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Why Now Is A Great Opportunity To Take Profit On Takeover Target Smith & Nephew plc

Smith & Nephew  (LSE: SN) (NYSE: SNN.US) is on a roll. If you are invested and you are perhaps tempted to cash in now, you may well be right. Here’s why. 

Performance/Premium

S&N shares have risen 7% since 23 December, when it was rumoured once again that S&N would be taken over by Stryker for about £13bn ($20bn). According to Bloomberg sources, S&N’s equity could be valued at almost 1,400p, for an implied 20% premium from its current level.

How realistic is such a price tag, though?

Firstly, S&N stock should trade below 900p to draw interest from investors, in my view.

Secondly, S&N is a prized asset but its shares had already gained 30% of value before Christmas Eve on the back of takeover rumours rather than meaningful operational improvements in 2014.

Value 

S&N’s share price rallied (+25%) to 1,100p in less than eight weeks to 10 June 2014. In those days, Zimmer had agreed to acquire Biomet for $13 billion, so investors decided to pay up for other takeover targets such as S&N in the sector. 

Based on S&N’s enterprise value (EV) divided by revenue, and EV/adjusted operating cash flow, the shares already trade in line with their mid-cycle multiples — and also trade at an implied 25% discount to peak-cycle multiples. In short, they are pretty expensive. 

While consolidation for medical device makers is on the cards, it’s unlikely that any buyer would be willing to offer a meaningful premium to S&N’s current valuation of 1,165p — although, admittedly, S&N could be broken up, while certain assets could be flipped to private-equity firms at a marked-up price. 

Another issue is that a tax-inversion deal isn’t likely to happen any time soon, although a smaller number of bigger players are competing in a sector where Medtronic and Johnson & Johnson may also decide to grow their asset base inorganically and, equally important, could deploy lots of cash held abroad.

S&N Is Not Cheap 

A full bid at 1,400p a share would value S&N at almost £13bn, for an implied forward adjusted operating cash flow multiple of about 11x — which seems a rich valuation for a business whose cost-cutting potential is more attractive than its organic growth prospects at this point in the business cycle. 

S&N stock is currently valued at a high multiple of 29x forward earnings, and trades 5% above the average price target from brokers, which are bullish, of course, about M&A prospects in a sector where rising costs point to more deal-making to preserve operating margins. Both S&N and larger players must also preserve market share as hospital consolidation in the US leads to lower budgets, which in turn puts pressure on suppliers’ profits. 

Yet do you recall what happened to the value of Shire when merger talks with AbbVie collapsed in October 2014? I would bet on a similar, painful outcome for S&N shareholders this year… 

S&N, Shire, GlaxoSmithKline and AstraZeneca do not top my wish list right now, but I strongly recommend you learn more about alternatives that do not price in any takeover premium and have the greater resources to ride out tough economies, based on fundamentals, as our analysts point out in a report that is FREE for a limited amount of time!

One strong defensive business, in particular, could easily deliver a 15% capital gain into 2015 -- and that doesn't include hefty dividend payments. Elsewhere, if you are looking for a company whose shares could be had on the cheap right now, you should consider our take on a transport company whose stock offers a 25% upside to the end of this year!

Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has recommended Glaxo and Shire. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.