By Dean Goh
A look at how identifying a company’s business model, economic moats and growth drivers decides its M&A deals.
Whenever we talk about the Merger and Acquisition (M&A) of companies, we tend to focus our attention on the technicalities of the M&A process. This means diving straight into industry reports to understand the industry’s competitive landscape and assessing potential acquisition opportunities, amongst others.
But there is a crucial step to undertake before even thinking about which companies a company should merge with or acquire. Before evaluating the potential operating/financial synergies a company can reap from the M&A process, it is highly important to first understand the company itself on a very fundamental level.
By getting a broad overview of a company’s business, we can reap greater insights into the rationale of a company’s M&A deals.
Business Model
First, how does a company make money? Where does money come from? How does Apple (APPL) generate an eye-boggling US 260 billion in revenue in Fiscal Year (FY) 2019?
Companies tend to have multiple revenue streams and identifying them gives us a general overview of a company’s core businesses. Let’s take APPL as a case study on how to analyse a company’s business.
A company will reveal its revenue streams in its annual report. It can usually be located in the “Business” portion of a company’s annual report. From the image below, you can see a breakdown of APPL’s businesses, and a brief overview of what each particular business entails.
So Apple breaks down its revenue stream into 2:
Products (which includes revenue derived from the sale of its “iPhone”, “iPad”, “iMac” and “Wearables, Home and Accessories”)
Services (which includes revenue derived from “Digital Content Stores and Streaming Services”, “iCloud”, “AppleCare” and “Licensing”.
Fig. 1: Apple’s Business Segments
Source: Apple’s 2019 Annual Report
We can tell that APPL sells many tech-related products and services. So it’s apparent that APPL operates in a very competitive industry by virtue of being in the tech industry. It faces the pressure to constantly acquire the latest technologies to innovate its products and stay ahead of its competitors like Sony and Samsung. In fact, CEO Tim Cook revealed that APPL acquires a company once every few weeks!
For example, back when voice assistant technology wasn’t a thing yet, Apple purchased Siri for US$200 million from the SRI International research lab in 2010. Siri was groundbreaking in that it was not a traditional search engine but more of a do-engine. APPL acquired Siri’s Intellectual Property (IP) rights which was worth a ton and also its engineering team to lead its mobile search efforts. Siri then became the first modern digital virtual assistant which was introduced as a feature of the iPhone 4S in 2011.
Next, we will find out the percentage of revenue each business contributes to Apple. This tells us which areas of business are most important to Apple. As you can tell from the image below, the iPhone is particularly important to Apple as this single business itself contributed to 55% of Apple’s revenue in FY 2019.
That’s why Apple has acquired many companies to boost features in its iPhone to always stay ahead of the very stiff competition in the market for smart mobile devices.
Case in point: In 2012, Apple purchased a mobile security firm AunthenTec for US$365 million. The deal includes provisions for AunthenTec’s patents, fingerprint sensors, touch chips and other security technologies. This acquisition tied in well with Apple’s plan to introduce fingerprint sensor technology for mobile payments in its new iPhone back in 2012. This made the iPhone more user-friendly and also well positioned to take advantage of the growing market for mobile payments. Given how Authentec was uniquely placed as a mobile security company supplying fingerprint sensor technology, it was imperative Apple did not have Authentec fall in the hands of its arch rival Samsung.
Fig. 2: Revenue breakdown of Apple’s business segments
Source: Apple’s 2019 Annual report
(The extent to which the company breaks down its revenue by its business varies across companies. In this case, APPL has decided to break down its “Products” revenue segment but not its “Services” segment.)
However, it’s a mistake to think that the business segment contributing most in revenue is the most profitable. The profitability of the business also depends on other financial metrics like a company’s gross margin (gross profit/revenue). As seen from the image below, although Apple’s “Services” segment contributes only about 18% of Apple’s revenue in FY 2019, it’s gross margin is almost double that of the “Products” segment at 63.7%. Services’ gross margin has also increased consistently since FY2017!
This tells us that Apple’s Services segment is a potential cash cow for Apple going forward and it is only expected that Apple would look to acquire companies that can improve its performance in this area of business.
Fig. 3: Gross margin of Apple’s “Products” and “Services”
Source: Apple’s 2019 Annual report
Hence, by 1) understanding a company's business segments, 2) its key revenue sources, 3) its most profitable business segments, you can make better sense of a company's M&A deals.
Economic Moats
Economic moats refer to a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.
Economic moats can be derived from many sources:
Patents/licenses/IP rights.
Economies of scale.
High switching costs.
Technological superiority.
Brand equity.
One reason why a company chooses to merge with/acquire companies is to strengthen its economic moat. This is with the long term goal of increasing their market share in a particular industry by edging out its competitors.
Consider the 2019 Disney-Fox merger worth a whopping US$71 billion.
The merger will see the consolidation of the American movie landscape. In 2018, Disney took top spot of the American movie market with an overall market share of 26%. Fox placed fifth at 9.1%. All things constant, Disney and Fox now commands 35% of the American movie market in 2018, entrenching a dominant market position for Disney. In 2019, Disney expanded its market share to about 38%, way ahead of its closest competitor Warner Bros with a market share of 13.8%.
Fig. 4: US 2019 Box Office Market Share
Source: Comscore
First, what really is Disney? Apart from its Disneylands, Disney generates revenue from its movies (e.g. Toy Story), streaming services (e.g. Disney+) and media networks (e.g. ESPN).
Fig. 5: Disney’s business segments
Source: Laughing Place
But before being able to dominate the movie market, Disney needs good characters and storylines. That’s when Disney’s economic moat comes in. It has created a unique brand, characters and storylines that have forged very deep emotional connections with its audience.
Looking at the top 15 highest grossing films in the US in 2019, 7 of the top 8 films came from Disney and they happen to feature characters that we are all familiar with - Star Wars, Avengers, The Lion King etc.
Fig. 6: Top 15 grossing films in the US 2019
Source: Comscore
This is when an important bit of information comes in:
Disney did not merge with the entire Fox group - Disney did not acquire Fox’s news arm, Fox Corp. But it did acquire 21st Century Fox, Fox’s movie and TV arm.
This allows Disney to expand its economic moat in its Intellectual Property rights over the characters and storylines that massively endear to its audience. The merger will see Disney-owned Marvel regain control of the X-Men and Fantastic Four characters. Given the popularity of X-Men, a good X-Men movie box office showcase will be a huge advantage to Marvel and thus Disney.
As seen from the chart above, a top grossing movie can bring in hundreds of millions of revenue for the company.
The Disney-Fox merger is an example of a horizontal merger where merging companies are direct competitors that offer similar products/services.
Growth Drivers
M&A is also a great way to achieve growth in a product/service line in the market that is currently not served by the company. It’s a faster way than to grow the company’s capabilities organically. Once the deal is complete, the acquiring company receives a combination of products/services, key expertise and talent from the target company. This new business pipeline quickly ensures that the acquirer can expand geographically or offer new product/service options to an enlarged customer base.
Let’s take a look at how Illumina (ILMN) has turned to acquisitions to grow its business.
ILMN is a company that sells its Genome Sequencing Machines (GSMs) to genomic research centers, academic institutions and research laboratories et cetera. GSMs contain ILMN’s proprietary sequencing technology which dissects and converts DNA into code that can be analysed.
Genome sequencing can reveal many details about a person’s DNA, allowing him/her to receive very specific medical advice/treatment based on his/her DNA rather than generic ones. Unfortunately, due to the high cost of genome sequencing, only a very small percentage of the world’s population have been genome sequenced. To date, ILMN’s GSMs are the fastest, most accurate and cheapest in the world at codifying DNA.
So how can ILMN leverage on its genome sequencing expertise to grow even further?
In September 2020, ILMN acquired GRAIL in a US$8 billion deal. GRAIL is an early cancer detection startup that uses Next Generation Sequencing (NGS) technology to screen, diagnose and monitor cancer. This enables ILMN direct access to the huge NGS oncology testing market, poised to grow at a CAGR of 27% to US$75 billion in 2035. GRAIL is only expected to be commercialised in 2021 but ILMN can support its commercialisation efforts with its large scale manufacturing and clinical capabilities. Talk about operating synergies!
The AIBC Perspective
We hope that we have provided you a good framework in understanding how a company’s business influences its M&A deals by looking at its business model, economic moats and growth drivers.
Other forms of mergers not covered in this article include:
Vertical merger: A merger between companies along the same supply chain.
Market-extension merger: A merger between companies in different markets selling similar products/services.
Product-extension merger: A merger between companies in the same markets selling different but related products/ services.
Going forward, you might want to try to look at a few of Alphabet’s (a.k.a Google) acquisitions (e.g. Youtube, Waze, Fitbit) and understand how it fits into the grand scheme of things for Alphabet.
Dean Goh
Dean is a first year Philosophy and Economics undergraduate at the London School of Economics. He started writing articles about REITs investments when he was 18. He then went on to write and publish articles on Singapore and US equities for an award-winning investment blog site before university started.
Disclaimer
This information should not and cannot be construed as or relied on and (for all intents and purposes) does not constitute financial, investment or any other form of advice. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. You are advised to perform your own independent checks, research or study.