How To Be In The Right Spot To Catch A Merger Wave

Invest in industries where the underlying economics is driving widespread deals

BankAmerica and NationsBank agree to merge, and both stocks leap. Ameritech jumps in value after SBC Communications comes calling. Ditto Humana with United Healthcare's bid. Tyco International wants to take over U.S. Surgical, and shares in USS surge by nearly half again their value just last February.

Seeing these recent deals and others, who wouldn't wonder about how to get in on the action? There's the dumb way and the smart way. What you shouldn't do is invest randomly on tips from friends and brokers, which professional investors say are more often wrong than right. "Like trying to catch lightning in a bottle," says chief equity strategist Stuart T. Freeman of A.G. Edwards & Sons. The smarter way to play takeovers comes with no guarantees--but can improve your odds of success while lowering your risks: Invest in industries where the underlying economics is driving consolidation.

PINPOINTING. How do you lower your risk? Buy companies that have suffered temporary setbacks but that still boast sound prospects. Either you'll profit when your pick gets taken over, or it may come out a solid survivor as its industry coalesces. Brian C. Rogers, manager of $15.5 billion at T. Rowe Price Associates, recently saw two of the stocks he bought for T. Rowe Price Value Fund--Waste Management and U.S. Surgical--targeted by acquirers. The bids sent their shares soaring far above his purchase price. He bought neither thinking takeover, but "to the extent that you invest in beaten-down companies where the problems are relatively short term, it's that kind of company that might attract a merger."

To help pinpoint consolidating industries, we turned to Houlihan Lokey Howard & Zukin, a Los Angeles investment bank whose Mergerstat database tracks deals dating back 35 years. Since Jan. 1, some $550 billion in mergers have been unveiled, more than twice last year's pace. Houlihan Lokey Managing Director Scott J. Adelson sees communications, health care, utilities, and financial services as the four areas most prone to consolidation. In such industries, he notes, deregulation is releasing a pent-up urge to merge.

Having isolated four industries ripe for consolidation, we combed through the Morningstar StockTools database of 7,500 public companies to locate those with solid fundamentals and stock prices that have trailed the market. Because they tend to be at the center of merger activity, we focused on midsize companies with market values of $500 million to $2 billion. Then we zeroed in on those that generate lots of cash--an apple of any acquirer's eye. For financial companies, we paid close attention to return on assets, a key indicator. We eliminated captive firms such as John Nuveen & Co., a municipal bond dealer dominated by St. Paul Cos.

From each of the four industries, we selected two companies (table) that appear attractive--future merger or not. Among financials, Eaton Vance stood out for steady growth and wide profit margins. In the fiscal half-year ended Apr. 30, it netted $22.3 million, up 15% from the previous year, on revenues of $115.3 million. IPC Holdings Ltd., a Bermuda reinsurer with close ties to American International Group, enjoyed a return on assets last year of nearly 17%, according to Morningstar Inc., putting it near the top of its class in profitability. Investment vehicles controlled by George Soros recently disclosed an 8.15% stake in the company.

Our screen of communications companies turned up two different plays. Based in Lincoln, Neb., Aliant Communications has expanded cellular-phone and local landline operations, but not at the expense of profits. Last year, on $286 million in revenues, the company netted $39.7 million and generated cash flow of $78 million. In another branch of the communications business, Heftel Broadcasting is growing rapidly in its Spanish-language radio-station niche. Based in Dallas, Heftel is expanding its stable of 36 stations, through two more in San Diego.

NEW RULES. Like Heftel, Express Scripts Inc., a St. Louis pharmacy benefit-management company, is off its recent high. But it's a stock for growth investors, trading at nearly 30 times estimated 1998 earnings of $2.57 a share. It paid $445 million last April to pick up a rival cast aside by the industry's crippled giant, Columbia/HCA Healthcare Corp. NovaCare Inc. shares, by contrast, have taken a beating as investors worry about how providers of health care will cope with new Medicare budget limits. NovaCare claims it's well ahead in adjusting its contracts to the new rules. But at $11 a share, NovaCare is trading at just 12 times the Street's consensus earnings estimate for the fiscal year ending June, 1999.

Also attractive are two utilities--Rochester Gas & Electric (RG&E) and United Illuminating Co. Both are entering a period of deregulation, and Houlihan Lokey's Adelson thinks this will foster consolidation. Out of little more than $1 billion in revenues, RG&E last year generated a prodigious $235 million in cash flow, according to Morningstar. New Haven's United Illuminating saw cash flow of $168 million on $710 million in revenues. Former Westinghouse Electric Corp. executive Nathaniel Woodson just took charge as CEO with a pledge to focus on that goal so beloved of investors, shareholder value.

Is there some way of knowing for sure which of these will wind up in a merger? Unfortunately, no. But with stocks like these, you're likely to have your downside well covered while looking for the big upside.