12 Potential Leveraged-Buyout Candidates

AFTER A LULL FOLLOWING THE 2008 financial crisis, leveraged-buyout activity is perking up with a $1.8 billion deal last week for children's clothing retailer Gymboree (GYMB) and a recent transaction involving Burger King. Seagate Technology (STX) said Thursday that it has been approached by private-equity firms about an LBO, and there was talk last week about a potential LBO of Yahoo! (YHOO) in a deal that could top $25 billion.

The heightened activity has led to speculation on Wall Street about which companies could become the next targets. After talking to a group of analysts and investors, we've come up with a list of a dozen potential LBO candidates, including Gap (GPS), Safeway (SWY), Dell (DELL), eBay (EBAY) and Whirlpool (WHL); disk-drive makers Seagate Technology and Western Digital (WDC), and retailers Aeropostale (ARO) and GameStop (see table, An Attractive Dozen).

We're analyzing the candidates the way private-equity firms do, by focusing on companies with modest debt—some have sizable net cash positions—that trade for reasonable multiples of earnings and pretax cash flow. Gap, for instance, trades around 19, or 11 times projected 2010 profits. It also has more than $2 a share in net cash. Whirlpool, at 84, trades for nine times projected earnings, and Dell, at 14, fetches 11 times forward profits with $4 a share in net cash.

Yahoo! is attracting interest because it holds cash and valuable stakes in Asian Internet companies that could be worth a total of more than $10 a share—60% of its stock price even after a two-point gain last week to 16 on the buyout speculation. Early this month, Jefferies analyst Youssef Squali wrote that asset-rich Yahoo! could fetch $20 to $23 a share in an LBO.

"Just about any company trading for 12 times earnings or less that isn't capital intensive can get LBOed in this market," an investor tells Barron's. One reason is the formerly unfriendly bond market; it is now much more receptive to LBOs, and with more discipline than in the wild days of 2006 and 2007 and debt-laden deals for Hilton Hotels, TXU, Harrah's Entertainment and Clear Channel Communications.

The technology sector is ripe for LBO activity because tech outfits usually have strong, cash-rich balance sheets.

An Attractive Dozen

Barron's has compiled this list of potential leveraged-buyout candidates. Because LBOs typically require heavy borrowing, many targets feature significant cash on their balance sheets, or relatively modest debt. They also usually present low ratios of enterprise value to pretax cash flow.

* eBay
* Dell
* Yahoo!
* Gap
* Fidelity Nat. Info. Svcs
* Safeway
* Computer Sciences
* Western Digital
* Whirlpool
* Seagate Tech.
* GameStop
* Aeropostale

Sources: Thomson Reuters; Bloomberg

The retail sector has also been popular with private equity despite the industry's historic volatility and sensitivity to the economy. Toys "R" Us, Neiman Marcus and Michaels Stores have all gone private in recent years.

Several Wall Street firms have drawn up lists of buyout candidates in response to concerns of their institutional bond clients, who want to avoid holding debt in such companies; LBOs, after all, set off explosions in corporate borrowing, downgrades of credit ratings and falling bond prices. In a recent report, Merrill Lynch's credit team spotlighted Omnicom Group (OMC), Clorox (CLX), CBS (CBS), ConAgra Foods (CAG) and Safeway. UBS put out a similar report earlier this month and highlighted Quest Diagnostics (DGX), Lubrizol (LZ), Computer Sciences (CSC), Pitney Bowes (PBI) and Expedia (EXPE).

The targets of past LBOs often have been surprises because of factors besides valuation, notably the receptiveness of corporate boards and managements. LBO shops hurt their reputation with boards by walking away from some high-profile deals in 2008 after the markets tanked.

Private-equity firms are eager to complete transactions because they're sitting on tens of billions of dollars of commitments from institutional investors—on which they typically earn fees—and will be forced to free the investors from those commitments if they don't invest the money. The firms' executives are great at boasting about their prospects, and they're now talking about doing $10 billion-plus deals. But despite the excitement created by a few deals, private-equity transactions still account for just 10% of 2010 domestic mergers and acquisitions, according to Capital IQ. The biggest LBO since the collapse of Lehman Brothers in 2008 was the $5 billion purchase of IMS Health earlier this year.

Corporate buyers have—and probably will retain—an edge because they have deeper pockets and access to lower-cost financing. Corporations also can realize greater cost savings from integrating acquisitions into existing businesses. This enables them to pay more.

It's easy to see why private equity is attracted to Seagate, the top maker of disk drives. Seagate and rival Western Digital have some of the lowest valuations in the tech sector even after moving up last week on the Seagate buyout report.