By David Sterman
For private equity (PE) firms, 2011 is the year of goldilocks -- everything's just right. Interest rates are low, the increasingly stable economy is pumping up corporate cash flows, and if you look hard enough, real bargains can be had.
The key for PE firms (also known as leveraged buyout shops) is to find companies that throw off lots of cash flow and also come with very healthy balance sheets. That way, a company can be acquired with its own cash and new loans, putting the buyout firms on the hook for only a moderate amount of upfront cash. Ideally, they look to take these companies public again a few years later (though with much weaker balance sheets by then). That's what has happened to the likes of Hertz (HTZ), hospital chain HCA (HCA) and Burger King (BKC).
A little sleuthing has revealed a list of companies that may now be in focus for a major deal in 2011. These companies are big enough (with a market value above $750 million) but not too big (with a market value of less than $15 billion) to appeal to the PE crowd. Just as important, these companies carry more cash than debt and have ample additional borrowing capacity. Lastly, these companies are so robust that free cash flow ((FCF)) is surging, yet their valuations remain reasonable.
Every stock in this group sports a FCF yield in excess of 10%. With that kind of yield, and the ability to sell bonds against them at 6% to 8%, these deals would be winners right out of the gate. Also, these companies are so robust that you can invest in their stocks even without hoping for a buyout. On a standalone basis, they're quite attractive.
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Not only private equity
Of course, the companies on this list would make compelling strategic acquisitions as well. Just this week, specialty drug maker Valeant Pharma (VRX) offered a hefty premium to acquire biotech outfit Cephalon (CEPH), which offers a powerful 12.7% FCF yield. That means the deal is likely to make money for Valeant right away, assuming the deal is approved. Looking at potential company-to-company transactions, telecom networking gear maker Tellabs (TLAB), business software developer Blue Coat Systems (BCSI) and Teradyne (TER), which makes equipment used to test semiconductors, all would bring steady customer bases and stable, recurring sales and profits.
On several occasions in the past, I've noted that technology companies such as Symantec (SYMC) or Western Digital (WDC) would be no-brainers for the PE crowd. I also think H&R Block (HRB), which has struggled badly in recent years, is the perfect PE play, as the bad news appears to be at an end and the company's valuations are quite low.
Of course, potential acquirers want to know that cash flow will remain stable well into the future. That's why I think companies such as AOL and The Washington Post Co. (WPO) are unlikely to be pursued. Cash flow at their core businesses appears to be steadily declining, so don't be tempted by the seemingly high FCF yields.
The for-profit education stocks may also start to get the attention of PE firms. The industry took many blows in 2010 as legislators grew concerned over weak graduation rates and even weaker student loan repayment rates. The resulting industry scrutiny has pushed shares of stocks such as Bridgepoint Education (BPI), Apollo Group (APOL) and ITT Educational Services (ESI) to the point where they sport 15% to 25% FCF yields. If investors grow concerned that the industry will stabilize in coming quarters and years, then those high FCF yields are bound to attract interest.
My number One PE play is Power One (PWER). This maker of high-tech power supply equipment had staged a remarkable comeback, as its shares surged from around $1.25 in early 2009 to $12 in early February 2011. That gain was fueled by a sharp 142% jump in sales in 2010 to just above $1 billion. Even more impressively, FCF grew from $47 million in 2009 to $180 million in 2010.
Since early February, investors have soured on the stock, causing it to fall nearly 30% in the past two months. The main concerns stem from slowing demand for solar power equipment in Italy, a key market for Power One. Analysts now think sales growth will cool to just 16% this year, and profits will likely be flat as pricing and margins take a hit.
Yet many investors, including the PE shops, really want to know how business will fare down the road. And on that front, the outlook for Power One remains quite bright. Dougherty & Company thinks shares will steadily move back up beyond to those early February highs to $14: "We believe the company is setting itself up for beat and raise quarterly results in 2011. The company has strong margins, is gaining market share, and its core solar market is expected to grow above 20% for several years."
Dougherty's price target implies a 2012 price-to-earnings (P/E) multiple of just 10. Private Equity firms would likely note that the company's FCF multiple could approach 25%, based on improving 2012 results.
The charm of high FCF yielders is that they are more likely to hold up if markets turn south. Only a few of these stocks will actually get acquired in 2011, likely delivering quick and hefty gains to shareholders, but virtually all of them hold appeal on a standalone basis as well. A buyout would simply hasten the time period for these stocks to appreciate.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.