William Trent submits: Normally investors like it when they own stock in a company that is being acquired, as the acquiror often pays a healthy premium for the shares. However, here is a case where both the acquiror and the target are on our Watch List. (For the record, we don’t actually own shares in either Advo (AD) or Valassis (VCI).) In this case, we will have to see whether the gains for Advo outweigh a likely loss of value at Valassis.

Update: The deal was announced, and Valassis has lost $133 million of market cap as of 11:30 AM while Advo shares gained $362 million. The market is saying that the combined companies are worth $230 million more than the individual components, a net positive for the Watch List, but more than 100 percent of the benefit accrues to Advo shareholders.

As yesterday’s Reuters reported:

Marketing company Valassis Communications Inc. (VCI.N) is in advanced talks to acquire Advo Inc. (AD) for at least $1.1 billion, according to people familiar with the matter, The Wall Street Journal said on Thursday.

The two firms have discussed a deal that offers shareholders of Advo a premium of more than 50 percent of its $763.2 million market capitalization, two people familiar with the matter said, according to the newspaper.

A deal, which could fall apart or have its terms change, would unite two stalwarts of the direct-marketing and advertising business, the Journal said.

You may recall that last week Valassis sharply reduced its earnings outlook, blaming competition and lower volumes. Buying one of the competitors should help the pricing environment, and there would probably be significant cost savings available in a merger of two small companies like this - it is likely that most of the corporate level expenses at Advo could be eliminated. But would these be worth the additional $400 million over Advo’s current market valuation? With Advo’s operating margin at 5 percent, there is lots of room for improvement. If it could be boosted even half-way toward the 13 percent margin Valassis enjoys it would justify the large premium.

Another somewhat unusual aspect to this deal is that Advo is trading at a significantly higher P/E multiple (19.6x to VCI’s 13.4x even before any acquisition premium) so the deal would almost by necessity reduce Valassis’ earnings per share even further. Although the P/E multiple for Advo is closer to Valassis’ on a forward-looking basis, there is no guarantee that the consensus estimates for Advo are any more accurate than the recent estimates for Valassis were.

AD-VCI 1-yr comparison chart: