(MONEY Magazine) – THIS MONTH: --Education stocks earn A's --Don't give up on Intel now

The latest motto on Wall Street: if you can't beat 'em, eat 'em. So far this year, U.S. companies have announced a staggering 7,700 acquisitions worth a record $700 billion. What makes this binge different from those in the 1980s is that acquisition-minded companies are pigging out with stock instead of cash. Even despite the market's 13% correction since its peak of 8259 in August, there are still blue chips with lofty price/earnings ratios that have an incentive to use their stock as takeover currency. Two cases in point: $396 million real estate investment trust Starwood Lodging's $13.3 billion bid for ITT and $4.5 billion telecommunications giant WorldCom's $30 billion bid for MCI. In both cases, the acquirers propose to pay shareholders of the target company primarily with stock.

Buying a fast-growing company is often the easiest way to keep jacking up earnings at the pace Wall Street has come to expect. "No matter what the market is doing, companies that use their stock to buy lower-P/E companies boost their earnings immediately," says Charles LaLoggia, editor of LaLoggia's Special Situation Report ($230 a year; 800-836-4330).

To see why, take a look at WorldCom's bid to swap 812 million shares of newly issued WorldCom shares for each share of MCI. (For information about the prospects of GTE, another eager suitor for MCI, see page 68.) WorldCom trades at a weighty 34.4 times 1998's projected earnings. So for every dollar of stock, the company will earn 2.9[cents]--$1 divided by 34.4. On the other hand, MCI trades at a P/E of just 31.1, or 3.2[cents] of earnings per dollar of share price. If the deal happened today, for each dollar's worth of shares WorldCom uses to pay for MCI, WorldCom would trade 2.9[cents] of its profits for 3.2[cents] of MCI earnings. Presto! The deal boosts WorldCom's earnings per share 4% even before the combined company realizes any benefit from streamlining operational costs.

How do you get in on the action? The best way, says Mario Gabelli, the renowned money manager in New York City: "Buy cheap stocks in consolidating industries, and wait for the consolidators to come and buy your companies." To help you find such prey, we asked more than three dozen analysts and investment advisers for their favorite takeover targets. Then we narrowed down the nominees to companies with long-term growth rates in excess of Standard & Poor's 500's rate of 7% annually, so even if an acquirer never shows up, shareholders ought to fare well. We also wanted stocks with P/Es less than the market's ratio of 18. The five candidates that meet these criteria all trade on the New York Stock Exchange and are listed here in descending order of their returns over the next 12 to 18 months from their late October market sell-off prices:

--GATEWAY 2000 (ticker symbol: GTW; recently traded at $28.50; no dividend). In October, Prudential Securities analyst Don Young predicted that this $5 billion PC maker could be taken over within a year. For one thing, the North Sioux City, S.D. company sells at an ultra-cheap P/E of 13, vs. an industry average of 16. (The company got that cheap after reporting a $107 million third-quarter loss on one-time charges and slower than expected sales.) Also, as a direct seller, Gateway benefits from consumers' growing appetite for buying machines straight from the factory. Some competitors, like $18 billion Compaq, are aping Gateway's approach, but Young believes the best way for one to enter the market is simply to buy Gateway.

Gateway has just rolled out its first servers and workstations, which have margins of more than 30% vs. 18% for its PCs. Moreover, it has opened 16 so-called Gateway Country stores across the U.S. to attract the 50% of customers who aren't comfortable buying a computer over the phone. Young estimates that Gateway's U.S. market share could double to 20% over the next five years. And Lou Mazzucchelli, an analyst at Gerard Klauer Mattison, is looking for earnings growth of 61% in 1998, pushing the cash cow's stock to $50, for a 75% gain.

--PHARMACIA & UPJOHN (PNU; $31.25; 3.5% dividend yield). This $7.2 billion London pharmaceutical giant recently traded at a P/E of just 18, vs. the industry average of 25. One reason for the deep discount is that P&U derives 68% of its sales from overseas, and analysts fear the strong dollar could knock two percentage points off its long-term 10% annual growth rate. But the steady cash flow generated by such P&U stalwarts as Rogaine hair-loss treatment (annual sales: $189 million) could entice Merck or Pfizer to make a bid in the next year.

According to Jack Lamberton, an analyst at NatWest, the company has a very promising new drug in Detrusitol, which could be on the market in early 1998. It is a prescription medicine to treat urinary incontinence, a condition that afflicts 7 million Americans. One big advantage: Detrusitol is less likely than existing remedies to cause dry mouth. Lamberton estimates that in three years the drug's sales could hit $700 million a year. David Katz, a money manager at Matrix Asset Advisors expects the stock to hit $48 in a year for a 57% return.

--JOHN NUVEEN (JNC; $35.25; 2.6%). Municipal bonds account for 95% of the $62 billion in assets at this Chicago purveyor of mutual funds and unit investment trusts. But in September, Nuveen bought Rittenhouse Financial Services, a $9 billion Philadelphia company that sells equity funds to high-net-worth individuals. Smart move, since net margins on equity products can run as high as 50%, far more than the typical 35% on munis. "Having a foothold in equities will help Nuveen attract the big fund companies like Marsh & McLennan and Franklin," says Matrix Asset Advisors' Katz. He thinks they'll also be enticed by Nuveen's P/E of 15.1, just below the industry average. Mario Cibelli, an analyst at Robotti & Co., thinks that within a year Nuveen will fetch a takeover bid of $48 a share for a 39% total return.

--FRONTIER (FRO; $21; 4.1%). The fifth largest telecommunications company in the U.S., $2.6 billion Frontier trades at a P/E of just 17, compared with WorldCom's 34.4. "Frontier is a sitting duck," says Charles LaLoggia. Reason: At the end of 1998, the Rochester, N.Y. company will complete its $450 million installation of a high-speed fiber-optic network that will help Frontier raise its long-distance net profit margins from 5% this year to 10% by 1999.

Installation costs have depressed Frontier's earnings this year. But analyst Megan Kulick at Merrill Lynch expects profits to rise 22% in 1998. Shedding unnecessary businesses such as calling cards and centralizing operations let the company cut its work force by 8%. Kulick thinks that the stock will hit $28 in the next 12 months for a 37% return.

--LONGS DRUG STORES (LDG; $24.50; 2.3%). LaLoggia picks $2.8 billion Longs as one of the companies most likely to be taken over in the next year. The Walnut Creek, Calif. pharmacy chain has 344 stores on the West Coast, making it the sixth largest drugstore retailer in the U.S. With a P/E of just 16, Longs is likely to attract notice from industry leaders like CVS (23 P/E) that want to expand on the demographically desirable left coast. Says LaLoggia: "Longs is a very cheap buy for CVS--or any big drugstore chain."

The Long family and the company's employees own 41% of the outstanding shares, but LaLoggia thinks they will accept a bid to fend off encroaching competition from Wal-Mart and Rite Aid, which have opened stores in Longs' area. Meanwhile, Longs plans to open 15 stores in 1998, which should help boost earnings by 10%, according to Eric Bosshard, director of research at Midwest Research. Bosshard expects that additional earnings growth and the stock's rock-bottom P/E will push the price to $30 within a year, for a 25% total return. After that, just stuff an apple in its mouth and serve it up.