Autumn’s leap in merger and acquisition (M&A) activity signals those ‘animal spirits’, the economic driver identified by economist John Maynard Keynes back in the 1930s, could be about to erupt again. American technology giant Applied Materials’ (AMAT:NDQ) $10 billion all-stock offer for Japanese rival Tokyo Electron (8035:T) may just be the first of many deals, large or small. A research report issued in September by Societe Generale suggests the world might be on the cusp of another major M&A boom to match that seen during the later stages of the 2003 to 2007 equity market bull run. Growing appetite for deals should be positive for investors’ portfolios, as bid whispers drives share prices higher and takeovers at premium prices enable shareholders to lock in handsome profits.

After some diligent research Shares can spot a quartet of stocks which may draw the attention of a corporate predator. They include international telecommunications powerhouse Vodafone (VOD), animal medicines expert Dechra Pharmaceuticals (DPH) and Xcite Energy (XEL:AIM), the explorer developing a heavy oil field in the North Sea. We can also see a rival making a lunge for Condor Gold (CNR:AIM), the Nicaragua-focused miner.

Cash rich

A good run in UK and US equity markets mean equity valuations may not stand at bargain basement levels anymore but cash piles are burning holes in many corporations’ pockets at a time when growth remains hard to come by. Management teams on the whole have remained cautious since the financial crisis, yet with economic data improving slowly, those companies with the balance sheet strength to turbo-charge growth prospects through M&A may face calls from shareholders to act as confidence levels build.

Executives who have nurtured hefty cashpiles could come under increasing pressure to deploy capital to ensure growth is generated and consensus earnings targets met. Significantly, the era of cheap money is continuing, for now, as the Federal Reserve chooses not to taper its quantitative easing push in the USA (18 Sept). Here at home, Canadian central banker Mark Carney and his colleagues at the Bank of England have stated interest rates will stay mired at their record low of 0.5% until the jobless rate reaches 7% or even lower, something the Old Lady of Threadneedle Street does not expect until late 2016.

Boardrooms will still note with interest the increase in ten-year bond yields in London and New York. Central banks are saying one thing but the bond markets believe another and since ten-year government paper is a benchmark for most corporate issuance, it is possible firms who plan to fund deals with debt may choose to pounce now.

In a report entitled The FTSE 100: Amassing the Cash 2008-2013 Capita (CPI) analyses the balance sheets of the UK’s largest firms, excluding financials such as banks. This analysis shows cash and cash equivalents have hit £166 billion, up £42.2 billion since 2008. That 34% advance reflects capital expenditure cuts, cost reductions and improved earnings. Net cash positions have changed even more dramatically as companies have paid down short-term debt, rising six-fold to £73.9 billion, up £61.7 billion from £12.2 billion in 2008.

With 17 sectors showing improved gross cash balances since 2008, versus only 13 with a deterioration, the scene could now be set for some big takeovers of UK firms by their large-cap counterparts. Commodities firms have led the cash accumulation charge. Oil and gas producers now account for more than one third of the FTSE 100’s cash piles, a trend which points to potential for a glut of deals in the resources space.

Decoding deals

Buying shares purely on the basis of a takeover is a mug’s game, as likely to lighten than fatten your wallet. A bad business, irrespective of its valuation, is unlikely to draw a predator and may simply be a value trap. Nevertheless, diligent investors can stack the odds in their favour by targeting firms which would represent an attractive investment proposition in their own right. Buyers can swoop for many reasons. They may be seeking either cost or sales synergies to fatten profit margins or to grab market share and generate economies of scale in consolidating industries. A complementary geographic fit justifies many a deal while a predator will also perhaps want to acquire a technological edge, key brands, control of a scarce resource or develop an enhanced service offering.

Bid whispers appear to be growing in frequency, with dealers, analysts and the press identifying takeover targets in an array of industry sectors. Those names in the frame are most often than not companies with a competitive advantage that would augment the growth prospects or strategic positioning of the buyer.

In the leisure sector, online gaming giant Bwin.party Digital Entertainment (BPTY) is rumoured to be in the sights of search engine giant Google (GOOG:NDQ) before Bwin’s online poker and casino games are up and running in the state of New Jersey. In the cash-generative utility sector, water and sewage services heavyweight United Utilities (UU.) is one of a number of names regularly identified as a possible takeout candidate in a sector where the number of publicly-quoted players continue to diminish as buyers latch on to guaranteed long-term cashflows. Share price strength at drug developer Shire (SHP) reflects its pharmaceutical portfolio’s attractions as well as its status as a perennial bid chatter subject, while the brand strength, pricing power and cash-generation of Golden Virginia-to-Gauloises Blondes maker Imperial Tobacco (IMT) mean it continues to be linked with an eventual takeover tilt, most likely involving international rival Japan Tobacco (2914:T).

In the resources sector, Russian oil producer Exillon Energy (EXI) has put itself up for sale following a number of preliminary approaches. A summer rebound at Condor Gold reflects the wider mining stocks rally as well as potential for a bid, with both Yamana Gold (AUY:NYSE) and B2Gold Corp (BTG:NYSE) thought to be potential stalkers.

Strong flow

Dealogic points out the value of US M&A deals hit $854 billion in the opening nine months of this year, the highest level since 2008. Recent standout transactions include Verizon’s (VZ:NYSE) US$130 billion (£84 billion) buyout of Vodafone’s 45% stake in their wireless joint venture across the pond (2 Sep). Software titan Microsoft (MSFT:NDQ) announced (3 Sep) it would put Finland’s Nokia (NOK1V:HE) out of its misery by buying its handset business for €5.4 billion, while one-time tech market darling BlackBerry (BBRY:NDQ) has finally succumbed to years of decline. It has agreed to a £3 billion takeover by its biggest shareholder Fairfax Financial, which controls 10% and will lead a consortium to mop up the remainder of the one-time smartphone king.

China continues to lunge for prime Western assets too. Its largest meat processor, Shanghui International, is to buy Smithfield Foods (SFD:NYSE), the globe’s biggest pork producer. At $4.7 billion, this is the largest Chinese acquisition of a US company and the buyer’s plan is to boost its capacity to feed the growing Chinese middle class.

Not all of the deals struck fall into the multi-billion-dollar category. Agile, nimble and innovative, small caps are being picked off by larger rivals who desire their growth prospects, cashflow, prized assets or intellectual property.

Non-woven fabrics producer Fiberweb has been swallowed by US firm Polymer (17 Sept) and the board at luxury car dealer H.R. Owen (HRO) has recommended an improved offer from Berjaya Philippines (BCOR:PM). This is a vehicle controlled by charismatic Cardiff City Football Club owner Vincent Tan which now owns a 50.2% stake. The increased mandatory cash offer was pitched at 170p, a 30.8% hike on July’s original 130p bid and a handsome 40.5% premium to the ‘undisturbed’ share price.

Shares in rare coin dealer and fine art auctioneer Noble Investments (NBL:AIM) have also sprung into life following an approach from stamp dealer Stanley Gibbons (SGI:AIM) first flagged (12 Sept). Last week’s (26 Sept) confirmed cash-and-shares takeover values Noble at £45.3 million or 255p per share, a 20% premium to May’s closing price before the two began confidential talks.

Yield to the power of free cashflow

Takeover deals happen for many reasons. Testosterone-laden boardrooms can give in to what former Financial Times columnist Philip Coggan famously termed ‘the urge to merge’ as executives mistake activity for strategy. Managers can decide they want to fill in a gap in their geographic or product portfolio or range of skillsets. A move to consolidate a market and take share may look like a plan. In all of these instances valuation may not be a consideration, even if it the most important one, at least for shareholders in the buyer. If the bidder overpays, its investors are likely to lose out badly.

One of the best ways to measure whether an acquirer is paying a sensible price, or determine whether a firm is cheap enough to draw the attentions of a predator, is to calculate the free cashflow yield. This number, expressed as a percentage, is simply the reverse of the operating free cashflow multiple. Simply put, if a firm trades on 20 times free cashflow it has a free cashflow yield of 5%.

This percentage ratio is calculated when you divide free cashflow by the enterprise value (EV) - not the market capitalisation. Remember, you must use EV here as the bidder will inherit not just the assets of its target, but the liabilities too.

Net operating profit after tax Minus capex PLUS depreciation PLUS amortisation MINUS change in net working capital

DIVIDED BY

Market capitalisation PLUS short- and long-term interest bearing debt PLUS pension deficit PLUS leasing obligations PLUS contingent liabilities MINUS cash and cash equivalents MINUS assets for sale

Quite simply the higher the percentage figure the better. Even with headline interest rates at zero, only the biggest of blue-chips will be able to borrow at less than 3%. So if the cost of borrowing to fund a deal is 3%, the free cashflow yield reward must be some way more than that to justify the risks involved. Any firm which is generating a free cashflow yield north of say 5% to 6% in this uncertain environment is doing well and may be considered a bid target.

Any approach where the price implies a free cashflow yield of 4% or less should, we would argue, be treated with caution for two reasons. First, the proposed transaction may fail if the target holds out for a higher offer, as happened with Severn Trent (SVT) and Kentz (KENZ), where the mathematics were initially borderline anyway. Second, the buyer could be overpaying and so investors here may be walking into trouble unless the integration plan goes perfectly. Shares warned the consortium’s spring bid for Severn Trent looked dicey (see Opinion, Shares 23 May) as the free cashflow yield was already looking low at the initial offer price. So it proved as once the initial approach was rejected the putative bidders could not make a higher offer stack up.

Condor Gold (CNR:AIM) 119p

Condor Gold (CNR:AIM) is making enough progress at its 2.5 million ounce La India gold project in Nicaragua to warrant takeover interest. As VSA Capital notes in a recent merger and acquisitions study, Condor’s management team ‘lacks the skills and experience’ to take the asset into production, a view supported by the how board has over the years made no secret of its desire to take the project to the bankable feasibility stage and then find a buyer. The most logical purchaser just happens to have raised a slug of cash. B2Gold (BTO:TSX) issued $259 million of convertible notes (due 2018) in August for ‘general corporate purposes’ and it even noted acquisition opportunities. Condor and B2Gold have swapped land in the past and they work in the same geographical area. A new resource statement is due on La India next month. A preliminary feasibility study is due imminently. B2Gold has subsequently played down talk that its summer fund raising was for a deal, saying it was simply to bolster its cash position. Yet B2Gold remains vocal about wanting to do an acquisition. It is not the only logical buyer for Condor. VSA reckons Yamana Gold (AUY:NYSE) and Goldcorp (G:TSX) could also be interested in the small cap. (DC)

Dechra (DPH) 721.5p

August’s disposal of its services arm could well make Dechra Pharmaceuticals (DPH) a tempting target for acquisitive drug firms. The sale left the Northwich firm with a net cash position and a pure veterinary medicine business with improved profit and cashflow potential. It is not hard to see why management made the decision to split the business. Dechra now has a chance to boost margins by providing its own-branded specialist treatments. The FTSE 250 firm’s services operations made a £11.1 million pre-tax profit from £333.2 million sales in the year to July, while the retained drugs business made £33.5 million from a £198.2 million turnover, a 16.9% return on sales. Dechra admittedly trades on a premium to the European large-cap pharmaceuticals sector on 20.3 times its earnings estimates for 2014. Yet there any not many big drug firms growing earnings at a double-digit trend clip, while Dechra also has 11 products in its pipeline that could boost its sales by some £35 million, or nearly 20%, if they are all approved. (MD)

Vodafone (VOD) 218.8p

As it works through the sale of its 45% stake in Verizon Wireless for $130 billion (£81.8 billion) to Verizon Communications (VZ:NYSE), which owns the other 55%, Vodafone could become a tempting target for a predator. US fixed-line telecoms service provider AT&T (T:NYSE) may swoop as a way to tap early stage adoption of high-speed fourth generation (4G) networks. Vodafone has only just switched on its own UK high-speed network and other nations have yet to start in earnest. AT&T’s likely strategy would be to accelerate that 4G rollout, while it is also likely to take a favourable view of Vodafone’s African assets. Such a deal could make sense for Vodafone shareholders. After its exit from the USA, the £106 billion group will be left heavily exposed to Europe where regulation is stiffest and competition fiercest. Analysts at Jefferies calculate post-disposal net debt comes to just one times forecast earnings before interest, tax, depreciation and amortisation (EBITDA) while an enterprise value to EBITDA (EV/EBITDA) multiple of 4.7 represents a big discount to the sector average of 5.5. If Vodafone shares struggle to hit the 250p levels predicted by many analysts once the Verizon Wireless stake is finally sold, probably by March, Vodafone shareholders may warm to a reasonable buyout proposal. (SFr)

Xcite Energy (XEL:AIM) 116.5p

In the small cap exploration and production (E&P) arena companies often lack the free cashflow which prospective bidders can use to place a price on a deal. Asset-backed valuations are the sensible alternative and a read-through from last month’s (16 Sep) recommended £103 million offer for North Sea oil firm Bridge Energy (BRDG:AIM) implies its peer Xcite Energy (XEL:AIM) could be attractive to an industry suitor. The Bridge deal was priced at a 5% discount to core net asset value (NAV) with nothing in the price for the company’s exploration assets. Broker Liberum Capital estimates a net asset value (NAV) per share for Xcite of 340p and that is based entirely on the 250 million barrels of proved and probable (2P) reserves associated with its Bentley heavy oil field. Basic arithmetic tells us a deal pitched on similar terms to the Bridge bid would value Xcite at 323p. The costs of getting Bentley to positive cashflow are estimated at $700 million and Xcite is looking at bringing in a partner to help. Were a larger company to find the asset particularly attractive it could move to acquire Xcite in its entirety, especially since it has such a focused portfolio. (TS)