Is It Time To Cash In On Takeover Target Smith & Nephew plc?

Smith & Nephew (LSE: SN) (NYSE: SNN.US) is the classic example of a company whose equity looks overvalued, but an investor may want to hold onto it for some time.

Tax Inversion

Are the Americans getting at it again?

If reports turn out to be true, Medtronic may approach S&N in order to exploit a lower corporate tax rate across the pond. The same rationale was behind the Pfizer/AstraZeneca’s mating game.

The difference between Astra and S&N is that the latter is not a strategic asset, is much smaller and would cost up to $18bn, i.e. just a fraction of Astra’s current value.

If Medtronic repatriates its cash pile held abroad, it’ll have to pay the taxman. So, a “tax-inversion” deal must be engineered, with the UK being used as a tax shelter.

Investors are adamant a takeover will happen. In fact, Stryker has also shown interest in S&N and needs to scale up its business, although anti-trust issues would likely force targeted divestments.

Operationally, life at Medtronic could continue without the joint replacement systems for hips, knees and shoulders that S&N manufactures and sells.

Stock Performance

The run of S&N stock seems unstoppable. Since I wrote about a possible takeover of the business on May 13, the market cap of this medical-device maker has risen by 17.7%.

Well, should a medical-device maker trade at almost 4 times sales and 30 times trailing earnings? Forward trading multiples tell a similar story: S&N is overvalued. Yet believe it or not, S&N could still be a compelling investment, even if no buyer shows up.

Fair enough, the risk that S&N stock will plunge is real. A 10% drop is conceivable. But look at Astra. Since first rumours emerged in January, its equity value has risen more than 20% — a surge spurred by M&A talk rather than meaningful operational changes.

Nothing Wrong With It

S&N is a solid business, with a strong capital structure and impressive profitability. If anything, its organic growth prospects are not particularly appealing, but additional cost savings could make a difference to the bottom line.

As consolidation in the sector continues, S&N needs to grow the size of its business to enlarge its product offering, or it will struggle to keep up with competitors. Hence, a takeover looks a distinct possibility.

S&N’s relative valuation, as gauged by S&N market cap plus net debt divided by its adjusted operating cash flow, has been on its way up for a few weeks now, but is still 30% below its last 10-year record, in spite of a stock price that is hovering around all-time highs. Medtronic must have noticed that.

Elsewhere, if you're willing to take some short-term risks to chase long-term value, you may want to consider the ailing food sector in the UK. It has been battered in recent times, but that's precisely when value should be sought.

Tesco is a valuable long-term play, according to our latest report. While I recently argued that Tesco ought to shrink to boost its performance, even in its current form it presents interesting features and a valuation that is not too demanding.

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Alessandro doesn't own shares in any of the companies mentioned. The Motley Fool owns shares in Tesco.