Market Overview

Record oil prices have done little to stunt the growth of the US economy.  Despite oil reaching highs above $70/barrel and the possibility of major disruptions to the oil production facilities in the Gulf of Mexico increasing both gasoline and home heating oil prices, the economy continues to grow at higher levels than recently forecast. 

Many economists are raising expectations for second half growth into the 4% range, an increase to projections from just several weeks ago, including those from the Federal Reserve.  The US economy has grown at an annual rate of 4.1% for the past two years and recent economic indicators have shown no sign of this abating, as real household spending has increased by 4% over last year.  Despite consumer confidence numbers dropping in July, spending in the third quarter has started strong, with car buying surging to a 20.9 annual rate in July, the second highest on record. 

As a result of the continued strong growth, as well as revised inflation numbers from the Bureau of Economic Analysis showing inflation last year to be higher than previously thought (2.2% instead of 1.6%), the Fed might be compelled to keep raising interest rates past the expected “neutral” level, where rates would neither hinder nor help growth, in order to contain inflationary pressures.

Merger Activity

With companies in the S&P 500 sitting on a near record $621.7 billion in cash, high levels of merger & acquisition activity continue.  In the wake of NYSE and Nasdaq’s recent acquisitions, regional securities exchanges continue to draw high levels of interest and investment.  Fidelity Investments recently teamed with Credit Suisse First Boston, Citigroup Inc. and Lehman Brothers Holdings Inc. to form a new electronic equities market with the Boston Stock Exchange.  Citigroup and CSFB were also among the four brokerage firms that agreed to invest almost $20 million in the Philadelphia exchange.  Commodities exchanges have seen increasing attention as well, as The New York Mercantile Exchange (NYMEX), with daily trading volume hitting a record 1.2m contracts earlier in the month, has seen private equity firms Blackstone and General Atlantic, among others, interested in buying an ownership stake. 

The level of competition among the footwear industry is increasing with Adidas recently announcing a $3.8 billion deal to buy Reebok International.  Adidas is expected to pay $59/share, a 34% premium over Reebok’s closing price before the deal was announced.  The combined company, whose Reebok operations will continue to be based out of Canton MA, will account for approximately 30% of the global athletic footwear market, trailing only Nike’s 37%.  Growth in the industry has been slowing in recent years, with sales increasing only about 3% in 2004.  This slow growth coupled with increasing competition has industry experts expecting continued consolidation.  

The above exhibits illustrates the proportion of liquid assets (cash equivalents and short term investments) relative to total enterprise value for a sample of middle-market public companies. Higher percentages correspond to more liquid assets on the balance sheet. In general, it is notable that liquid assets have gone down relative to total value. However, closer inspection of the data reveals that this change is almost exclusively driven by the increase in company valuations; average liquid assets balances are virtually unchanged from a year ago (approximately $40MM for Business Services companies, approximately $45MM for Industrial Product companies and approximately $55MM for the Software companies in our sample). On average, these liquid asset balances suggest there appears to be significant room for unlocking value by either pursuing strategic acquisitions or by distributing cash to shareholders. And with liquid assets currently at about 30% of enterprise valuations, many companies with cash-rich balance sheets may make attractive acquisition targets for purely financial reasons.

Comparing the three business segments in the above analysis, it is clear that Software companies are on average most flush with cash and that Industrial Products companies have the lowest liquid asset balances relative to total value. One of the likely drivers behind this observation is the volatility of the cash flows in each of these segments: Software companies, which typically have the least predictable cash flows, have the largest cash buffers, whereas the more predictable cash flows of Industrial Products companies allows for lower average liquid asset reserves in this segment.