Bettor's Guide to Buyouts

Nat Worden

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If you thought the leveraged buyout machine was humming in 2005, just wait until next year.

More than $100 billion plowed into private equity coffers in 2005, and firms such as Blackstone Group are raising funds that top $11 billion.

Dan Primack, editor-at-large with Venture Economics, a provider of information and analysis on the private equity industry, says the industry could end up doubling its 2004 fundraising this year, and that should lead to some monstrous deals.

"Every company is ripe for a buyout in 2006, short of Microsoft (MSFT Quote) or Google (GOOG Quote)," Primack says. "Private equity firms have become the largest M&A players in the market. They're bigger than strategic buyers now, because all they do is takeovers. They're the modern-day conglomerates, except that [unlike] real conglomerates, they like to liquidate."

When buyout firms get active in the public markets, stock owners benefit from the high prices they're willing to pay for shares. That was the case in this year's blockbuster deals, such as Sungard Data Systems, Toys R Us and Neiman Marcus. Now, observers say, 2006 could be the year when buyout firms finally top the $25 billion takeover of RJR Nabisco in 1989 -- the largest single deal ever closed in the history of the LBO.

Steven Kaplan, a University of Chicago business professor, compared today's private equity craze with previous high-water marks for the industry, reached in 1988 and 1999.

"The stock market was very robust, which it is today in terms of valuations," Kaplan says. "The credit markets were very liquid, which they are today. As a result, buyout firms had some pretty good exits, so their returns looked pretty good. That attracted a lot of money, and when the money got spent, returns weren't so good. That could be exactly what we're looking again now."

Private equity's buy side is designed to make the rich richer, and its asset requirements keep most people out. But you can still make money from the game if you can figure out which company is going to be taken out before it happens. For starters, check out the retail sector.

Buyers view retailing as easy to understand, laden with stable cash flows and ripe for consolidation. The rise of Wal-Mart(WMT Quote) has left old-line retailers with too many stores and bloated cost structures. Many investors see untapped value in their real estate portfolios.

What follows is an odds sheet on possible 2006 buyouts compiled from discussions with experts from across the stock market.

Even Money

Saks (SKS Quote) Market cap: $2.4 billion.

Saks alleviated some of the buyout speculation surrounding its shares by selling off its Northern department store group for $1.1 billion, freeing itself from the baggage of an ill-fated 1998 merger. Nevertheless, a big portion of its investor base still distrusts the people running the company and would jump at a chance to have them replaced. Meanwhile, Saks' luxury chain, Saks Fifth Avenue, is a jewel whose value could be unlocked in the hands of a buyout firm.

"In a period of explosion in the luxury field, Saks is underperforming," said Howard Davidowitz, chairman of Davidowitz & Associates, a retail consultancy. "Saks is a prime candidate for a buyout."

2-to-1 Odds

Dillards (DDS Quote) Market cap: $2 billion.

Tom O'Neill, CEO of the private equity shop Exodus Capital Advisors, points to Dillards, the regional department store chain, as a company with real estate assets that make private investors' mouths water.

"There are a number of retail companies in which the value of their real estate portfolio has dramatically increased in recent years, and that hasn't been reflected in their market cap," said O'Neill.

4-to-1 Odds

Lexmark International (LXK Quote) Market cap: $4.5 billion.

One prerequisite for a leveraged buyout candidate is strong cash-flow generation. Buyers must be sure that a company will be able to make interest payments after its balance sheet it loaded up with debt.

Lexmark, a printer business originally bought from IBM (IBM Quote) by private equity players in 1991, boasts strong cash flow despite competitive pressures that have hit its top line. The stock, which has shed roughly 40% of its value over the last two years, caught an updraft in November after analysts said an LBO appears economically viable.

Takeover artists also look for underperforming, non-core assets that could be sold, and Lexmark's money-losing inkjet business could be ripe for divestiture.

4-to-1 Odds

U.S. Steel (X Quote). Market cap: $5.5 billion

The manufacturing sector has always been a shopping center for private equity, and U.S. Steel, which boasts significant steelmaking capacity in the U.S. and Central Europe, is considered undervalued in some quarters.

After dropping as much as 32% this year, its shares have rebounded in recent months after a takeover battle for Dofasco, a medium-sized Canadian steelmaker, renewed Wall Street's interest in the company.

5-to-1 Odds

Computer Sciences (CSC Quote). Market Cap: $9.2 billion.

CSC, one of the world's largest information technology firms, with $14 billion in annual revenue, held talks with Lockheed Martin (LMT Quote) about a sale in November that never bore fruit. Still, buyout specialists could take a shine to the company, since Uncle Sam is expected to be stepping up outsourcing of computer and other technical systems work to IT firms. CSC stands to benefit.

Government contracts result in some of the most reliable revenue streams in the market, and CSC shares, having dropped over 20% in the first half of the year, have been spiking in anticipation.

6-to-1 Odds

Wendy's (WEN Quote). Market cap: $6.4 billion.

Wendy's is being bullied by activist hedge funds that say the fast-food chain is an "inefficient holding company." The latest and loudest complaints come from billionaire investor Nelson Peltz. His investment vehicle, Trian Fund Management, is calling for Wendy's to spin off its Tim Horton's, Baja Fresh Mexican Grill, Cafe Express and Pasta Pomodoro brands.

Earlier this year, hedge fund Pershing Square Capital put similar pressure on the company, forcing it to sell part of its Tim Hortons doughnut chain and authorize a $1 billion share buyback. Subsequently, its stock jumped 12% to an all-time high on July 29.

Trian says that didn't go far enough and says Wendy's continues to "perpetuate a highly inefficient and costly conglomerate structure." Such talk quickens the pulse of many a buyout arbitrager.

8-to-1 Odds

Limited Brands (LTD Quote). Market cap: $9.1 billion.

Limited Brands has a long history of selling off retailing chains that eventually go public and achieve success on their own, from Abercrombie & Fitch (ANF Quote) to New York & Co. (NWY Quote).

Now, its Limited Stores and Express chain are flailing, and the company's longtime CEO, Leslie Wexner, could be looking for financial buyers for those businesses. If he fails to shear off the company's dead weight in favor of stellar performances by its crown jewels -- Victoria's Secret and Bath & Body Works -- a private equity firm could be tempted to do it for him.

10-to-1 Odds

J.C. Penney (JCP Quote). Market cap: $13.6 billion.

J.C. Penney achieved a stunning turnaround last year under the leadership of its former CEO, Alan Questrom, but that hasn't exempted it from buyout rumors. The department store chain boasts off-mall real estate assets, and while its financial position has come a long way recently, analysts say its competitive position is still precarious over the long run.

20-to-1 Odds

Sears Holdings (SHLD Quote). Market cap: $20 billion.

Ed Lampert, the hedge fund manager who used Kmart to buy Sears earlier this year, sometimes acts like a private equity buyer. He's focused on slashing costs, selling off assets and maximizing cash flow. Lampert, however, used equity to buy Sears -- not debt -- and he's trying to trim fat from the retail empire while reaping the benefits of the public market.

Despite his success, the massive publicity that Sears has received appears to be getting on Lampert's nerves, particularly after shares of Sears Holdings plunged 30% since the summer. Rumors are swirling that Lampert is considering taking Sears private to get out of the spotlight.

Despite the chatter, most observers think Lampert will persevere and try to prove his critics wrong again. Taking Sears private would be expensive, but given all the speculation surrounding its real estate assets, the merchants of debt would surely be willing to help Lampert raise the money.

30-to-1 Odds

Gap (GPS Quote). Market Cap: $15.6 billion.

Gap's balance sheet and cash flow have been restored thanks to the financial expertise of its CEO, Paul Pressler. That said, its sales are in a tailspin thanks to a series of fashion missteps that could jeopardize its brand, and it appears to be having a terrible holiday season.

Shares of Gap have shed more than 20% over the last two years. Meanwhile, its three main brands -- Gap Stores, Old Navy and Banana Republic -- are said to be cannibalizing each other. Many feel the assets could be more valuable as separate entities, and parts of the business could probably liquidated. This has the buyout sharks circling.

50-to-1 Odds

McDonald's (MCD Quote). Market cap: $44.4 billion.

After forcing change at Wendy's, Pershing Square Capital's Bill Ackman moved on to fast food's Big Kahuna -- McDonald's (MCD Quote). The hedge fund guru is lobbying the golden arches to spin off its real estate holdings into an investment trust -- a move he thinks could unlock hidden value in the burger chain.

McDonald's, whose shares have languished in recent years, has dismissed the plan as short-sighted, but Ackman is persistent. The sheer size of McDonald's makes a buyout of the company almost fanciful, but as history shows, casino capitalism has a penchant for thinking big.

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