Today, I want to talk to you about one of my favorite hunting grounds for undervalued stocks. I don’t find opportunities in this particular location all the time, but when I do it’s generally a pretty good one.

What I’m talking about is searching the scrap heap of busted merger & acquisition (M&A) deals. Most M&A deals go through as planned. The deal is negotiated ahead of time, two parties come to an agreement and the announcement is made.

Occasionally, we see hostile offers, but those are offers, not announced deals. And when you get an announced deal, sometimes they do fall apart. It could be due to buyer’s remorse, financing that didn’t go through, material changes in the business of the target company or even anti-trust issues.

So, there are lots of reasons a deal could fall apart, although it is somewhat rare. When it does happen, though, the target company usually falls back to or below the level it was trading at before the deal was originally announced.

That often creates a bargain opportunity because now investors know that a rational buyer was willing to pay a much higher share price for the target company. For some reason it didn’t go through, but the real value of the company might be much closer to the target price than to the price where the shares have fallen back to.

Sportsman’s Warehouse Holdings, Inc.

And that’s exactly what I think we have happening with today’s stock pick. Earlier this year, Bass Pro Shops announced that they were going to buy Sportsman’s Warehouse Holdings, Inc. (SPWH), a chain of sporting goods stores primarily in the western part of the country.

They had 112 stores, and the Federal Trade Commission (FTC) reviewed it and decided it cannot happen. Therefore, the deal has fallen apart. Now, before we go into too much detail, I want to tell you about my favorite busted deal story.

In 2007, a hedge fund called Cerberus Capital Management made an offer to buy United Rentals, Inc. (URI) at $34.50 a share. Then came 2008, and financing for deals just disappeared and the market collapsed.

So, for a stock that was trading up near $34, shares of URI went into a freefall to around $5 a share. Now, people looked at that and saw it as a risk worth taking at $5 a share. Well, if you had just sat on the stock for six years, you would have made 10 times your money.

But really patient investors who still own the stock today, the stock has gone from $5 to over $300 a share, or a 65-to-1 return on your money from this busted deal stock. They won’t all give you that kind of return, but most of the time when I get involved with a busted deal, it’s a quality company at a fantastic price.

I think that’s what we have here with Sportsman’s Warehouse. They sell traditional sporting goods items and have a very robust firearms business. The FTC doesn’t want the deal to go through because Bass Pro Shops already owns Cabela’s, and they dominate the retail sporting goods industry. Therefore, the bid was withdrawn, and SPWH has fallen sharply.

Now, management has shown us that they are interested in selling the business, and $18 should be the floor price for a new deal, which would be a nice return from current levels. But we’re only paying seven times earnings for this fantastic business. It’s got a rock-solid balance sheet and is producing tons of free cash flow.

Furthermore, during the pandemic, people returned to outdoor sports, especially golf, hunting, fishing and camping. And like I mentioned, Sportsman’s Warehouse has a robust firearms business, both for rifles and handguns.

How popular are firearms right now? On Black Friday, 188,000 background checks were filed with the FBI for folks wanting to purchase firearms. The pandemic, civil unrest and the uneasiness in society have increased peoples’ desire to own firearms for personal protection. We have seen firearm sales skyrocket, especially for women.

So, I think this is going to continue to be a great business, and it might even be an attractive takeover target for a private equity firm at some point. We know management is open to selling and probably looking for something of an exit strategy, so that’s not a bad plan.

It’s a great business at a fantastic price. It’s probably worth around $18 a share or more. So, this is a busted deal stock with solid upside potential and, I think, very limited permanent downside risk because of that rock-solid balance sheet and the amount of free cash flow they are continually generating.

That’s an excellent combination for very high long-term profits.