Market Overview

Hurricane season has dominated the headlines lately and is having a significant impact on the US economy as well.  Hurricane Katrina alone is expected to lower second-half US economic growth and increase both unemployment and inflation.  With the movement of goods disrupted, key ports still closed, and oil and gas drilling platforms, refineries and pipelines damaged forecasts for second half growth have been lowered by approximately 0.4%.  Economists expect GDP to expand at a seasonally adjusted annual rate of 3.6% in the third quarter and 3.2% in the fourth quarter, down from last months forecasts of 4.2% and 3.6% respectively.  However, there should be a slight boost to economy in early 2006 as hurricane reconstruction gets underway.

Despite Katrina’s expected effect on the economy, the Fed last week continued to raise rates at a “measured” pace, boosting the federal funds rate by another quarter percentage point to 3.75%.  The Fed released a statement saying that Katrina would likely cause short-term, but not long-term, economic disruptions.  Cash from job growth and strong corporate profits has been fueling continued growth in the economy.  However, corporate profits are the most likely to be impacted by Hurricane Katrina.  Early estimates of Katrina related damage are already higher than last season’s hurricane related subtraction of approximately $23.3 billion from corporate earnings.  In addition, rising energy costs continue to feed fears of inflation, although core inflation remains quite tame.  Overall forecasts for inflation are up sharply for November and the remainder of the year, with overall August CPI up 3.6% year over year.

Merger Overview

Several large firms have made big plays for software firms recently.  Oracle continued its recent buying spree by agreeing to acquire Siebel for $5.8 billion and HP announced its acquisition of Peregrine Systems.  Oracle, with barely enough time to digest both PeopleSoft and Retek, has struck again, offering $10.66 for each share of Siebel stock, a 17% premium over the previous day’s closing price.  Siebel, founded by ex-Oracle senior executive Tom Siebel, dominated the CRM market after its founding in 1993 but recently found itself facing increasing competition from Salesforce.com and other providers offering a hosted CRM solution.  Oracle envisions the acquisition adding 4,000 customers and 3.4 million CRM users.  A large percentage of Siebel’s software runs on Oracle databases, and Oracle envisions using Siebel’s solution as its centerpiece CRM solution, offered alongside Peoplesoft and Oracle applications.

European merger activity has seen a recent boom, with activity up over 50% in all major markets.  One of the largest recent deals was eBay’s purchase of Luxembourg’s Skype Technologies SA for $2.6 billion in cash and stock along with potential performance related payments that could be worth as much as $1.5 billion.  Skype, who gives its basic PC-to-PC voice service away for free, is expected to grow revenue from $60 million this year to $200 million in 2006 but is not expected to turn a profit until the fourth quarter of next year.  eBay sees the transaction combining Skype’s leading Internet voice capabilities with Paypal’s leading online payment service to provide users of eBay’s existing classified listings and auction business and its newly acquired Shopping.com division with a more robust consumer experience.

The above exhibit illustrates the (median) cost structures of the middle market public companies in our sample. Gross margins are highest for software companies, whose costs of goods are relatively low once the software is developed. To offset this cost benefit, software companies have to spend more research and development (R&D) costs, as well as in sales, general and administrative (SG&A) expenses compared to the other two categories. Industrial products companies have the lowest gross margins due to the typically asset intensive and/or labor intensive nature of their businesses, which drives up the cost of goods. However, they can suffice with more moderate investments in R&D and lower overhead costs. Business service providers are roughly in between software companies and industrial products companies with respect to their cost structure. Overall, the median EBITDA margins are similar across the three segments, despite the different composition of the cost structures.