Takeover Trio in Healthcare

08/07/2015 9:00 am EST

Focus: STOCKS

Richard Moroney

Editor, Dow Theory Forecasts

Betting on takeover speculations is a good way to lose money on stocks with inflated valuations, cautions Richard Moroney, editor of Upside, which specializes in small- and mid-cap stocks.

But looking for an attractively valued grower with a takeover kicker can make sense, especially in an environment of rampant deal making.

One way to estimate a company’s appeal to potential suitors is its enterprise ratio, which approximates a company’s total value relative to its earnings power.

The enterprise ratio equals stock market value plus debt, minus cash (enterprise value), divided by earnings before interest, taxes, depreciation, and amortization (EBITDA).

Healthcare has been the busiest area for mergers this year and Lannett (LCI), a generic drug firm and ICON (ICLR), a contract research organization, are rated Best Buys within the sector.

Economies of scale are crucial for generic drug makers, known for their tight profit margins. Lannett’s strong balance sheet and free cash flow could win the affection of large, growth-starved drug makers.

ICON performs clinical trials for healthcare companies and could attract a larger contract research organization or a provider of diagnostic testing services.

ICON has a close relationship with Pfizer (PFE), accounting for about one-third of ICON’s sales. ICON’s balance sheet, supported by $155 million in free cash flow generated over the past year, offers net cash close to $3 per share.

In addition, the managed-care industry is lurching toward consolidation. The five biggest health insurers may soon become three in order to gain market share and improve negotiating leverage with hospitals, which have undergone their own wave of mergers.

Even without such consolidation among the industry’s big players, Health Net (HNT) is a potential takeover target.

Health Net’s medical membership has grown 9% over the past year to 6.0 million, primarily from the US military’s health system Tricare, Medicaid, and commercial plans. Both stocks are rated Best Buys.

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