3 Companies That Are Potential Buyout Targets

BOSTON ( TheStreet) -- With stocks in a slump -- the benchmark S&P 500 has fallen 5% from a peak two months ago -- individual investors are trying to figure out which companies may rebound because they offer value and which may continue their slide.

In this topsy-turvy world -- even hot-gadget maker Apple ( AAPL) and defensive stalwart Exxon Mobil ( XOM) are down -- emulating private-equity investors' approach to evaluating companies may be the smartest move.

Stocks are barely up so far in 2011 after two years of strong gains as higher commodity prices crimp corporate profits, consumer spending is lackluster amid high unemployment and the Federal Reserve is ending its second stimulus program this month. By focusing on corporate balance sheets and private-market valuations, investors may be able to navigate volatility in these summer months.

A stock's price isn't always indicative of value, and the difference between the two can lead to hefty profits, says Mark Travis, chief executive officer of Jacksonville, Florida-based Intrepid Capital Funds. One of his top picks is Tellabs ( TLAB), a beaten-up communications-equipment maker that is among the worst performing stocks on the S&P 500 this year.

Travis tries to determine the price that a rational buyer, paying in cash, would offer to acquire a company. With companies holding a record amount of cash -- more than $2 trillion -- following Travis' strategy makes more sense today than ever. Many companies he follows are growing fast and generating a lot of cash, but retail investors know very little about them because they fly under Wall Street's radar.

The strategy also takes advantage of the recent mergers-and-acquisitions frenzy. Through May, there were 1,276 announced deals with a total value of $454 billion, a 39% increase over the same period in 2010, according to a report by advisory firm PricewaterhouseCoopers. U.S. M&A activity will "continue to pick up steadily through the balance of 2011," PwC says.

But after a two-year rally in equities since the March 2009 bottom, aided by the Fed's bond-purchasing programs that boosted asset prices, Travis says the challenge in finding takeover targets has been made tougher. "Higher prices don't mean more opportunity, but more risk," he says. "A lot of the businesses we found were closer to fair price."

That has pushed Travis to be defensive in his posture. He says he couldn't find many businesses that had characteristics that private-equity investors would like, namely an unlevered balance sheet, lots of cash generation and downside protection in the share price. As such, the Intrepid Small Cap Fund ( ICMAX) had 34% of its $777 million in total assets in cash equivalents, as of March 31. The Intrepid Capital Fund ( ICMBX), meanwhile, had 12% of its $345 million in cash equivalents at the end of the first quarter.

Travis says his firm was invested in one takeout that occurred in late March, and that he has started to find some companies that carry both merit and risk for investors who can stomach the investment. "To find something in this environment where prices are up 100% over the last 24 months, you're going to have to buy something that has some ugly characteristic to it or it wouldn't be cheap," he says.

While investors focus mainly on S&P 500 companies, Travis and Intrepid Capital tend to be buyers of small-cap stocks. Travis says smaller companies that generate cash consistently attract suitors, either larger companies in their industry or private-equity firms. If neither comes forward, Travis is happy knowing the investment will continue to grow as the company's cash builds up.

For those investors looking to capitalize on the gap between price and value, Travis offers three stocks that he owns through Intrepid Capital Funds.

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CSG Systems International ( CSGS)

Company Profile: CSG Systems International is a provider of customer-interaction-management services, account-management and billing software to communication industries. The company's key clients include Comcast ( CMCSA), AT&T ( T), Verizon ( VZ) and Dish Network ( DISH), among others.

Current Share Price: $18.27 (June 28)

One-Year Stock Performance: -6%

Travis' Take: As Travis said, with merit comes risk. The stock currently trades at a forward price-to-earnings ratio of 7.4, a significant discount to the market. However, Travis says investors can pick up the stock at such a cheap price due to CSG Systems' high customer concentration risk.

According to the company's last annual report, filed in March, CSG Systems derives a substantial amount of its sales from a small number of clients. Approximately two-thirds of CSG's current revenue is generated from its four largest clients, with Comcast accounting for 24% of its nearly $550 million in revenue last year.

Despite this risk, Travis says that CSG shares are probably worth about $25 each for a number of reason. "I can buy it at a multiple of less than 10 times earnings. The balance sheet shows the company has about $180 million in net debt, so it's not particularly levered," he says. "It generates $100 million in free cash flow, so with a $638 million market cap, that's pretty attractive."

In terms of potential suitors, Travis says the obvious choice would be Amdocs Limited ( DOX), which he calls the 800-pound gorilla in the business support systems industry. "I don't know what the trust issues would be if Amdocs tried to acquire CSGS," Travis says, adding that a private-equity firm could also lever CSG up and take it private.

"It's a very stable business, the kind of business we like at Intrepid," Travis adds.

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Tellabs ( TLAB)

Company Profile: Tellabs is a communications-equipment maker, building access products for broadband and offering network consulting services.

Current Share Price: $4.41 (June 28)

One-Year Stock Performance: -36%

Travis' Take: "This one is really ugly," Travis says of Tellabs, and it's no wonder why. Tellabs has been among the worst-performing stocks on the S&P 500 this year as the company struggles with flagging sales and an awkward transition from its legacy switching products to mobile internet, which is currently the hottest tech trend.

Travis says that Intrepid Capital has owned the stock off and on and recently began buying more of it. One of the biggest reason is the discount to book value, he says. The stock currently has a price-to-book ratio of 0.8, meaning that shares can be had for 80 cents on the dollar, although a rebound to full value is anything but guaranteed. But with a big cash position, Travis says Tellabs is worth the risk.

"Its cash levels are high. With a market cap of $1.6 billion, it has $1.2 billion in cash," Travis says. "We think we're buying this company for less than book, which is largely cash. We think the shares are probably worth $7."

The challenge, like with CSG Systems, is high customer concentration risk. Tellabs is very dependent on AT&T ( T) and Verizon ( VZ). Revenue from AT&T was 35% of consolidated revenue in 2010, Tellabs said in its most recent annual report, while Verizon accounted for 20% of the company's consolidated revenue last year.

As far as potential buyers, Travis thinks one of Tellabs' competitors might find an advantage to acquiring the company. "This one is more cyclical, but there might be somebody who would take it out. There may be some competitors in the space who would be interested," he says.

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Home Retail Group ( HMRTY)

Company Profile: Home Retail Group is the U.K.'s leading home- and general-merchandise retailer. The company owns Argos, a multi-channel retailer that sells toys, jewelry and small appliances, and Homebase, a home-enhancement retailer. The company has an ADR that trades on the over-the-counter (OTC) market in the U.S., although Travis says he purchased shares directly on the London exchange.

Current Share Price: 161 pence (June 28)

One-Year Stock Performance: -28%

Travis' Take: Of all the companies Travis has examined lately, he argues that the U.K. retailer is among the best buyout candidates for firms focused on price-to-earnings ratios. "I'm hoping someone is waving a red flag in front of Henry Kravis," Travis jokes, referring to the co-founder of big-time buyout firm KKR ( KKR).

Owning this stock doesn't come without significant risks. Purchasing shares on the foreign market can be difficult for individual investors to accomplish. But more worrisome is that consumer discretionary stocks aren't exactly the booming sectors in the market currently. "Great Britain is suffering economically like we are here in the U.S., and the retail environment is tough," Travis says.

However, Home Retail Group shares in London offer "a hugely compelling valuation," Travis says, noting that the stock trades for six times operating income, has a 9% dividend yield, and a large portion of market capitalization in cash. "I think it's probably worth 240 pence, so it's basically 70 cents on the dollar," Travis adds.

-- Written by Robert Holmes in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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