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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

How to Play the Buyout Game: 3 Tips For Finding the Best Deals

Wall Street can be so predictable sometimes. 

A company announces an acquisition. The buyer's stock almost always takes a big hit, and the seller's stock almost always surges. 

Because some deals never end up generating the profits promised by management, most investors choose to shoot first and ask questions later. But by asking yourself these questions first, you can do a better job of figuring out when to buy, hold or sell. 

The key issue for every investor looking at a merger or acquisition target is to decide whether the company is articulating a compelling reason for the deal.  If so, you can bet it will boost profits in short order. 

Most companies want to make "accretive" deals, meaning earnings per share (EPS) once the deal is integrated, hopefully within a year or two. "Dilutive" deals, which hurt per share profits, are rarely the intended outcome. But unfortunately, some deals expected to be accretive turn out to be dilutive when management over-estimates the projected benefits of a key acquisition.

I have personal experience with this phenomenon. As a former Wall Street analyst, I once recommended clients sell shares of a magazine distributor called Source Interlink. The company announced a deal that, in management's view, would be very accretive. I, however, thought otherwise. 

I believed the deal would actually be dilutive because management had unrealistic goals (by the way, this ended up causing me a great amount of grief -- Source Interlink threatened me with a lawsuit). Lucky for me (and my reputation), my analysis was correct and the company eventually declared bankruptcy.

If you know what to look for, some of the best investment ideas can be found among sold off suitors.  When an acquisition is announced, buyers can be sold off in a knee-jerk fashion. But if these companies can make a clear case that a deal will be accretive, savvy investors will benefit from both a cheaper stock and a brighter profit outlook. 

So here's what to look for to see if a deal is really going to be accretive:

1) Feasibility of cost cuts -- Many companies look for targets with redundant manufacturing capacity or a bloated cost structure. If costs can be cut when the two entities are combined, the acquiring company is likely to generate impressive returns on investment (ROI). 

If this is the acquirer's strategy, play close attention to management's discussion when they announce the deal. They will usually be very specific in terms of cost-cutting targets. Most times, those cuts do take place, and can be counted on as part of your analysis.

Cost cuts are a key factor behind Hertz's (NYSE: HTZ) newly-announced decision to sweeten its offer for Dollar Thrifty (NYSE: DTG), which I discussed last week.

Hertz has made a very clear case that it can eliminate many redundant costs and the purchase -- even at this higher price -- will be accretive. That's why shares of Hertz surged +7% on Monday. 

2) Ability to cross-sell -- Management is often very bullish about selling Company A's products to Company B's customer base, and vice-versa. But this is probably one of the biggest buyout myths.

Deals that rely on cross-selling can actually benefit rivals instead. That's because mergers almost always lead to an interruption in the sales force.  Each sales team takes a step back to get trained on the other company's products. But customers may not be inclined to wait weeks or months for a pitch on the new broader product line. And then they are susceptible to fresh proposals from rivals.

Cross-selling has been a key factor behind Dell's (Nasdaq: DELL) recent decision to buy data storage company 3PAR (NYSE: PAR). Dell figures it can add another arrow to its quiver when pitching a broad suite of products to clients. Trouble is, if those clients already use another vendor for data storage, they are not likely to terminate all those other relationships just because Dell can now service all their needs. 

3) Buying with cash vs. stock -- How a deal is financed can make all the difference. 

If new shares are issued to the acquired company, the buyer will need to generate even higher profits (on a percentage basis) to make the deal accretive. For example, if a deal is expected to boost sales and profits by +8%, but the share count will also expand by +10%, then EPS will be lower, and the deal is dilutive. 

But if a deal is paid for with cash (not borrowed money, but cash sitting on the balance sheet), then the hurdle is much lower. Dell was earning scant interest on its cash, so even if its 3PAR acquisition is underwhelming, it is still likely to generate more profits than the interest earned on the parked cash. (Though in this instance, Dell can be criticized for paying a very high price -- it probably could have found a better way to boost profits, such as with an aggressive buyback of its own stock.) 

We've covered a lot of ground here on the latest buyout news. If you want to continuing learning about the exciting world of mergers, acquisitions and buyouts, check out How to Profit From Frontrunning LBOs and Tips on How to Analyze an Acquisition Announcement.