Own a Takeover Target? Yay! Now What to Do?

With announcements of corporate mergers coming at a record pace this year, many individual investors have faced the unexpected news that one of their stocks has become a takeover target.

If a bid should be made for a stock you own, your first reaction probably would be to celebrate. But then comes decision time.

In most cases, a merger announcement sends the stock of the target soaring, giving investors the opportunity to quickly lock in a profit by selling.

However, selling is also likely to trigger capital gains taxes. Moreover, if you choose to hold on to the stock, you may reap bigger profits later, if the deal goes through. But holding also means you must assume the risk that the deal will collapse--or that the market overall will move against you.

What to do? This primer can help you sort things through:

Question: A stock I own just got a takeover bid. What are my options?

Answer: They generally boil down to three: 1) Sell immediately on news of the merger bid, when the share price of the target firm often gets an initial boost amid euphoria over the deal. 2) Hang on to your shares, waiting for a potentially better bid, or to sell just before the deal is completed. 3) Hang on to your shares, planning to accept the terms of the offer, which usually will be cash, stock of the acquiring company, or a mix of both.

Q: When should I consider selling right away?

A: When the offer’s prospects seem tenuous because of legal or regulatory hurdles, or because the target company balks at the offer.

In these dicey situations, the stock price of the target often soars on the initial bid announcement but then drops back.

Although investors who own the target’s stock outside a tax-sheltered retirement plan may owe capital gains taxes if they sell, they may still come out ahead by taking a quick profit and investing the money elsewhere.

Q: Has this been true of some recent takeover bids?

A: Consider the merger deal announced between financial services giants Travelers Group and Citicorp on April 6. Citicorp accepted Travelers’ offer, which was worth $182.50 a share in Travelers stock at that point.

But the combination faces serious regulatory hurdles, in part because, under current law, banks are prohibited from owning insurance underwriting operations.

Although Citicorp stock soared 26% on April 6, to $180.50, and Travelers zoomed 18% to $73, both stocks have since dropped sharply, to $154.94 and $63.13 now, respectively.

Likewise, when Lockheed Martin bid for Northrop Grumman last summer, Northrop shares jumped 24% to $110. But the government has since challenged the combination on antitrust grounds. So Northrop shares, at $107.69 now, are lower than they were nine months ago. Meanwhile, the stock market as a whole has risen in that period. Northrop stockholders may be wishing they had taken their money and bought another investment.

Q: What else can force a target company’s stock lower after an initial jump on news of a bid?

A: The target may reject the bid. That’s what happened in the case of Bank of New York’s recent offer for Mellon Bank. The bid sent Mellon shares up 12%, to $78, the day of the announcement. But Mellon said it’s not for sale--and its stock has tumbled back to $69.06.

Even in cases in which a deal is friendly--and the bid is accepted--the target’s stock may fall back for other reasons. For one, it may take months to consummate the deal, so time becomes a factor.

More important, market conditions are a big issue: If the acquiring company has made an offer to swap some of its shares for the target, the target’s stock could be dragged down if the acquiring company’s stock falls, either independently or with the general market.

Q: What clues should I look for to evaluate a deal’s prospects?

A: It helps to become a news junkie in the weeks and months after a merger announcement, said Alan Skrainka, chief market strategist at brokerage Edward Jones in St. Louis. Even if you don’t initially know what hurdles a deal may face or the potential advantages of a particular combination, news coverage following a merger’s announcement is almost certain to spell them out.

Q: When can a target’s shareholders feel more confident hanging on to their shares?

A: If the offer is for cash and the deal faces few regulatory hurdles, the final value of the deal should be as promised by the acquiring company.

Atlantic Richfield, for example, is paying $29 a share in cash for Union Texas Petroleum. That tender offer is already underway. So there is little reason for investors to sell at Union Texas’ current market price of $28.19.

If a deal is a stock swap, shareholders of the target company who would like to sell out may still opt to hold on if they feel that the bidder’s stock will rise in the near term. That would automatically raise the deal’s value.

Finally, if you think the target might get a better bid from a rival suitor, that would obviously be a reason to wait to sell.

Q: In stock-swap offers, why not just hang on to the target’s stock and get the shares of the acquiring company?

A: Many investors do just that. One big advantage of holding on, rather than selling, is that you generally don’t face a capital gains tax bill, because stock swaps often are structured to be tax-free exchanges.

Moreover, if the deal truly has merit, there are costs to be saved and advantages to be gained in the combination, resulting in a more profitable company in the long run.

“If management appears fairly bright, it makes sense to hold on,” says Joseph Lisanti, senior editor of Standard & Poor’s Outlook market newsletter in New York. “If you sold, you would have to pay tax and then reinvest what you have left in a company that you hope will do as well.”

Q: When does it make sense to wait to sell a target’s stock just before a deal is completed?

A: If the offer is a stock swap, and you don’t expect the bidder’s stock to fall much in the interim, but you don’t like the look of the combined company and thus would ultimately rather have cash than the buyer’s stock.

Some studies have suggested that a high percentage of mergers don’t work out. “These are deals where you look at them and think, as my grandmother used to say, ‘Your eyes are bigger than your stomach,’ ” says Lisanti. “If you are looking at a clash of cultures or a situation where it looks like it isn’t going to work--like when the company is buying into an industry that it knows nothing about--you might be better off paying the tax and cashing out.”

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Art of the Deal

Companies that receive surprise takeover bids often see their shares jump sharply on the day of the announcement. But the stock price may then recede--at least temporarily--for any number of reasons, including fear that the deal may not go through, time considerations before consummation and general market conditions. How stocks of some recent targets have fared:

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Stock close Date of bid/ Stock day before stock close price Target company takeover bid that day Friday Citicorp $142.88 April 6/$180.50 $154.94 BankAmerica 86.50 April 13/91.13 85.13 Mellon Bank 69.88 April 22/78.00 69.06 Union Texas Petroleum 20.50 May 4/28.50 28.19 Chrysler 41.44 May 6/48.81 53.88 Dekalb Genetics 77.00 May 11/94.25 94.50 Ameritech 43.88 May 11/46.00 44.75

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Source: Bloomberg News