Are LBO's making a comeback?

Zacks

Are LBO's coming back when the broader market is about to hit new all-time highs?

Leveraged buyouts (LBO's) occur when management works with private equity or other partners to buy all of the stock of a company with the hopes that managing it privately will result in higher profitability. You usually see a LBO when the market is depressed and the stock is not 'fully valued' by investors.

The old formula called for private equity companies to come in and buy a company. The experts would then come in and clean up what they could, which generally means a whole lot of people get fired. Management would then have the company raise several hundred million dollars in debt. The money would then be used to pay a one-time dividend to the owners. The company, having seen its expenses contract, is likely to show greater profitability and is then sent back to the public via another IPO.

Lately we are seeing a new trend in the LBO market. The founders are coming back and looking to bring their old companies private because they believe they can run them better. The two great examples of this are Best Buy (BBY) and Dell (DELL). Each is an interesting story in its own right, but the concept of the LBO and why the founders are risking billions of their own dollars is a lesson that needs to be learned.

Best Buy

Chairman Richard Schulze, who founded the company and owns about 20 percent of its stock is looking to work with private equity groups to take the company private. The goal here is that the company generates plenty of free cash flow, so the new owners would likely look to use that to pay the interest on any new debt or loan taken out to acquire the company.

Shares of the retailer fell 49% in 2012 as investors were concerned that consumers were using the store as a showroom for later purchases made online at sites like Amazon (AMZN). Buyout discussions date back to August, but little has happened outside of rumors since then. One thing is certain, the potential total value of the deal has contracted by a big amount.

The thing to learn from this deal is that just because some wants to buy something, it doesn't mean you should too. Since the August talk of a buyout started, the stock has dropped a little more than 17%, and that comes after 32% increase from January 7 to present levels.

Dell

A more recent story is that of Dell, and its founder Michael Dell moving to secure private equity and an investment from Microsoft (MSFT) to take the company that bear his name private. Dell holds approximately 16% of the company and has billions more invested in MSD Ventures, his investment vehicle.

News the LBO deal for Dell hit on January 14, and was discussed as a deal that is hard to get done... at least until the news of a Microsoft participation of for as much as $3 billion hit the wires.

Dell has been under fire from Apple (AAPL) a company that has innovated around products where the Dell model called for the removal of unnecessary costs in the supply chain. After the majority of costs were removed, there wasn't much else for Dell to do. Apple, on the other hand, developed iPods, iPhones and iPads and owned the 'coolness' factor.

The take away from the Dell deal is all about the cloud. Maybe you have heard about this thing call the internet and how companies are moving to have all their software or programs accessible from the cloud. This means they will need a significant backbone in the form of servers to handle the traffic and storage space required for such a move. Dell's most recent quarter saw consumer sales struggle and server sales skyrocket.

Who else could be on the list?

I took a look around for other stocks that could be the focus of LBO's. IAC Interactive (IACI) tends to fit the bill with a founder holding a large stake in the company. Barry Diller has made many deals in the internet space but yet the stock is down slightly over the past year.

Some good free cash flow and a lower price over the last year does not make a stock a must have in a portfolio. It does, however, lend itself to the discussion of an LBO which may be enough to make a trade.

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Brian Bolan is a Stock Strategist for Zacks.com. He is the Editor in charge of the Zacks Home Run Investor service, a Buy and Hold service where he recommends the stocks in the portfolio

Brian is also the editor of Follow The Money Trader a trading service that tracks institutional money flows and looks for great stock picks from that data.

Follow Brian Bolan on twitter at @BBolan1

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