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It is often said that you should never invest in a stock in hopes of a takeover, but I find that to be fundamentally wrong, as your rationale for picking a potential takeover target should use much of the same analysis being used by prospective buyers, whether it be publicly traded companies, private equity, or other interested buyers.

I have always had a great eye for takeover targets, putting aside the daily market chatter and rumors that amount to nothing 99% of the time. Combining a very basic approach in fundamental analysis (valuation metrics such as forward P/E, price to cash, price to cash flow, and EV/EBITDA) along with the current trends in recent M&A deals can lead to great stocks, whether eventually acquired or not, that will outperform the broader market.

The market is nearly 20% off its recent highs and although I am in the camp that expects another 10% move down in the market, a lot of compelling values are starting to surface across all industry groups. Private Equity is on the prowl, LBOs are coming back around, and public companies are sitting on piles of cash looking to invest in growth initiatives and for business diversity purposes, trying to generate returns for investors.

The recent M&A trend has seen substantial takeover premiums paid and a few bidding wars have developed. The current hottest industry is medical devices where there have been more than 5 deals in the past month alone.

For the purpose of this analysis I will be looking at companies with less than $10B market caps, as I do not expect a wave of massive deals as credit markets tighten. I will break this down by the major sector groups as an easy way to look at relative valuation.

Basic Materials

Lubrizol (LZ) has a $5.36B market cap and trades 8.8X earnings, 2.55X book, and 8X free cash flow. With nearly $1B in cash on the books and a debt/equity ratio of 0.65, Lubrizol is a potential leverage buyout (LBO) play. As a niche play in chemicals and additives the 30% growth in sales quarter over quarter is attractive to potential suitors.

Dril-Quip (NYSE:DRQ) is a $1.77B market cap company that provides offshore drilling equipment, and shares have come under pressure with the uncertainties surrounding offshore drilling. Shares trade 14.6X earnings, 2.4X book, and 21.7X free cash flow with zero debt on the books and $150M in cash assets. The recent weakness in offshore related names is likely to bring in the "big oil" names hunting for valuable assets, and along with Ensco (NYSE:ESV), Rowan (NYSE:RDC), and Pride (NYSE:PDE), Dril-Quip is an attractive target.

Consumer Goods

Nu-Skin Enterprises (NYSE:NUS) is a $1.56B maker of personal care products with shares trading 11.75X earnings, 3.9X book, and 15.5X free cash flow. As a growth play in personal care it makes a nice target for a Procter and Gamble (NYSE:PG) or Estee Lauder (NYSE:EL).

Energizer (NYSE:ENR) is a $3.55B maker of batteries and other personal care products, and shares are very cheap at 8.9X earnings, 1.85X book, and 6.75X free cash flow. The Company has $370M in cash on the books and a debt/equity ratio of 1.25, mainly long term debt, and is another potential LBO target.

Financial

RenaissanceRe Holdings (NYSE:RNR) is a reinsurance provider that trades 6.7X earnings, 0.84X book, and 5.55X free cash flow with a $3.2B market cap.

Aspen Insurance (NYSE:AHL) is a reinsurance provider that trades 6.75X earnings, 0.61X book, and 4.8X cash flow (2.73X cash value). At a market cap of $1.9B Aspen is an easy target in an industry that was hot with M&A a few months ago.

Healthcare

Medicis (MRX) is a $1.33B market cap producer of dermatology products and trades 9.8X earnings, 1.75X book, and 2.4X cash value. The Company has some of the top technology advancements in it's industry and is on the verge of being a top growth play.

Forest Labs (NYSE:FRX) has had its share of problems the past year but still has a deep pipeline and with a $8.2B market cap, and trading just 2.5X cash value, 8.3X cash flow, and 6.9X forward earnings it is a value that can not go unnoticed. It would require a fairly large deal here, but the Company would likely be willing sellers after recent set backs.

Staar Surgical (NASDAQ:STAA) and Dexcom (NASDAQ:DXCM) are two niche plays that did not make the valuation cut but appear to be interesting targets. In Biotech I see Seattle Genetics (NASDAQ:SGEN) as a prime takeover target, along with Alexion Pharma (NASDAQ:ALXN).

Industrial

Chart Industries (NASDAQ:GTLS) is a $431M market cap maker of industrial gases and other equipment with shares trading 9.88X earnings, 0.91X book, and 2X cash value with a 0.5X debt/equity ratio. The Company has grown earnings at nearly a 20% clip the past 5 years and is a market share leader in all its business lines.

Snap-On (NYSE:SNA) is a $2.33B market cap maker of small tools and a name I feel should have been the target of Stanley Works (NYSE:SWK), instead of Black and Decker (BDK). Shares trade 11.3X earnings, 1.85X book, and 10.7X cash flow. With a debt/equity ratio of 0.72 and nearly $500M cash on the books it could fall into the LBO category.

Consumer Services

Brady Corp (NYSE:BRC) is a $1.3B market cap makers of signs, labels, and other identification products, a very specific industry. Shares trade 12.25X earnings, 12.8X cash flow, and 1.3X book value. Consistent earnings growth and a leader in its industry, Brady is a buyout waiting to happen.

Technology

Monolithic Power (NASDAQ:MPWR) is a $633M market cap specialized semiconductor play trading 12.4X earnings and 3.6X cash value with 30% growth rates. With its recent patent victory, the overhang is gone and it makes for an attractive takeover target.

Informatica (NASDAQ:INFA) is a $2.18B market cap software maker trading 6.16X cash and 21.7X cash flow, a bit rich on valuation but in a hot industry of data warehousing, and growing earnings at a 20% rate quarter over quarter.

Utility

NRG Energy (NYSE:NRG), after a failed takeover bid, remains a great value with a $5.36B market cap at 0.65X book, 2.95X cash and 3.9X cash flow. At this valuation it should not be long before another Company comes to the table looking to takeover NRG's assets.

***

These are the names I came across as the top potential takeover plays among the more well known stocks, and at the very least are great value plays. This is intended to be a starter list, and more due diligence and analysis is required to slim down this list, but I will be watching M&A action closely the next year and will continue to observe the trends and try and catch a few more buyouts, always a great feeling.

Disclosure: Author is long STAA, DXCM, LZ, SGEN, and SNA

Source: M&A Market: Potential Acquisition Plays in Each Sector