Video Games, Automakers Top Apple’s Vertical Integration Prospects

Bryan Adams, Director, FactSet M&A; Matt Vodicka, Associate Product Manager, Core Applications; and Varun Rampall, Associate Product Manager, Research Product Development contributed to this article.

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As 2017 draws to a close, a trend across some of the year’s largest M&A deals has appeared: vertical integration. With the acquisition of Whole Foods, Amazon gains Whole Foods’ successful 365 brand, and the recently announced CVS-Aetna deal gives the drugstore chain the ability to expand its in-pharmacy medical services, both deals made in the pursuit of higher profit margins. Now rumors are swirling that Apple may be looking to acquire a company outside its historic areas of operation, with Tim Cook himself providing admittedly ambiguous commentary on the subject:

“On M&A, […] we’re always looking in the market about things that complement things that we do today, become features in something we do, or allow us to accelerate entry into a category that we’re excited about. And so as I’ve said before, our test is not on the size—we would definitely buy something larger than we’ve bought thus far—it’s more about the strategic fit and whether it’s a great technology and great people. We continue to look and we stay very active in the M&A markets.”

In its latest fiscal year results as of September 30, Apple highlighted the $268.9 billion it has in cash plus marketable securities on its balance sheet. Even with its recent $400 million bid for music identification service, Shazam, there’s plenty of cash left for a considerable acquisition on the part of Apple. While 94% of this cash sits overseas, the recent tax bill proposed by the U.S. Senate would reduce the tax rate on bringing that cash back to the U.S., perhaps giving Apple the resources necessary to complete a mega-deal.

In a research report from May 2017, Citi analyst Jim Suva identified seven potential M&A targets for Apple outside the areas in which it traditionally operates, including media firms, video game developers, and an automaker.

What would be the geographic revenue, supply chain, and business industry classification impacts of one of these hypothetical mergers and which target is Apple most likely to move on?

Potential Media Targets

Suva pitched Netflix, Disney, and Hulu as the three media operations Apple might approach for acquisition, though he notes that a Hulu deal has an almost 0% chance. Disney made a successful $52.4 billion bid for Fox assets since Suva published his report, which changes the M&A landscape for Apple and leaves us with Netflix. Netflix is also the largest of the three potential targets, with an enterprise value of approximately $87.02 billion.

A hypothetical deal between Apple and Netflix would reflect Apple’s interest in enhancing consumer content offerings. While Smart Phone Manufacturing would remain Apple’s primary business (accounting for 63.39% of total revenue), the acquisition of Netflix would create product synergy and represent 3.62% revenue growth in the Media Downloading and Streaming Digital Content Sites sub-industry. This would increase Apple’s revenue share in that sector (which includes Sony, Alibaba, Baidu, Pandora, and 28 additional public competitors) from 51.31% to 67.74%, and could raise anti-trust concerns.

If there was a way for an Apple-Netflix deal to get around anti-trust legislation, each entity would benefit from the other’s geographic market. Both companies are domiciled in the U.S., but Netflix generates approximately 30% more of its revenue from the Americas than Apple does. This means that Apple would gain exposure to the Americas, while Netflix would gain exposure to international markets.

An Apple-Netflix deal is unlikely to come to fruition, given the legislative ramifications. However, the acquisition of an automaker or video game developer would open Apple up to new sources of revenue, rather than increase its market share in an existing line of business.

Could Apple Go into the Auto Industry?

Cook has fielded shareholder questions regarding the potential acquisition of electric car manufacturer Tesla for years. There are several reasons why people are still discussing an Apple/Tesla acquisition: Apple’s promotion of CarPlay, its practice of hiring former Tesla employees, consumer interest in Apple creating a car, and ongoing whispers about Project Titan (Apple’s self-driving electric vehicle). This deal is perhaps the most controversial, with Tesla founder Elon Musk claiming it’s unlikely. Despite this, some investors remain convinced Tesla is a perfect fit.

Tesla is unique in that it does not share any customers or strategic partners with Apple. Apple would acquire Tesla’s existing relationships, many of which fall within Utilities (Enel Green Power, Sinomach Automobile Co., and Vector Limited are all customers, while Terna S.p.A. and Valaner Inc. are partners), along with Retail Trade giant Home Depot. Apple already shares 12 of Tesla’s 58 existing suppliers; however, given Tesla’s well-documented supply chain issues (the word “bottlenecks” was used seven times in its latest filing), it is unclear how Apple would benefit from those supplier relationships.

Tesla’s unique connections would help Apple’s entry into the electric/self-driving automobile space. That being said, Apple has the size and brand recognition to make its own introductions, though industry players may have concerns about Apple cannibalizing their industry, as it did with music and photography.  Moreover, when Cook was Apple’s COO, he was widely credited with supply chain management, so a combined entity could help with Tesla’s issues.

Investor sentiment aside, we can take a bird’s eye view of Tesla’s financials to value the acquisition. Tesla’s free cash flow, which shows the amount of cash a company has remaining after capital expenditures, has been negative for the last 10 years. While Tesla appears to have significant cash on its balance sheet, it has substantial cash investments (such as manufacturing plants) and has been unable to generate profits while paying for such expenditures. Its net income has also been negative for the last 10 years. If we were to value Tesla by dividing its net income, depreciation, amortization by its total assets, Tesla’s cash flow would be 0.01, significantly lower than other potential targets.

When we weigh the pros (new supply chain relationships and an opening into car manufacturing) and cons (Tesla’s production bottlenecks, the rate at which it burns through cash, and wildcard Musk), the associated risks seem too high for Apple, given only a 2.69% increase in the combined entity’s revenue.

Apple Might Want to Play with Video Games

The acquisition of a video game developer would be less risky acquisition for Apple than a target in media or the auto industry. Each potential target in this sector is almost identically exposed (to each other and to Apple) by geographic region, meaning a combined entity would have similar sensitivities to geopolitical risks, natural disasters, and health epidemics.

In addition, many of the potential targets in this industry would create a new revenue stream for Apple while allowing it to focus on its core business. The recent outperformance of these types of companies also makes them a solid bet for Apple. Out of our three video game developers, which acquisition would be the best fit?

Potential Target	Likelihood (According to Suva)	Current Market Share of Games Software Industry	Current Revenue Exposure to Handheld and Smart Phone Games Software	Cash (in millions) as of most recent fiscal quarter-end	EV/EBTIDA	Revenue Growth for Hypothetical Combined Entity
Activision Blizzard	10%	11.79%	25.33%	3576.00	17.69x	2.65%
Electronic Arts	10%	9.07%	12.94%	4355.00	19.77x	2.05%
Take-Two Interactive	10%	3.36%	0.00%	1732.24	30.67x	.77%

Take-Two Interactive probably makes the least sense as a target. It has the highest EV/EBITDA ratio (suggesting it’s potentially overvalued), it does not have a mobile offering, and it would have the smallest impact on revenue growth.

Our two remaining targets, Electronic Arts and Activision Blizzard, are more comparable to each other than to Take-Two Interactive—Electronic Arts has 9.07% of the $53 billion Games Software Industry, while Activision Blizzard holds 11.79% . As far as being prospect for acquisition, it’s a toss-up between the two, though there are a few factors that could give Activision Blizzard the advantage.

Activision Blizzard derives a larger percentage of its sales from mobile products than EA does, partially because it acquired Candy Crush Saga developer King Digital in February 2016. This mobile segment exposure may make it a better fit for Apple. Activision Blizzard also has lower EV/EBITDA and higher return on equity than EA does. Also, Electronic Arts has been repurchasing shares recently which could be an indication that the company has few profitable investment opportunities and is using share repurchases to drive up its stock price.

It Comes Down to Expanding into New Product Lines

Six of these seven targets are content contributors. We have seen that Netflix and Amazon now owning and creating their own content has proven to be a game changer for their businesses. But while a media industry acquisition could raise anti-trust concerns, this would be less of a problem if Apple were to acquire an automaker or video game developer, as it has no exposure to either industry. Ultimately, Apple is sitting atop an immense pile of cash and is poised to have its own vertical merger, should it decide to deepen existing or expand into new product lines.

Article by Katherine Guerard, FactSet