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Credit Insights

Takeovers: Rumors and Candidates

Investors should pay attention to bond covenants as buyout activity heats up.

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Early last week, rumors surfaced that  Sara Lee (ticker: (SLE), rating: BBB) had been approached by KKR with a takeover offer that was rebuffed. This rumor led to a hunt across the rest of the consumer product sector to identify other leveraged buyout targets. Pretty much anything with a market capitalization below $10 billion is now considered as potentially being in play. Names like  Clorox (ticker: (CLX), rating: A-),  ConAgra (ticker: (CAG), rating: A-),  Fortune Brands (ticker: (FO), not rated), and  Newell Rubbermaid (ticker: (NWL), rating: BBB-) all experienced significant bids in their credit default swaps. As the week wore on, the market expanded its search for LBO candidates to the retail sector, where  Limited Brands (ticker: (LTD), rating: BB+) was discussed as a candidate. With private equity firms sitting on more than $400 billion in uncommitted capital available for takeovers, we expect an uptick in LBO deals in the near term, particularly while interest rates are low and before capital commitments must be released to investors.

We are not surprised that Sara Lee may have become an LBO target, given its respectable free cash flow characteristics (it generates a free cash flow yield in the midsingle digits) and debt/EBITDA of less than 2 times. In addition, the firm has been in limbo since the departure of CEO Brenda Barnes for health reasons in August, and KKR may consider this a window of opportunity. On the basis of our preliminary LBO model analysis, which considers $4.6 billion-$5.1 billion in added leverage (4.0-4.5 times our projected fiscal 2010 EBITDA), an exit multiple of 8 times, and a required internal rate of return of 15%-18%, we view $13-$15 per share as a reasonable takeout range.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.