by Louis Basenese, Small Cap & Special Situations Expert
Thursday, October 22, 2009: Issue #1121

With the healthcare debate still raging in Washington, this should shock you…

Healthcare mergers and acquisition (M&A) activity is at an all-time high.

You’d think with so much uncertainty surrounding the future of the industry, the dealmakers would be as lonely as a geek on prom night.

But that’s just not so.

• Based on the dollar value of transactions, roughly one-third of all deals in the United States this year involved healthcare companies – considerably higher than the historical average of 10%, according to Dealogic.
• And based on the number of transactions, about 13% of all deals in 2009 have involved healthcare companies. Again, that’s notably up from the historical average of 9%.

Let me share why we can expect the record-setting activity to continue – and, of course, three ways to capitalize on it.

What’s Greasing the Skids for Healthcare M&A Activity?

At first glance, you might question the savvy of healthcare executives to make acquisitions in such an uncertain climate. After all, healthcare stocks have significantly lagged behind in the S&P 500 rebound, rising only 9.6% compared to a 20.8% increase for the Index, year-to-date.

But rest assured, they’re not buying blindly. In fact, the companies at greatest risk of cost cuts (and, in turn, less profits) – insurers, hospitals and nursing homes – remain on the sidelines.

Instead, it’s companies in other categories – like drug makers, research labs, equipment manufacturers and healthcare technology companies – that are so acquisitive. Here’s why…

Regardless of the end result of the legislation in Washington, one thing is glaringly obvious: millions more Americans will get healthcare coverage. And that represents millions more potential customers.

Companies are simply jockeying for position, so they can capture a larger share of the new demand. And takeovers represent the quickest way to do so.

Healthcare Takeovers Expand Market Share Cheaply

In addition to being quick, takeovers are also a cheap way for healthcare companies to expand their market share.

Consider that the average healthcare stock now trades for roughly 12 times earnings – a bargain, considering the average stock in the S&P 500 trades around 20 times earnings.

So with healthcare reform imminent, companies don’t need to waste the time and money, or take the risk to try and expand organically. Not with so many attractive targets trading on the cheap.

And the fact that financing remains available for healthcare deals only makes the growth-via-acquisitions strategy more irresistible. You see, while banks shy away from lending to other sectors, they’re all too amenable to lend a hand to a completely recession resistant industry with strong growth prospects.

Case in point: Pfizer (NYSE: PFE) and Merck (NYSE: MRK) secured tens of billions in financing to fund their acquisitions during the darkest days for the market (in January and March).

With more healthcare M&A likely, here are three healthcare companies I strongly believe are takeover bait…

Put These Three Healthcare Stocks on Your Watch List

~ Bristol-Myers Squibb (NYSE: BMY): When Pfizer ponied up $68 billion to acquire Wyeth in January, it set the stage for more Big Pharma tie-ups. Sure enough, Merck stepped up to purchase Schering-Plough for $41 billion in March.

And making the case for someone to buy Bristol-Myers is easy…

• It recently divested non-core assets.
• It’s sitting on $8 billion in cash, which acts as an instant rebate.
• It boasts a solid pipeline of cancer drugs, which hold the potential for faster FDA approval and higher margins.
• Multiple suitors exist including Sanofi-Aventis (NYSE: SNY), GlaxoSmith Kline (NYSE: GSK), AstraZeneca (NYSE: AZN) and Johnson & Johnson (NYSE: JNJ).

The fact that BMY shares trade at their lowest valuation in a decade only makes a deal more likely. And it doesn’t hurt that we get paid a 5.4% dividend yield while we wait.

~ Onyx Pharmaceuticals (Nasdaq: ONXX): If you’re looking for the next biotech deal, Onyx could be it. In Nexavar, it boasts the first FDA-approved drug for liver cancer, the third-deadliest form of cancer. And it just made a move to strengthen its pipeline by acquiring privately held Proteolix. The potential for additional applications for Nexavar should entice the company’s current partner, Bayer AG, to make a move to acquire ONXX before someone else does.

~ Medidata Solutions (Nasdaq: MDSO): The $787 billion federal stimulus package includes roughly $20 billion for healthcare information technology (IT) – a sum that only serves to accelerate the trend to bring the healthcare industry into the digital age. And that bodes well for Medidata.

I’ve outlined the fundamentals for Medidata here before. In short, its products eliminate millions of dollars in waste from each clinical trial. And suitors would be buying the fastest growing company in the space – the company’s revenues jumped 32% last quarter.

Moreover, a measly market cap of $362 million makes a takeover more compelling, as suitors could easily buy MDSO with cash on hand.

And remember… investing in a stock before a takeover announcement results in an average gain between 43.5% and 53.7%, according to the number-crunchers at FactSet MergerStat. So clearly, it’s a strategy worth pursuing.

Good investing,

Louis Basenese