Market Overview

The volatility that has characterized the markets recently has lessened significantly, as investors have largely conceded another rate increase will occur at the Fed’s June meeting.  The continued presence of inflationary pressures, evidenced by the May core PPI numbers increasing more than expected and continued high energy prices, has increased the likelihood of costs being passed through to consumers and corresponding increases in core prices.  As a result, the Fed is widely expected to make its 17^th rate increase in a row at the June 28-29 meeting.

Investors and market watchers have instead begun focusing on the impact of interest rate increases and inflationary pressures on corporate earnings and economic growth.  In early June, top US forecasters increased their inflation expectations for the year and said economic growth is poised to slow abruptly as consumer spending eases, according to a Blue Chip Economic Indicators newsletter survey.  According to the survey, GDP growth is expected to slow from the first quarter’s 5.3% to 2.9% in the second and third quarters and 2.8% in the fourth quarter.

M&A Activity

The recently announced joint venture between Nokia Corp and Siemens AG, which will result in the combination of their telephone equipment units in a deal valued at roughly $31.6 billion, has increased M&A speculation in the telecom market.  In an industry plagued by high and sometimes redundant research and development costs, the new entity is expected to allow the companies to realize R&D savings as high as $1.58 billion.  Following closely the announcement of the Alcatel-Lucent deal, this additional consolidation has led to market speculation that other large telecom equipment providers will follow suit and snap up smaller, innovative companies in order to enhance their technology and expand their customer base.

Amid the recent flurry of cross-border stock exchange activity, the SEC has released a fact sheet stating that cross-border mergers will not necessarily bring non-US exchanges or companies under US securities law, citing an unwillingness to become a roadblock to mergers such as the proposed NYSE/Euronext acquisition.  The announcement comes as John Thain, chief executive of the NYSE Group, continues to express interest in the London Stock Exchange, despite the Nasdaq’s 25% equity stake.  Thain recently reiterated the NYSE interest in the London Stock Exchange, but left open the possibility of a combined NYSE/Euronext entity competing head to head with the LSE, with the possibility of a new stock market being launched in London if the combined company does not attract enough international listings.

The above exhibit illustrates both the median EV/Revenue multiple and the variation of these multiples, based on our sample of M&A transactions in the software, industrial products, and business services industries over the last 12 months.

As the exhibit identifies, the software industry carries a median EV/Revenue multiple of 2.3.  This is significantly higher than both the industrial products and business services industries.  Similarly, the uncertainty of M&A outcomes is also higher, as illustrated by the wide dispersion of valuation multiples, which range from 0.6 to 7.6.  The higher median valuation multiple coupled with higher variation follows the historical norm that the software industry has been more volatile, but with greater potential returns, than the industrial products and business services industries.

In contrast, the exhibit also highlights the fact that companies in the industrial products and business services industries capture lower EV/Revenue multiples than the software industry, with median multiples for both at 1.3. However, the dispersion of valuation multiples around the median is much narrower, and accordingly carries considerable less risk in possible outcomes.  More specifically, business services valuation multiples range from 0.4 to 4.1, while those for industrial products range from 0.4 to 3.4.  These industries are generally deemed less volatile and more mature, and therefore are expected to receive lower valuation multiples within a narrower range than the software industry. 

As a final note, the exhibit illustrates that the range of valuation multiples for business services is greater than that of industrial products.  This demonstrates how business services companies attract a wider variety of company profiles operating in environments with varying degrees of risk.