Takeover Targets

WMC, Southcorp, Pacific Hydro . . . what will be the next takeover target on the ASX? With luck, 2005 could still be another great year for profitable takeover activity. Smart investors can exploit this market without taking undue risk. Here's how.
Nothing stops the power of a good idea, and it is much the same with takeovers: they may not always be easy, and they can result in short-term dislocation for staff structures, but a well thought through takeover bid usually succeeds.

The stage is set for a lot more takeover moves: interest rates remain low, the stockmarket is still well priced and, crucially, there is a hint of takeover fever in the air.

The textbook takeover of Melbourne mining company WMC by BHP Billiton earlier this year might just have been the deal that lit the spark of a new takeover era. BHP Billiton and WMC shareholders, along with stockmarket analysts, lauded the takeover because it made perfect sense for both companies. The only thing that stopped the $9 billion deal getting full marks was the insistence of BHP boss Chip Goodyear that it would be cash only.

The perfect way to play the takeover game is to invest in stocks that, as well as being good value anyway, have the added attraction of being likely takeover targets.

The total value of Australian-based takeovers in 2004 was $163 billion. The first six months of the calendar year are, traditionally, the slowest period for merger and acquisition activity, though this year's first half showed an acceleration in activity. Takeover activity in the six months to June 30 (calculated at $A1 to US75¢) involved about $63 billion, up 6.8 per cent from $59 billion for the same period last year.

After WMC, the biggest takeover bids this year have been Foster's $3.2 billion for Southcorp and IFM's $788 million for Pacific Hydro.

Takeover activity could involve almost any of the 1600 stocks on the ASX, and there are quite a few good-value targets.

First, targets must meet quantitative criteria. They must be good value or, at the very least, have a price tag that can justify the chief executive of a predator company mounting an offer. Ideally, a predator should be able to finance the takeover with the earnings of the target.

On a range of market variables, many ASX stocks are good value in that they are trading below the long-term average market ratios. Assessing quantitative criteria is the easy part (more on that later); it is much harder to assess the qualitative criteria.

Questions that need answers include:

• Is there a predator big enough to buy the company? For example, who would buy Commonwealth Bank?

• Is it possible to get shareholder agreement? Who could persuade Gerry Harvey to sell his controlling stake in Harvey Norman?

Quantitative criteria help find realistic takeover targets, but qualitative criteria best indicate the likely course of events should a bid be launched. And don't ever forget that stockbrokers and investment bankers are constantly stoking takeover speculation.

Over the past decade, several stocks have been subjected to takeover false alarms. In 1996, the Australian Financial Review announced on its front page that Standard Chartered Bank was to buy ANZ. In the same year, The Australian announced that Heineken was to buy Foster's Brewing. Sure, there's no smoke without fire, and there was low-level activity in each case, but nothing came to pass.

More recently, there has been talk that publisher John Fairfax and Company has been in discussions with the Ten Network and the West Australian Newspapers Group, but so far there are no takeover proposals.

How should investors react to such reports? With caution. The fact is, companies in the same industries have myriad interlocking objectives and agendas '” not to mention senior executives who move with ease from one employer to another. What can safely be drawn from the news reports on John Fairfax is that the media industry is a likely sector for takeover activity; and that Fairfax (as predator or target) almost certainly will be at the heart of it.

Earlier this year, Bruce Rolph, an analyst at Citigroup Smith Barney, did extensive quantitative analysis on takeover targets. Rolph burrowed through the ASX looking for key indicators. In one exercise, he listed his top stocks on the basis of selling on a low price-to-book ratio. The table below is based on Rolph's work - the targets trading on the lowest price to book are at the top of the list.

This list illustrates that many stocks might meet quantitative criteria but are non-starters on the qualitative dimension.

Qantas, for instance, on a price to book of just 1.03, might well be cheap, but a takeover bid would run into a blizzard of government red tape.

Now, take a look at the ASX for companies that have under-performed their "domestic and global peer group". Citigroup pointed to a different set of stocks. Here are the first 10 that emerged from that process:

Minara Resources, Alumina Ltd, Iluka Resources, Lihir Gold, Oil Search, Santos, Fairfax Holdings, Seven Network, Austereo Ltd and CSR Ltd

Though this selection was made on quantitative criteria, it has thrown up a vastly different list from those in Rolph's qualitative list. And only Austereo is in each.

These lists show that, even within the strict confines of quantitative analysis, a wide range of stocks could be takeover targets.

Qualitative analysis of the second list would reveal obstacles to any predator. For example, any company hoping to take over the Seven Network would have to reach agreement with television mogul Kerry Stokes.

Nevertheless, the two lists offer fascinating snapshots of under-priced ASX stocks, some of which could soon become takeover candidates.

When searching for stocks that could ultimately carry a takeover premium, the first step is to examine those that are good value anyway, the gamble being that technical aspects of the stock will attract a predator. Although the two quantitative tables singled nearly 20 stocks, there are literally dozens that carry quantitative or qualitative attractions for predators.

Another way into takeover action is to buy stock in a target after a bid has been announced. This is speculative investing and best left to hedge funds '” which is why it is worth knowing how hedge funds play the numbers game in such situations.

For example, MM&E Capital, a Melbourne-based hedge fund, works on the principle that, if it buys stock in an announced target, there is a 45 per cent chance of making a 17 per cent return as long as a rival offer is made. Tom Elliot, managing director of MM&E capital says there is a 55 per cent chance of losing 2 per cent if a rival offer is not made.

Takeovers come in waves. The spurt of activity in the mining industry '” led by the takeovers of WMC and Portman Mining'” is a reliable indicator that more action is imminent. In the 1990s, the Commonwealth Bank bought the State Bank of Victoria in exceptional circumstances, the state-owned Melbourne-based bank being in parlous circumstances. Within a decade, the entire regional banking sector had been swept up in a torrent of takeover activity.

In the space of about five years, many regional banks, including Challenge Bank in Perth, the State Bank of South Australia in Adelaide, the Bank of Melbourne, Advance Bank of Sydney and Metway Bank of Brisbane, disappeared, snapped up by larger rivals.

Something very similar could occur in selected areas of the ASX in coming months, the most obvious takeover hot spot being mining, followed by metals, industrials and media.

Assuming that you wish to avoid the hedge fund strategy, the smartest way forward is to look for quality stocks that offer a quantitative basis for long-term investment yet also have the added prospect of a takeover premium if circumstances change and predators come into the market.

ACTION PLAN

Long-term investors looking for good-value stocks that may offer the additional prospect of a takeover premium should seek cheaply priced blue-chips or well regarded small to medium size companies.

If you want a takeover target that will also serve as a good investment, then, on a quantitative basis, the company must be trading cheaply. Indicators of "cheapness" include a reasonable price-to-book ratio (ideally less than 1.5) or companies trading at a discount to their peers either in local or global markets.

Whether a takeover offer will emerge will depend on qualitative criteria. Get answers to the following questions. Is there a feasible predator locally or overseas? Would there be legal or regulatory restrictions to such a deal? If there is a controlling shareholder, would this key player be willing to sell?

Working with these questions in mind, here is Eureka Report's top 20 takeover targets for 2005: