Four Firms Ripe for the Taking

Drug giant Pfizer is planning to buy Wyeth, and Merck has a deal to acquire Schering-Plough. Outside of Big Pharma, Suncor Energy is purchasing Petro-Canada, and IBM is said to be in talks to scoop up Sun Microsystems. Meanwhile, Warren Buffett is reported to be on the lookout for takeovers to deploy his sizable, though somewhat reduced, cash hoard. Although a deep recession may not seem like the most auspicious time for mergers, these recent deals suggest that well-heeled firms are finding bargains among today's beaten-down stocks and using their war chests to buy entire companies lock, stock and barrel.

That's good news for investors who can sniff out these potential takeover targets ahead of time. But the merger and acquisition game today is likely to be much tamer than it was in the not-so-recent past. The main reason: the disappearance of leveraged buyouts, which depend heavily on borrowed money. "Since banks aren't lending, you need to be more of a strategic buyer than a private-equity buyer," says Tom Forester, manager of the Forester Value fund.

When one company buys another, it generally pays a premium to the current share price. In the merger heyday of the late 1990s and early 2000s, a takeover could boost the price of the target's stock by as much as 50%. "We are no longer in a period where companies are holding out for unrealistic prices like they were as recently as three to six months ago," says Jim Tringas, manager of the Evergreen Special Values fund.

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Most managers, including Tringas, insist that they do not trawl for stocks that they hope will become subject to a takeover. If that happens, it's just the icing on the cake of an otherwise attractive investment. Nonetheless, a handful of money managers pointed us to potential takeover targets. Here are four companies that might be ripe for the taking.

Technology is probably the best stomping ground for upcoming deals because many tech companies headed into the downturn with healthy balance sheets and a lot of cash. Just look at Microsoft, which has a $20-billion kitty, and Cisco Systems, which has a $30-billion stash. Either one has the wherewithal to make a run at VMware (symbol VMW), which makes software that allows users to run virtual operating systems, and both companies are rumored to be interested. But for a takeover to succeed, a suitor would first have to strike a deal with EMC because the big producer of data-storage systems owns 84% of VMware.

VMware's once-rapid growth has stalled because of the recession, and rivals are catching up with the company's lead in technology. Analysts estimate that VMware will generate revenues of $2.1 billion in 2009, down from $1.9 billion the previous year (they see earnings growing from 77 cents a share last year to 89 cents this year). Investors have responded by punishing the stock; EMC spun off VMware at $29 a share in August 2007, and the stock quickly rocketed to $125. But it closed March 26 at $25.72. "When VMware was the most attractive from a technology perspective, its stock was highly valued," says Morningstar analyst Michael Holt. To attract a suitor, VMware may have to show that it can innovate faster than potential acquirers.

The energy sector is also a fertile area for acquisition candidates. Despite falling demand stemming from the global financial crisis, large exploration-and-production companies will be short of capacity once the recession ends and demand picks up again. A takeover of a player with strong reserves could be a boost.

XTO Energy (XTO), which acquires and develops onshore oil and gas properties in the U.S., could be a tempting target, says Ralph Shive, manager of Wasatch 1st Source Income Equity fund. "When prices are as down as they are now, that's a nice time to go after an independent player that has been able to grow its reserves," he says.

Shares of XTO closed March 26 at $33.67, 52% below their record high, set in June 2007. The stock sells at ten times 2009 earnings estimates of $3.05 a share, which would be about 16% below last year's earnings.

Health care is another area worth examining. The consolidation in Big Pharma is under way. Some major drug makers are also seeking to improve their product portfolios by snatching up biotech companies-witness Roche's $47-billion bid for the 46% of Genentech that it doesn't already own. But because biotech companies are valued much more highly in the market than big drug manufacturers, many logical hookups aren't financially feasible. Explains fund manager Forester: "There is a mismatch there. The Big Pharmas are selling at such lower price-to- earnings multiples than the biotechs, and everyone wants to use stock to make an acquisition. That would be dilutive to the biotechs, which have much higher multiples."

On the other hand, buying a company that holds a lot of cash makes more sense. Zimmer Holdings (ZMH) is the top maker of such orthopedic devices as hip and knee implants. The aging of baby-boomers bodes well for the firm's long-term growth prospects. Johnson & Johnson, which has $12 billion in cash, would seem to be a natural buyer. "JNJ will usually acquire some new technology, and that becomes spending on research and development," says Shive, who owns shares of JNJ. "Its salespeople can then sell the new product right away."

At $37.53, Zimmer's stock is 59% below its record high, set in April 2007. The shares trade for a bit more than nine times estimated 2009 earnings of $3.88 per share, an unusually low P/E for Zimmer.

Finally, there is the ultimate demographic play: Hillenbrand (HI), which owns the Batesville Casket Company. As one of the nation's biggest sellers of caskets, Hillenbrand benefits from an aging population. The company also cashes in on alternative death rituals by selling cremation caskets and urns.

Hillenbrand isn't likely to attract another casket maker as a suitor. However, a buyer looking for a well-priced asset could find the company attractive. The stock, at $16.04, is 28% below its debut in March 2008, when Hillenbrand was spun out of Hill-Rom Holdings. "The longer-term fundamental value of the company would give someone an opportunity to come in with a premium to the current stock price," says Tringas, the Evergreen fund manager, who notes that Hillenbrand generates a substantial amount of free cash flow (profits left over after the capital expenditure necessary to maintain the business).