Takeover Targets

12/30/2005 12:00 am EST

Focus:

Richard Moroney

Editor, Dow Theory Forecasts

"Buying stocks solely on takeover appeal is dangerous," cautions Richard Moroney in Upside. "So, takeover-minded investors should emphasize quality stocks with appeal based on both operating momentum and acquisition potential." Here are his favorites.

"To find such doubly appealing names, we designed a takeover screen based on certain characteristics. First, we looked for Solid Quadrix scores, which is our proprietary rating system. We screened for companies with above-average scores for Quality, Financial Strength, and Overall. We also look for a low enterprise multiple.

"Commonly used in value and takeover screens, the enterprise multiple compares the total value of a company to its cash flow. Often what matters most to a potential suitor is cash flow, since cash flow can help service the debt needed to fund a buyout. Here, we have uncovered several reasonably valued takeover plays, all of which have solid Quadrix scores, below-average enterprise multiples, and strong underlying fundamentals.

"Biosite (BSTE NASDAQ) develops tests that improve physicians’ ability to diagnose diseases. The core Triage product is used in one-half of US hospitals. For 2006, the company says it expects 10% sales growth and per-share profit growth of about 7%. Management has a history of issuing conservative guidance, and the 2006 growth targets appears beatable. Biosite’s Overall Quadrix score is 83, with an impressive score of 95 for both Quality and Financial Strength. The company has little long-term debt and nearly $7.50 per share in cash. With an enterprise multiple of 8.9, about half its industry average, Biosite seems cheap and remains a Buy.

"First Cash Financial Services (FCFS NASDAQ), an operator of pawnshops and check-cashing stores, has an enterprise multiple of 9.1, compared to 12.6 for the average consumer-finance firm. Over the last three years, per-share earnings have grown at a 25% annualized rate, reflecting robust loan volumes, improved fee revenue, and an expanding store base. Strong cash flow has allowed the company to increase its cash position while adding new locations. The company is ramping operations in Mexico. First Cash earns a 92 Overall score, keyed by an 87 in Quality and 95 in Financial Strength. The stock is a Best Buy.

"Selective Insurance (SIGI NASDAQ) sells property and casualty insurance through roughly 750 independent agents in 20 Eastern and Midwestern states. It operates in a highly competitive industry with significantly larger rivals. But Selective has a reputation for excellent service, helping it retain profitable accounts. The company boasts solid finances and carries an A+ financial-strength rating from A.M. Best—an important selling tool. Selective earns a 98 Overall score, ranking it near the top of the 78 property and casualty insurers in Quadrix. Selective is rated Best Buy.

"At 8.6, the enterprise multiple at West (WSTC NASDAQ) is well below the commercial services group’s average of 10.7. West is a leading provider of outsourced communication solutions. In June, West acquired Sprint’s conferencing-related operations for $207 million. Looking ahead, results should benefit from market-share gains and a shift toward such higher-margined services as receivables management. For 2006, Wall Street expects per-share earnings of $2.03—up from $1.63 last year. For 2006, the consensus estimate is $2.29. With healthy earnings growth likely through 2007, the stock seems undervalued at 18 times projected year-ahead profits. West is rated Buy.

"Zygo (ZIGO NASDAQ) manufactures and sells high-performance optical systems and components used in the auto, semiconductor, and aerospace and defense industries. In addition, sales should benefit from moves into faster-growing, higher-margined markets like flat-panel displays. A rock-solid balance sheet with no long-term debt provides a strong foundation for growth. Still, the stock comes with some risks. Several of the company’s end markets are extremely cyclical, and Canon accounts for more than one-third of revenue. The stock trades at an enterprise multiple of 9.3, compared to 10 for the average company in electronic manufacturing services. Zygo is rated Buy."

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