CORPORATE TAKEOVERS ARE

difficult to predict, but looking for likely targets is a worthwhile pursuit. The attributes that tend to attract buyout specialists can pay off nicely for shareholders whether or not a deal occurs.

Consider Longs Drug Stores, which holds a dominant position in Northern California, a market that CVS, for one, has yet to cover. SmartMoney.com highlighted the company a year ago, and a year and a half before that, after it turned up on our Takeover Targets stock screen. On both occasions we noted that we've no idea whether a deal is likely, but that prospects for the stock appear bright regardless. It's up 135% since the first story and 15% since the second. In a moment we'll add to our own not-so-frenzied buyout banter with a third look at the company.

Stock screening software can't search for possible buyouts based on things like geography and corporate culture, but it's great for finding under-priced assets with room for improvement. At the center of our screen is a valuation metric that reads like a line from an eye exam chart, but is actually simpler than it looks: EV/Ebitda. EV stands for enterprise value. It's the cost to buy all of a company's shares and pay off everything it owes while applying its available cash to the purchase. Ebitda stands for earnings before interest, taxes, depreciation and amortization. It ignores, among other things, ongoing charges related to past purchases of fixed assets. Like any earnings measure that can cover up past mistakes, Ebitda is subject to misuse. But it's useful to merger-and-acquisition specialists as a gauge of the profit potential underlying a company's current reported earnings. Think of EV/Ebitda as similar to the price/earnings ratio, except with a company's true takeover price on the top of the ratio and the money it's earning right now on the bottom.

Our screen also looks for subpar operating margins. Operating expenses include many of the easiest cost cuts to be made after a merger. For example, ad budgets and employee services can be consolidated and redundant managers can be dismissed. So a low operating margin is sometimes a sign of improvements waiting to be made. Our screen also looks for companies that are of below-average size for their industries that have generated excess cash over the past year. See our screen recipe for a list of all the demands and use our stock screener to run the search for yourself anytime. It recently reduced an 8,000-company database to eight survivors, including Longs.

Founded in 1938 in Oakland by Tom and Joe Long, Longs Drug Stores consists of more than 500 stores and a small prescription-benefit-services company, RxAmerica. The stores produce more than 90% of sales. More than 430 of them are in California. The company owns 40% of its stores and 29% of the plots those stores stand on.

Longs sells standard front-end fare like birthday cards, aspirin, Cheetos and film developing, and it has private-label brands including Longs, Bayside Basics and Pacific Living. Its sales are evenly split between the drug counter and the front, whereas most drug chains collect only a third of their sales at the front. That serves as an advantage for Longs, since front-end items are more profitable. Giant chains like CVS are more efficient in their corporate spending thanks to economies of scale, but Longs has been improving. Last year it spent 21% of its sales on so-called selling, general and administrative expenses. That's a percentage point more than CVS/Caremark, but also a percentage point less than Longs spend the year before.

When we first looked at Longs in 2004, we noted that the company had embarked on a plan to centralize decision-making with regard to merchandise and pricing, rather than leave the matter to store managers. That effort seems to have paid off nicely. In 2004 the company turned just 1.3 cents of each sales dollar into operating profits. Last year that figure reached 2.4 cents. It has further to go. The average for drug chains is more than 6 cents. Last year Longs began installing a new system for store ordering and inventory management, which could give a further boost to profitability. It was in place at just over half of stores as of January and should reach all of them by year's end.

The company, like the stock, seems less of a bargain than it was three years ago, but a bargain nonetheless. Longs carries an EV/Ebitda ratio of 9.4. That's up from 6.7 at the time of our first story, but well below the 17.5 for CVS and the 11.7 for Walgreen. CVS is perhaps the most logical fit in terms of geography. The company is on record as saying it wants to expand to Northern California and that acquisitions might be the most logical way to do so. It's also on record, though, as saying it's not particularly impressed with Longs' real estate. Whether that means a deal is out, or that CVS is simply downplaying the value of a chain it might one day wish to buy, is anyone's guess.

Andrew Wolf at BB&T Capital Markets is unique among the nine analysts who cover Longs in that he recommends the stock and has done so since our first story. (That makes him also unique in having been right.) He thinks the company can earn between $3 and $4 a share with further efficiency improvements, up from $2.41 forecast for this year. "I can see how the company could be attractive to a buyer, but to me it seems a good investment on its own merits," says Wolf. "The company is still under-earning its potential but it's already leading an impressive turnaround and it has a strong balance sheet. Things like that appeal to all sorts of investors, especially individual stock buyers."