The Top Targets for the Next Takeover

InterDigital's cheap enough to be on someone's radar.
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Each month at Stockpickr we use the Takeover Targets System to hunt down companies that are trading on the cheap, making them ripe for acquisition, especially in this frenzied M&A environment. We then list those names in our System Trades of the Day portfolio.

The takeover targets system, which calls for buying the stock on the first day of the month and holding until month's end, has historically returned 5.7% per trade. The system also has not had a down year in the simulations we've run, in both bull and bear markets. We update the

Takeover Targets

portfolio monthly so that the trades can be viewed for the entire length of the month.

The premise is fairly simple: When stocks become cheap enough -- that is, we believe, when they trade for less than five times cash flows -- they become attractive to private-equity firms and other corporations, which may look to buy them for their cash flows even if their business is declining.

Two stocks on the list continue to catch our eye, and we have been watching them for the past few months.

The first is

InterDigital Communications

(IDCC) - Get Report

. If your cell phone rings, you might be making use of a patent owned by InterDigital and licensed by your cell-phone manufacturer.

Patent licensing is a business that results in very choppy revenue and cash flows. But don't worry about InterDigital; it has $125 million in cash, and it generated about $300 million in cash flows last year. Also, its recurring licensees have increased their payments to InterDigital by 32% year over year. The business is solid, and its core customers aren't going anywhere.

The King of Prussia, Pa., company has an enterprise value of $1.5 billion, and I wouldn't be surprised if a company such as

Qualcomm

(QCOM) - Get Report

were to swoop down and acquire InterDigital for just six times cash flows. I'm apparently not the only one who thinks that way -- InterDigital recently maxed out its $200 million share-buyback program, extending it to $300 million.

Super-value mutual fund

Heartland Value

(HRTVX) owns shares of InterDigital. As an aside, Heartland is one of my favorite value funds to piggyback. It has returned an average of 15.7% over its 22-year history by focusing primarily on value-based micro-caps. Other stocks owned by Heartland include

Actuate

(ACTU)

and

Alaska Air Group

(ALK) - Get Report

.

Pioneer Drilling

(PDC)

is the other name we have been following on our takeover list. The San Antonio, Texas, company provides drilling services to oil and gas exploration companies.

In other words, if you have a few million acres of land you'd like to drill in search of oil or gas, you would hire Pioneer to come in and do the job. As long as people need oil and as long as oil prices remain above $40 a barrel, oil companies will be willing to spend more money to drill in places where it's harder to extract the stuff.

Pioneer has a pristine balance sheet with $91 million in cash in the bank, giving it an enterprise value of just $675 million. I say "just" because the company's EBITDA (earnings before interest, taxes, depreciation and amortization) is $182 million, meaning it trades at just 3.5 times cash flows. It has margins of 32%, and analysts expect revenue to be pretty much even next year compared with this year.

But Pioneer's business isn't really that important to us. In fact, it doesn't matter if its business gets cut in half, because right now it has an earnings yield of nearly 30%. In other words, if its revenue and earnings remain the same, then for every $1 you spend to buy shares of this company, you get a return of 30 cents. This is a ludicrous amount, and it cannot be sustained.

One of two things is likely here: The company's business will decline, or the company will get acquired. Let's say you have $675 million to spend. You can either get a 6% return in Treasury bills or you can make 30% a year by buying Pioneer. Sure, that 33% is going to decline, but it doesn't matter -- you can get 10% on your money and you're still doing fine, particularly given the company's strong competitive position and clean balance sheet.

Pioneer is a holding of John Keeley's

Keeley Asset Management

. Keeley is a well-known small-cap investor whose other holdings include

Terex

(TEX) - Get Report

and

McDermott

(MDR) - Get Report

.

At the time of publication, Altucher and/or his fund had no positions in stocks mentioned, although positions may change at any time.

James Altucher is president of Stockpickr LLC, a wholly owned subsidiary of TheStreet.com and part of its network of Web properties, and a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of

Trade Like a Hedge Fund

and

Trade Like Warren Buffett

. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback;

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