron ore deposits in Mauritania. Mauritania is the only West African country that exports iron ore, but, according to the US Geological Survey, the region has the potential to produce 10% of the world's iron ore supply.

If you invest in the commodity sector, you know that China has been aggressively buying iron ore reserves. But it's not just China. Pretty much every developing country with a steel industry (and that means just about every developing country) is in the hunt.

For example, Saudi Iron & Steel, the largest steelmaker in the Persian Gulf, is on the hunt again. In 2007, Saudi Iron & Steel's parent, Saudi Basic Industries, also known as Sabic, pulled out of a deal to develop an iron ore mine in Mauritania. Now, with the company looking to increase its steel production to 16 million metric tons by 2020—it stood at 5.5 million metric tons at the time it canceled its Mauritania deal— Sabic is combing through Africa looking for other iron ore deals.

Coal Rush, Part One

Just as there's no steel without iron, you can't make steel without metallurgical coal. As you might expect then, if there's a global iron ore rush, then there's also a global metallurgical coal rush.

For example, ArcelorMittal (NYSE: MT), the world's biggest steel producer, bought a 14.9% stake in Australia's Macarthur Coal (OTC: MACDY) for $560 million in May. The acquisition is part of the company's strategy to lift its 15% self-sufficiency rate in this type of coal. (Macarthur is the world's largest producer, according to the company's Web site, "of low volatile pulverized injection coal used for steel making.") At the end of June, ArcelorMittal increased its stake in Macarthur to 19.9% after talks on a possible takeover ended without a deal.

Coal Rush, Part Two

And lastly, there's good old thermal coal. About 80% of China's power plants burn coal to produce electricity. For India, the figure is 70%. And coal demand is growing—about 4% to 6% annually in China, for example.

Over the past five years or so, coal supply has kept up with demand, thanks to rapidly expanding production in China, India, Indonesia, Australia, and South Africa. But looking forward, that period of rapid supply increases seems to be drawing to a close as problems such as insufficient infrastructure dampen growth.

Coal production in Indonesia, for example, which grew 80% over the past five years, is projected to grow just 20% over the next five. In Australia and South Africa, port and rail capacity will require heavy investment to avoid becoming a bottleneck constraining growth. In India, an inadequate rail system means that the country will rely on imports to fill part of its needs. Supply and demand in China will remain in balance in 2010 and 2011, but after that, supply will struggle to keep up with demand for coal-powered electricity.

So in this sector, too, there's a global race to secure demand that has seen Chinese, Indian, and US companies such as Peabody Energy (NYSE: BTU) rush to buy stakes in the coal sectors of Australia and Indonesia, in particular. (For more on Peabody, see my blog post "Peabody's the name if Asian coal is the game.")

NEXT: Three Takeover Targets to Watch Now

Taking Aim

So if those are my three barrels, what fish would I aim at now?

Some we can eliminate quickly. I think you're late to the game in iron ore. The companies being acquired now are very small and very speculative. I think the risks here outweigh the gains. Indonesia would be very attractive for fish shooting, except that the government's policies restrict foreign ownership. Joint ventures, minority stakes, yes. Takeovers, no.

My top three acquisition plays?

• Macarthur Coal looks like it may become the focus of a bidding war between ArcelorMittal and Korean steel giant Posco (NYSE: PKX). ArcelorMittal's stake is up to 19.9%. and Posco recently bought a 10% position.

• Whitehaven Coal (OTC: WHITF) is certainly behaving like a stock that's in play. The company has been linked to rumored deals with Posco, Xstrata, Peabody Energy and Macarthur (with Whitehaven acquiring Macarthur and vice versa). The company has said that it is in talks but not with whom or about what sort of deal.
  The company is a producer of high-quality thermal coal and is one of the few Australian coal miners that doesn't yet have a connection with an overseas strategic investor.

• Walter Energy (NYSE: WLT) is a US producer of hard coking coal for the steel industry. Production in the second quarter came to 1.54 million metric tons, an increase of 31% from the second quarter of 2009. For the third quarter, the company projects production of 17 million to 19 million metric tons of coking coal. The April 2009 spinoff of the company's financing business certainly enhanced the attractiveness of the company as an acquisition.

It's easy to get giddy about potential profits as an acquisition drives up stock prices and say, "I'll buy at any price." But you'd really like to buy at a reasonable price so that if a deal doesn't materialize, you've still got a good shot at making money on the company's fundamentals.

I'd look to buy Macarthur Coal at $21.50 a share or below, Whitehaven Coal at $5.70 or below, and Walter Energy at $70 or below. They're all well under those prices now.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

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Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.