Look for a Wave of Tech Mergers

• ByTim Melvin, RealMoney.com Contributor
• On 1:30 pm EDT, Tuesday October 6, 2009

Yesterday, we saw Brocade become the latest company to put itself up for sale this year. Takeover activity is increasing as there are still a lot of very cheap assets in the markets and corporate America does have a pretty healthy cash hoard. The first half of the year was for dealmakers, with transaction volumes about 12% of what they were at the peak in the first quarter of 2007. That period saw deal volume of over $500 billion, while the second quarter of this year saw only $60 billion. If the decline in the U.S. dollar continues, we are going to see a wave of foreign as well as domestic strategic takeovers.

I am of the opinion that the market can still move lower, and when this happens, it is going to trigger a merger wave. The energy and financial sectors are going to be ripe for consolidation when we do emerge from this recession. It is going to be a lot cheaper and easier to buy earnings and assets in the stock market than it will be to build them on your own. Real estate will be an obvious place to buy assets at fire-sale prices, as I discussed in a recent article. Oppenheimer is so confident of an increase in merger activity that the firm is expanding its risk arbitrage department to take advantage of an increase.

Technology companies such as Brocade are also going to see a lot of deal activity. It is a lot easier to buy the data storage and management business of Brocade than it is to develop products and build the business from scratch. I ran some screens to see if there were any likely candidates at relatively cheap valuations, and even after the run-up this year, I found a few that might be attractive acquisitions.

Lexmark strikes me a potential takeover candidate, particularly if the market takes the price lower in the months ahead. The company had a competitive advantage a decade ago, selling printers for less than its competitors. In recent years, however, its cost advantage has been eliminated, and the company has struggled. Hewlett-Packard has dominated the market for printers recently, especially in the increasingly popular laser markets. The competitive marketplace and weak economy could continue to pressure Lexmark's results into 2010. As a result, the shares have become cheap and may be attractive to a buyer who wants to enter the printing or office automation markets. The stock trades for just 11 times earnings and just 39 cents on the dollar of sales. The enterprise value-to-earnings before interest, taxes, depreciation and amortization (EV/EBITDA) ratio is below 3.

One of the best businesses to be in right now is the processing of electronic payments. Heartland Payment Systems happens to be in the business of providing such services to U.S. merchants. At the end of 2008, the company had over 165,000 smaller merchants' accounts and 82 large accounts, with over 500,000 locations between them. All together, Heartland processes over 100 million transactions on a monthly basis. The company got hit by hackers in one of the largest data breaches ever earlier this year, and this has weighed on earnings as well as the stock price. In the second quarter, Heartland took a $19 million charge to account for claims and legal fees as a result of the breach. In spite of this setback, it's a great business to be in, and Heartland might be a cheap way to enter the field. The stock trades at a price-to-sales (P/S) ratio of 0.33. I think the stock is a little rich on an EV/EBITDA basis, with a ratio of 6.5, but if it were to fall back below a 5 ratio, I think it becomes a very attractive takeover candidate.

If I wanted be in the mobile and consumer electronics business, I could build a company and sales network from scratch, or I could just make an offer for Audiovox . I have written about this company before, and it's a very cheap stock. The stock trades at just 60% of tangible book value, and one-third of the stock price is in cash on the books. The announcement in January of the first in-car PlayStation 3 could be a revenue driver when car sales recover and make the company even more attractive to a potential suitor. The P/S ratio is 25 cents on the dollar of revenue.

Tech is one of the sectors that I think could see an enormous amount of takeover activity over the next five years. It's going to be more cost-effective to buy research and development via takeover as opposed to in-house development. When you can expand product offerings and revenue for pennies on the dollar of sales and low EV/EBITDA ratios, it just makes business sense.

At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.

Buzz up!