Is it possible to determine whether a company is a potential takeover candidate before a public announcement has been made? Absolutely - if you know what to look for. Read on to learn the characteristics that well-financed suitors look for in their target companies. Once you know what the big companies are looking for, you'll be able to determine which companies are prime candidates for takeovers. (To learn about how you can benefit from takeovers as an investor, read Trade Takeover Stocks With Merger Arbitrage and Cashing In On Corporate Restructuring.)

Product/Service Niche
A large company has the luxury of being able to develop or acquire an arsenal of varying services and products. However, if it can buy a company at a reasonable price that has a unique niche in a particular industry (either in terms of a product, or service), it will probably do so.

Smart suitors will wait until the smaller company has done the risky footwork and advertising before buying in. But once a niche is carved out, the larger firm will probably come knocking. In terms of both money and time, it is often cheaper for larger companies to acquire a given product or a service than to build it out from scratch. This allows them to avoid much of the risk associated with a startup procedure.

Additional Financing Needed
Smaller companies often don't have the ability to market their items nationally, much less internationally. Larger firms with deep pockets have this ability. Therefore, look for not only a company with a viable product line, but one that, with the proper financing, could have the potential for large-scale growth. (For more insight, see Venturing Into Early-Stage Growth Stocks.)

Clean Capital Structure
Large firms want an acquisition to go forward on a timely basis, but some companies have a large amount of overhang that dissuades potential suitors. Be wary of companies with a lot of convertible bonds or varying classes of common or preferred stock, especially those with super voting rights. (For related reading, see Knowing Your Rights As A Shareholder.)

The reason that overhang dissuades companies from making an acquisition is that the acquiring firm has to go through a painstaking due diligence process. Overhang presents the risk of significant dilution and presents the possibility that some pesky shareholder with 10 to 1 voting rights might try to hold up the deal. If you think a company may be a prospective takeover target, make sure it has a clean capital structure. In other words, look for companies that have just one class of common stock and a minimal amount of debt that can be converted into common shares.

Debt Refinance Possible
In the latter half of the 1990s, when interest rates began to decline, a number of casino companies found themselves saddled with high fixed interest first mortgage notes. Because many of them were already drowning in debt, the banks weren't keen on refinancing those notes. And so, along came larger players in the industry. These larger players had better credit ratings and deeper pockets, as well as access to capital and were able to buy up many of the smaller, struggling casino companies.

Naturally, a large amount of consolidation occurred. After the deals were done, the larger companies refinanced these first mortgage notes which, in many cases, had very high interest rates. The result was millions in cost savings.

When considering the possibility of a takeover, look for companies that could be much more profitable if their debt loads were refinanced at a more favorable rate.

Geographic Proximity
When one company acquires another, management usually tries to save money by eliminating redundant overhead. In other words, why maintain two warehouses if one can do the job and is accessible by both companies? Therefore, in considering takeover targets, look for companies that are geographically convenient to each other and, that if combined, would present shareholders with a huge potential for cost savings.

For example, many analysts believe consolidation in the drug industry is likely because it is not uncommon to see company headquarters and operations in this industry situated near competing firms. As such, consolidation of these firms could lead to higher margins and increased shareholder value.

Clean Operating History
Takeover candidates usually have a clean operating history. They have consistent revenue streams and steady businesses. Remember, suitors and financing companies want a smooth transition, so they will be wary if a company has, for instance, previously filed for bankruptcy, has a history of reporting erratic earnings results, or has recently lost major customers.

History of Enhancing Shareholder Value
Has the target company been proactive in telling its story to the investment community? Has it repurchased its shares in the open market? Suitors want to buy companies that will thrive as part of a larger company, but also those that, if needed, could continue to work on their own. This ability to work as a standalone applies to the investor relations and public relations function. Suitors like companies are able to enhance shareholder value.

Experienced Management
In some cases, when one company acquires another, the management team at the acquired company is sacked. However, in other instances, management is kept on board because they know the company better than anyone else. Therefore, acquiring companies often look for candidates that have been well run. Remember, good stewardship implies that the company's facilities are probably in good order, and that its customer base is content. (For related reading, check out Evaluating A Company's Management.)

Minimal Litigation Risk/Threats
Almost every company at some point in time will be engaged in some sort of litigation. However, companies seeking acquisition candidates will usually steer clear of firms that are saddled down with lawsuits. In general, suitors avoid acquiring unknown risks.

Expandable Margins
As a company grows its revenue base, it develops economies of scale. In other words, its revenues grow, but its overhead - its rent, interest payments and maybe even its labor costs - stays the same, or increases at a much lower rate than revenue. Acquirers want to buy companies that have the potential to develop these economies of scale and increase margins. They also want to buy companies that have their cost structure in line, and that have a viable plan to grow revenue.

Solid Distribution Network
Particularly if the company is a manufacturer, it must have a solid distribution network or the ability to plug into the acquiring company's network if it is going to be a serious takeover target. What good is a product if it can't be brought to market?

Make certain that any company you believe could be a potential takeover target has not only the ability to develop a product, but also the ability to deliver it to its customers on a timely basis.

Word of Warning
Investors should never buy a company solely because they believe it is, or may become, a takeover target. These suggestions are merely meant to enhance the research process and to help identify characteristics that may be attractive to potential suitors. (To learn more about these companies, read Pinpoint Takeovers First.)

Bottom Line
With the investment community focused on ever-increasing profitability, large companies will always be looking for acquisitions that can add to earnings fast! Therefore, companies that are well run, have excellent products and have the best distribution networks are logical targets for a possible takeover.

Related Articles
  1. Active Trading Fundamentals

    The Biggest Private Equity Firms in Los Angeles

    Learn why Los Angeles is a thriving market for private equity, and identify the five largest private equity firms operating in the city.
  2. Economics

    Understanding Organic Growth

    Organic growth is the increase in a company’s revenue and value due to internal operations.
  3. Economics

    Explaining Market Penetration

    Market penetration is the measure of how much a good or service is being used within a total potential market.
  4. Economics

    Calculating the Marginal Rate of Substitution

    The marginal rate of substitution determines how much of one good a consumer will give up to obtain extra units of another good.
  5. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  6. Stock Analysis

    5 Reasons Thoratec Corp. Keeps Impressing Investors

    Learn about Thoratec Corporation and its position in its industry. Understand five key factors why the company has impressed investors.
  7. Entrepreneurship

    Top 5 Startups That Emerged in Boston

    Learn why Boston is a hot market for startups, and familiarize yourself with a few of the top startups that have emerged from the city.
  8. Entrepreneurship

    Startup Analysis: How Much Is Palantir Worth?

    Learn about the private company Palantir, its valuation and how its valuation was derived. Understand how the company operates and if it deserves the valuation.
  9. Stock Analysis

    Jawbone: An IPO You Should Have on Your Radar

    Learn about the company Jawbone and how it has become successful with multiple product lines. Understand the benefits of investing in an IPO
  10. Entrepreneurship

    How to Prep Your Business for a Sale

    Once you have a clean, stand-alone business with solid finances, it's time to put a price on it. Here are the steps needed to prepare for a sale.
RELATED TERMS
  1. Supply

    A fundamental economic concept that describes the total amount ...
  2. Black Money

    Money earned through any illegal activity controlled by country ...
  3. Weighted Average Cost Of Capital ...

    A calculation of a firm's cost of capital in which each category ...
  4. Runoff Insurance

    An insurance policy provision that provides liability coverage ...
  5. Caribbean Free Trade Association ...

    The Caribbean Free Trade Association (CARIFTA) is a multilateral ...
  6. Caribbean Single Market and Economy ...

    An initiative currently being explored and slowly implemented ...
RELATED FAQS
  1. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  2. How long does it take to execute an M&A deal?

    Even the simplest merger and acquisition (M&A) deals are challenging. It takes a lot for two previously independent enterprises ... Read Full Answer >>
  3. What does marginal utility tell us about consumer choice?

    In microeconomics, utility represents a way to relate the amount of goods consumed to the amount of happiness or satisfaction ... Read Full Answer >>
  4. How is the marginal cost of production used to find an optimum production level?

    The marginal cost of production can be tracked to show the optimal production level where per-unit production cost is lowest ... Read Full Answer >>
  5. What is the difference between JIT (just in time) and CMI (customer managed inventory)?

    Just-in-time (JIT) inventory management focuses solely on the need to replenish inventory only when it is required, reducing ... Read Full Answer >>
  6. What are some examples of Apple and Google's best-selling product lines?

    There are many good examples of product lines in the technology sector from some of the largest companies in the world, such ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!