As a dividend investor, I am constantly looking for companies with high amounts of cash that may be returning it to shareholders. While this might be the most obvious use of excess cash, there is another reason to be mindful of a company’s balance sheet. Not only can cash be used to pay dividends and buyback shares but it can also make a company a potential takeover target. A large stockpile of cash and inexpensive valuation make the three companies below attractive targets for private equity, activist investors and competitors.
When looking at potential takeover targets, I prefer the enterprise-to-sales ratio for valuation purposes. A company’s enterprise value is its market capitalization minus balance sheet cash after removing long-term debt. It is the value of the company’s debt-free assets and equity and used by many to value acquisitions. Potential buyers usually look at the enterprise value against either sales or earnings before interest, taxes, depreciation and amortization (EBITDA).
While a low valuation and a lot of excess cash might offer options for a potential suitor, stable revenue growth is always a catalyst for a buyout as well. Higher sales means that a target does not necessarily have to be accretive on cost cuts alone.
Accretive growth, split or recapitalization
HCI Group (HCI) is a property and casualty insurer in the state of Florida. Shares trade for an enterprise value of 1.0 times sales, under the average of 1.28 times for the group. A lot of this is due to the company’s net cash of $166 million after debt, nearly 40% of the stock’s market capitalization. Sales are expected to grow by 12.3% in 2014 and by just over 8% next year. The shares pay a 3.0% yield and management just authorized a $40 million buyback. The insurance industry is not exactly a high growth market and the ability to acquire sales growth of low double-digits will be extremely attractive to larger players as an accretive target.
TrustCo Bank Corporation (TRST) is a $670 million holding company providing banking services to customers in New York, Florida, Vermont, Massachusetts and New Jersey. The company also operates a real estate investment trust (REIT) that holds mortgages. Shares trade for an enterprise value of 2.6 times sales against a peer group average of 3.9 times. As with HCI Group, the valuation has a lot to do with a huge cash pile. The company has net cash of $295 million on the balance sheet, almost 44% of the company’s market cap. Sales are expected 1.2% higher this year to $156 million and 4% higher in 2015. Shares pay a 3.7% dividend yield and may be attractive to a private equity or activist firm looking to unlock shareholder value by splitting the banking and real estate assets.
United Online (UNTD) operates in two segments, content & media and communications. The content & media group offers social media services through branded websites like Classmates, StayFriends and Trombi. The communications segment offers internet access through the NetZero and Juno brands. Shares trade for an enterprise value of just 0.41 times sales, well under the company’s nearest competitor Earthlink (ELNK) with an EV/Sales of 0.69 times or compared to other social media providers. The company has $68 million in cash on its balance sheet with no debt for 42% of its capitalization. Sales are expected to decline by 4.3% this year to $224 million but are expected up 1.5% next year. Shares pay a 5.1% dividend and could be an attractive target on either a split of the two segments or just to recapitalize the company. Recapitalization, or adding more debt to the financial structure, allows buyers to immediately realize some profits.
Investing in the three companies are not without risk. At a market capitalization of just $163 million, United Online is classified as a micro-cap while the other two companies are small-cap stocks. Liquidity in the shares is under 600,000 shares daily on average and the quote spread is going to be much larger than in the stocks of larger companies. While the high amount of cash on the companies’ balance sheets makes them attractive as takeover targets, it also opens up the risk of management misuse as well. Rather than return the cash to shareholders or accept any buyout offers, the company’s may decide to squander it on pet projects or unprofitable acquisitions.
Despite the risks, all three companies are attractive on a valuation basis and could be targets for strategic or financial reasons. With net cash of more than 40% of market cap, potential buyers will have a lot of options when deciding what to do with the acquisition. High dividend yields mean that investors can take a position and wait for a catalyst that sends the shares higher.