Ahead of this week's AAPL earnings, investors were looking forward to more clues what the company with the quarter-trillion cash war chest would do with the funds that are now greater than the GDP of Greece, and aside from the token increase in shareholder distributions, they got little else, which has once again prompted speculation who Apple will acquire once the company decides to shift away from corporate bond holdings (recall that as of this quarter Apple now has more corporate debt on its books than the biggest bond mutual fund) to acquisitions.
Apple's problem, if one wants to call it that, is simple: while the company's growth has slowed, selling fewer iPhone in the March 31 quarter than a year earlier as a result of sliding Chinese sales, the firm’s cash balance has continued to grow. Indeed, as of March 31, Apple had almost $260 billion of cash on the balance sheet. About 95% of this cash sits outside the US.
Some more details from Citi: Apple’s is generating ~$50-$55 billion of FCF per year, of which free cash flow generated in the Americas is about 15-20% (~$10bln) given higher capex needs in the US (data center, corporate headquarters build out). About $13 billion is being used for dividends. And, the balance is used to repurchase shares. That’s akin to $45-$50 billion per year, in total, for capital returns. This results in a 1.7% dividend yield and a 5% annual reduction in shares outstanding.
And while Apple may well continue on its simple path of conservative stock buybacks and dividends, a far more interesting and pertinent question is what if it doesn't. To answer that, here is Citi's Jim Suva, who writes that "we Identified Seven Potential M&A Targets: Three are media firms: Netflix, Disney and Hulu. Three are video game developers: Activision, Electronic Arts and Take-Two. And, one is an auto maker: Tesla. Each target confers some strategic benefit to Apple."
First, some more details on how Citi constructed its potential acquisition screen:
To our way of thinking, the most attractive Apple target will fulfill five key criteria:
- First, Apple should be able to bring a competency to the target. And, crucially, the target should bring a competency to Apple. That is, the strategic fit should be mutually reinforcing.
- Second, in a perfect world, the target would have global scale. After all, Apple is a global firm.
- Third, the transaction should face limited regulatory scrutiny from the anti-trust authorities.
- Fourth, the acquisition should go a long way to using the majority of Apple’s cash on hand. A small tuck-in acquisition should garner less interest.
- Fifth, the target should not have significant non-core assets that don’t fit with Apple’s strategic aims.
Most of these criteria – global scale, regulatory scrutiny, portion of cash used and non-core assets – are easy to assess. But, strategy is a bit more subtle.
But, over the past year, Apple has focused on their Services (AppStore, Apple Care, Apple Music) business and active paying subscriber base. In recent earnings, management highlighted their active paying subscriptions totaled 165 million (not unique subscribers as some may be paying for more than once service like Apple Care and Apple Music). Management continues to highlight the strength and growth rates of their Services business segment which has grown by 19% y/y on a TTM basis. The firm has a goal to double Services revenue by FY2020 from FY2016 levels of $24 billion.
While streaming music has been successful - with 17 million paid subs - Apple’s TV business is still limited. Indeed, discussions with several media and cable firms have not yet borne fruit. Nonetheless, TV remains an area of intense interest including small forays into original content (exclusive music videos, reality TV shows and Carpool Karaoke).
With this background in mind, Citi developed a short-list of prospective targets. It includes three media firms (Netflix, Disney and Hulu), three video game developers (Activision, Electronic Arts, and Take-Two Interactive) and one auto manufacturer (Tesla).
Citi's details behind each company's rationale:
Disney
Disney has two positive attributes for Apple. First, on the positive side of the ledger, the firm is increasingly using technology to differentiate its consumer offerings and Apple could accelerate this. This occurs in the movie studio, the theme parks and increasingly at the network division (via BAMTech). Second, Disney’s size suggests it would use slightly more than Apple’s excess cash (assuming a 40% premium).
But, there are two drawbacks. First, the firm still derives the bulk of its revenues inside the US (due largely to ESPN). Second, the firm does own some assets that Apple may view as non-core (including theme parks, hotels, cruise ships and consumer products). While these assets could be spun-off or divested, what makes Disney such a unique entity is the ability to monetize its intellectual property across a wide array of businesses. Dismantling the firm’s assets could be risky.
Netflix
Netflix fares particularly well against our screens. Nearly 100% of the firm’s revenue comes from the on-line video business (except a small legacy DVD by mail segment). And, Netflix would allow Apple to accelerate original content creation, something Apple is focused on. Moreover, like Apple, Netflix is a global player. Netflix’s success - and a core tenant of its strategy - is to be widely available. In order for the Apple + Netflix deal to be “mutually beneficial”, we believe Apple could offer a sweetened Netflix offering to its installed base while non-Apple users could continue to pay the regular subscription rate. Perhaps the only drawback is this: Netflix would consume about ~35% of Apple’s cash balance and Netflix stock has rallied in recent years. That may cause some investors to suggest it may be too late. But, Netflix is a unique firm. And, tax reform is a potentially material change.
Tesla
Tesla may be of interest to Apple if the firm is truly interested in the auto segment. The good news is Tesla is global (deriving 40% of sales outside the US). Some drawbacks include Tesla’s lack of profitability and cash flow generation. In addition, unlike Tesla, Apple traditionally outsources its physical product production. And, the recent Solar City transaction could be viewed as non-core to Apple. Acquiring Tesla would consume about ~32% of Apple’s cash balance.
Activision, Electronic Arts and Take-Two
All three video game developers fit nicely with Apple’s overall strategy. And, all three firms generate a significant portion of revenues outside the US. Perhaps the only drawback is this: these firms would only consume 4% to 25% of Apple’s cash balance.
Hulu
Hulu is a subscription VOD platform jointly owned by a handful of media firms including Disney, Comcast and 21st Century Fox. The firm is poised to launch a virtual pay TV service later this year to compete with Google’s YouTube TV, Dish’ Sling and Sony’s Vue. There are two drawbacks to this transaction. First, since the asset is jointly owned - and private - it may be difficult to reach an agreement with the owners. Second, the asset is quite small and would consume less than 5% of Apple’s cash balance.
If we score each target based on these five criteria (with “1” representing attractive and “5” representing unattractive), it suggests Netflix and Disney score relatively well. But, Tesla, Take-Two and Hulu score less well.
The table below summarizes the findings, which suggest that Netflix is the most likely acquisition candidate, while Tesla is last.
Citi next runs several pro forma models to determine deal suitability based on three criteria: i) First, assess how the acquisition would change Apple’s top-line growth rate. ii) Second, assess how the acquisition would alter Apple’s EPS growth versus the status-quo and versus accelerated buybacks. iii) Third, assess how Apple’s stock might react based on the pro forma financials.
It makes the following assumptions: "First, a 40% premium to the prevailing market price of each target. Second, we assume all offers are 100% cash. Third, we assume no revenue synergies. Fourth, we assume 1.5% of the target’s costs can be eliminated. Fifth, we assume Apple generates 1% interest income on its cash balance. Sixth, for the pro forma multiple, we simply take the weighted average multiple based on the mix of net income between Apple and the target."
What do the pro forma models suggest? A few things:
- First, Apple can generate the greatest lift in EPS growth from larger buybacks. (But, buybacks do not help the top-line growth rate.)
- Second, if Apple acquired Disney, it would slow the top-line and hurt EPS growth. But, it would result in the most upside for the stock, about 20%.
- Third, if Apple acquired Netflix, it would help the top-line improve by 70bps, help EPS growth by 80bps and would help the stock by 7%. But, Netflix only uses ~35% of Apple’s cash balance.
- Fourth, if Apple acquired Tesla, it would help the top-line improve 230bps and help EPS growth by 110bps. Apple’s stock would also rise by 7%. But, Tesla would only use ~32% of the firm’s cash.
- Fifth, for Activision, Electronic Arts, Take-Two and Hulu, the firms are so small they do not materially alter Apple’s top-line growth or EPS growth. And, they all have a muted impact on Apple’s equity value (from 0% to 5%).
* * *
Citi summarizes its findings in the following chart...
... and has these parting words:
Apple is best served by pursuing a hybrid approach. That is, if Apple acquires Netflix, it would help boost the firm’s top-line and EPS growth a fair amount. But, since Netflix will only require 35% of Apple’s cash balance, the firm could use the remaining cash for larger buybacks. This would give Apple equity appreciation as significant as a Disney acquisition. And, unlike Disney, Netflix M&A plus larger buyback wouldn’t come with any non-core assets (like cruise ships, theme parks or consumer products). As such, we suspect Apple’s next step is to consider acquiring Netflix and announce a larger share repurchase authorization. We do expect Apple to continue to also make smaller tuck in acquisitions, related to technology assets.
To note, Apple's acquisition philosophy is best understood by looking at its past history. While the company has made small tuck in acquisitions and predominantly private companies, we note the company's largest acquisition was Beats in 2014, which they acquired for ~$3bln. Importantly many of the acquisitions have been in countries where Apple has had cash trapped overseas. As such, Apple avoided the repatriation tax. Recent acquisitions have been in the field of Artificial Intelligence, augmented reality, security and facial recognition. The company has occasionally commented that they are not against large acquisitions. Should tax reform occur, we believe the probability of large M&A increases. Importantly the cultures between Apple and any target need to align as management is most interested in strengthening their platform for their installed base and improving the overall consumer experience of their products and services. Apple tends to not be interested in turnaround stories