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Michael Dell's attempt to take the company he founded private and Berkshire Hathaway's bid to acquire Heinz both highlight how the current environment has made major acquisitions attractive. Cash flow analysis could tell us who's next.
Companies with AAA credit ratings can borrow funds at about 3.8 per cent interest. In theory, one of these firms could acquire any business with a free cash flow yield above four per cent and realize a steady profit, since the interest payments on the funds borrowed to make the acquisition would be lower.
It's not quite that simple in practice. A potential target where cash flow swings wildly from 1 per cent to 20 per cent, for example, is not an ideal candidate. If the buyer is going to lever up with debt to make the deal, it wants to be sure the cash flow will be there, every quarter, to cover the interest payments.
A takeout target overloaded with debt is also not desirable. If they have to continually tap the market for new funds (as real estate companies or miners do), a future increase in corporate bond rates could wipe out available cash.
To attempt to find the next takeout target, we sorted all S&P 500 companies by free cash flow yield, tossing out banks (cash flow stats are meaningless for banks) and constituents with negative cash flow. There were nine companies that ranked in the first or second decile for both cash flow yield and debt to equity ratios: Gamestop Corp., Microsoft Corp., Apple Inc., EMC Corp, Total Systems Services Inc., Garmin Ltd., Broadcom Corp., Teradyne Inc., and NVIDIA Corp.
A couple of observations emerge immediately: The primary candidates to acquire Microsoft and Apple are, of course, the companies themselves, via share buybacks; and any potential bidder for the semiconductor names would likely demand significant margins for error. The industry has been largely commoditized (the differences between their products have shrunk), with all of the cyclicality and volatility that implies.
See this chart for current cash flow yield and debt equity numbers for each firm – and don't be surprised if one of them is involved in the next big deal.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow