Merger math: if you know where to look, there are lots of tempting targets

Kiplinger's Personal Finance Magazine, Sept, 1998 by Manuel Schiffres

Consider this: the $592 billion worth of merger deals that were announced in just the second quarter of 1998 nearly equaled the record total for an entire year of $667 billion. Eight of the ten largest deals in U.S. history were announced during the three-month period, reports Mergerstat, a service that tracks buyouts. Among them were Travelers Group's merger with Citicorp, SBC Communications' purchase of Ameritech, and Daimler-Benz's deal to buy Chrysler. Obviously, size is no longer an impediment to buyouts.

The temptation to try to buy into a takeover target before the deal is announced is tantalizing. After all, it's not uncommon for the stock of the target company to jump 20%, 30% or more in a single trading session.

But investing in perceived targets is dicey. If you're wrong on either the stock or the timing, your investment may be dead money for months or even years. And if the stock turns out to be a stinker and no buyer comes to the rescue, you lose. Stocks in some industries that are rife with rumors of anticipated mergers--such as the brokerage and cable-TV industries--have already climbed. And more deals are being structured as "mergers of equals," arrangements that often don't produce the kind of pop in price that merger investors seek.

Remember, too, that companies often become takeover candidates because they are troubled. As Charles LaLoggia, publisher of the newsletter Special Situation Report, notes, takeover targets often suffer from poor or erratic earnings and operate in intensely competitive industries. "All the things that cause a stock to act badly are also the things that cause a takeover to take place," he says.

An alternative way to cash in on merger mania is to invest in companies that are enhancing their growth prospects through judicious acquisitions. Yet even that strategy has its pitfails--witness the 16% drop in AT&T in the nine days alter it said it would buy cable giant Tele-Communications, as investors concluded the deal would hurt AT&T's profits, at least over the short term.

At any rate, there's no sign that the takeover binge will slacken soon. One reason for the explosion in deals is the bull market itself: Companies are using their soaring stocks as currency with which to pay for deals. And as Stanley Feldman, professor of finance at Bentley College, in Waltham, Mass., points out, because most stock-financed mergers are accomplished through a so-called pooling of interests, there are no tax implications for either the buyer or the selling shareholders.

We asked mutual fund managers, analysts and newsletter writers for their suggestions of takeover stocks to watch. Here are their choices, divided among several broad categories. We've also identified attractive "consolidator" companies that are growing through acquisitions.

FINANCIAL SERVICES

Banks have gobbled each other up at a breakneck pace. The number of U.S. commercial banks has plunged from 14,000, in 1985, to about 9,000. The impetus to consolidate should get another charge when Congress gets around to modifying the Depression-era law that limits banks from becoming involved in other financial businesses. That could come next year.

Although most of the publicity has focused on the megadeals, the best opportunities probably lie with small banks. James Schmidt, manager of John Hancock Financial Industries and Regional Bank funds, says two regional banks are ripe for plucking. One is Mercantile Bancorp (symbol MTL, New York Stock Exchange, recent price $53), parent of Mercantile Bank in St. Louis. Mercantile, says Schmidt, has "scarcity value" as the last independent, publicly traded bank that focuses on St. Louis. If a deal were struck tomorrow, it could fetch a 25% premium over its recent price, he says.

Schmidt's other choice: First American (FAM, NYSE, $49), which itself has been busy making deals. Since April, the Nashville owner of First American National Bank has announced or consummated five acquisitions. Tennessee banks are attractive, says Schmidt, because the state has good growth prospects and because the major superregional banks have yet to make inroads there.

A "very depressed" bank stock with takeover potential is Pacific Century Financial (BOTT, NYSE, $23), says Christopher Wiles, manager of two Rockhaven funds. Pacific, which owns the Bank of Hawaii, is the largest banking presence in the islands. Hawaii's economy has been weak because of the economic meltdown in Asia and the resulting fall off in tourism. But the stock now trades at just 1.6 times book value (assets minus liabilities), versus an industry average of around 3.3. Notes Wiles: "Eventually, if someone wants a steppingstone to Asia, you could see it as an acquisition target," he says.

Merger activity is also beginning to pick up in the insurance business. A small insurer that Donaldson, Lufkin & Jenrette sees as someone's mating partner is ARM Financial (ARM, NYSE, $24). Annuities, most of them fixed, account for two-thirds of ARM's profits, and guaranteed investment contracts sold to institutions make up the rest. ARM, says DLJ analyst Vanessa Wilson, would be attractive to an insurer seeking a greater presence in the asset gathering business.