3 Ideal Activist Takeover Targets

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With rumors circulating about consolidation in the office equipment industry, it is a good idea t,o buy now before the speculation turns into reality. Several producers are meaningfully trading below intrinsic value despite leading free cash flow yields. I encourage diversifying across the industry to hedge your bets, since many of these companies are in turnaround mode or suffering from a slump in sales.

Staples (NASDAQ: SPLS): A Private Equity Takeover Target

At a respective 8.7x and 8.1x past and forward earnings despite tremendous free cash flow generation, Staples is a compelling buyout target. Growth has been barely factored into the stock price, as evidenced by the PEG ratio of 0.89x, and the dividend yield of 3.8% helps hedge against any downside. However, with the firm well under its historical 5-year 16.1x PE multiple, I don't see much downside going forward.

So will Staples be a buyout target? Multiple reports have highlighted rumors that private equity firms are mulling a takeover of the office equipment retailer. It's easy to see why a takeover would be attractive. The firm generated $1.2 billion in free cash flow for the TTM ending 2Q12 - a 15.2% yield against the market cap. That's more than enough to pay off leverage, which is very low at a debt-to-equity ratio of 0.3x. And finally, analysts forecast a 9.7% annual EPS growth over the next 5 years.

Assuming Staples meets expectations, 2016 EPS will come out to $1.87. At a multiple of 12x, that translates to a future stock value of $22.44. The stock is currently worth half that amount. Discounting the future stock price back by 10%, Staples should be worth nearly $14 today. I thus strongly encourage backing the retailer.

OfficeMax (NYSE: OMX) & Office Depot (NYSE: ODP): Both Activist Targets

Both of these firms are structurally weak compared to Staples. Office Max has surged nearly 90% from its bottom in August and is now worth 9.6x the future stock price - still compelling, but highly uncertain given that EPS is recovering from just $0.46 over the TTM. Office Depot is similarly cheap at 0.6x book value, and is also very uncertain. Analysts currently rate the stock closer to a "sell" than "buy".

In my view, both of these companies are possible activist targets. Over the last 5 years, OfficeMax and Office Depot have lost 77% and 88% in value, respectively. They are currently selling as though their stores will never return to historical levels. Put differently, a tremendous amount of risk has been factored into their stock prices, and unless a series of quarterly misses detract from the turnaround story, the long-term looks good. Fortunately, OfficeMax has beaten analyst expectations in all of the last 4 quarters. Office Depot, on the other hand, had a devastating 55.6% miss in 2Q 2012 with negative EPS of $0.14. 

However, Office Depot was recently targeted by activist investor Starboard, which has a history of effectively shaking up management to unlock value. They purchased a 13.3% position in the company and called upon management to cut costs and move onto higher-margin segments. Starboard, however, should push for a buyout, which has historically led to the greatest returns from shareholder activism. The turnaround story is still compelling given that most of the downside has already been factored in. Should Office Depot be put up for sale in an industry consolidation, its parts could be sold for more than the whole, as evidenced by the 0.6x price-to-book ratio.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Staples. Motley Fool newsletter services recommend Staples. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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