Markets are trading mixed this morning as investors digest earnings and weigh the impact of slowing global growth. Before getting into our thoughts on a note put out this morning discussing potential takeover targets for Apple (AAPL) , we want to call out that macroeconomic readings that were not released due to the government shutdown have started to flow in, with the Commerce Department reporting this morning that new orders for manufactured goods (durable and nondurable) in November fell 0.6% to $499.2 billion. This followed a 2.1% decline in October and came up well short of expectations for a 0.3% monthly increase. As a reminder, this is a crucial reading as manufacturing is responsible for roughly 12% of the U.S. economy.
Importantly, new orders of non-defense capital goods excluding aircraft (i.e., core capital goods) were down 0.6% in November, following a 0.5% advance in October and a 0.6% decline in September. The reading also missed expectations for a 0.1% monthly increase. Recall, capital goods are not sold to consumers, rather they are tangible goods used in the manufacturing of consumer goods. For this reason, core capital goods are a key metric that many consider to be a proxy for business investments. It is important to consider new orders for capital goods excluding transportation equipment (planes and automobiles) because the high value of these goods can easily skew month-to-month readings, increasing volatility and making it more difficult to analyze the underlying trend. Shipments for core capital goods also fell in November, pulling back 0.2%, missing expectations of a 0.1% monthly advance and coming off the heels of a 0.8% advance in October and a 0.3% drop in September.
Given the backwards looking nature of this November reading, we will keep our analysis brief as we do not believe it to be having a significant impact on today's action and will simply note that we view the data as serving to support the Fed's patient and cautious stance on further rate increases. While the U.S. economy is still expanding, it is clearly beginning to show cracks, no doubt resulting, at least in part, from the ongoing trade conflict with China. Members interested in digging deeper can view the official release here.
Looking to company specific updates, on Monday morning analysts at JP Morgan published a note speculating on what they view as strategic M&A fits for Apple that would serve to bolster the companies Services business and catalyze the segment's growth. Recall, services growth is at the core of our investment thesis thanks to the associated revenue stream, which is both recurring in nature and more profitable (better margins) than the overall business. Those are two factors that we believe will result in higher, more consistent earnings over time, as the segment's revenue share becomes more material and offsets the slower growing iPhone, which is also seeing an elongated replacement cycle.
According to the analysts, there are three industries they believe the company should be looking at including video games, the smart home speaker industry and original video content companies. Interestingly, and if you ask us, perplexingly they didn't call out healthcare (except for a passing mention of Peloton, which one could argue is loosely related to healthcare, more below), despite CEO Tim Cook explicitly calling out that in an interview with Jim, here, that "if you zoom out into the future, and you look back, and you ask the question, 'What was Apple's greatest contribution to mankind,' it will be about health."
On the video game front, the analysts believe an acquisition here makes sense for several reasons including the ongoing industry transition to mobile, a factor we called when we owned video game publisher Activision Blizzard (ATVI) as we believe this transition would provide more access to the Chinese market, where mobile eSports is highly popular. Additionally, the analysts noted that the increasing presence of high-end mobile games could be a catalyst for handset replacements as the ability to play cutting edge games would be another factor of consumers to weigh when debating whether or not to hold onto their device for another year or upgrade. In the analysts' view, Activation Blizzard would "be the best strategic fit." We would also note that in early January a video game acquisition was also speculated on by journalists at Barron's who called out Nintendo (NTDOY) as potential target.
While we won't comment as to the likelihood of either acquisition actually occurring, we could see a takeover in the field making sense and view Activision and Nintendo as both being good fits should the company decide to go in that direction given that both companies have significant content already developed for mobile platforms. Activision has its King division and Nintendo via its deep intellectual property portfolio of Gameboy games and the Switch, which we remind members was designed to be playable both at home and on the go. However, on the other hand, we would note that an acquisition on this front would drag Apple into a highly competitive industry that is seeing a massive shift toward free-to-play content and question whether Apple would have any interest in developing gaming content rather than simply providing the medium through which others sell content (the App store) and taking a cut off the top.
Another field the analysts called out as being sensible for M&A activity is the smart home speaker space, calling out Sonos (SONO) as a potential target given the company's "differentiated position as a premium home speaker system relative to Amazon (AMZN) Alexa and Alphabet's (GOOGL) Google Home, strong loyalty among current consumers, and robust international presence." Per the report, the analysts believe an acquisition in the space would allow for increased customer engagements, Apple Music synergies, and a means to catch up to with competitors as Siri is largely seen lagging the Amazon Alexa and Google Home platform.
Our take is that while an acquisition on this front may be accretive, it is not as compelling as the video game scenario (if at all) as it would be a hardware-based acquisition and fly in the face of management's goal of being viewed as a software and services company. That said, while not their first pick, the analysts also briefly called out Peloton as another potential target. While we would not put much into this one either as we don't believe fitness to necessarily be what Cook was referring to when he called out the healthcare space as an area of major interest for the company, we would view it more sensible than the Sonos call out given that it does at least more closely align with Apple's stated healthcare focus, provides a recurring revenue stream via its monthly memberships and could potentially play to an increase in Apple iWatch sales via increased integration with the platform as a means of better tracking workouts. Again though, we view it as interesting but wouldn't hold our breath.
The final field called out by the analysts was, no surprise here, video content. According to the analysts, Netflix (NFLX) would be the best strategic fit, though they do add that "a combination is less likely as Netflix is unlikely to be a seller for a modest premium." This seems like an easy callout given Apple's reported plans to release a video streaming platform later this year. According to the note, "As per networking leader, Cisco, 75% of network traffic is driven by video, and by 2022 the same will expand to 82% of all IP traffic."
Given this, we certainly understand Apple's interest in the space, however, we simply don't believe an acquisition on the scale of Netflix make sense given the impact it would have on Apple's balance sheet, a factor called out by the analysts, and the rapidly increasing competition in the space. We would also note that in our view, it would make much more sense for Apple to simply ramp up its own investments in original content, rather than shell out the well over ~$150 billion (current Netflix market cap) it would cost to even try and acquire Netflix when factoring in a takeover premium. To this point, compared to Apple's current original content investment level of ~$1 billion, the analysts estimate that Netflix investment's stand at ~$14 billion for 2019, while Amazon's sits at ~$5+ billion. Given the differences here and when considering that Apple would need to not only takeover Netflix but also continue investing in original content, a real cash burn, we simply do not view this as a financially sensible move. Why spend all cash on the balance sheet (maybe more) to buyout a company selling at ~76x forward earnings, burning cash at a rapid clip, when you could invest a fraction of that and produce original content for your own platform which is already globally distributed thanks to Apple's 1.4 billion device installed base?
Bottom line, while we are calling out the note for members, as it will no doubt be talked about as calls for a game changing merger grow louder, and it's always fun (for us at least) to speculate as to how Apple could put its massive cash pile to work, we would take this with a grain of salt as Apple is more known for doing bolt-on acquisitions rather than larger transformative ones, and in our view some of the potential targets called out in the note appear to be in direct contrast to the company's financial discipline and management's services-oriented narrative. We therefore are not factoring in the potential for these takeovers into our investment thesis and continue to focus on organic Services growth, the growing adoption of wearables and opportunities in the healthcare space
That said, we do believe a larger scale merger should be considered, however, as we've called out above, we believe that Cook's recent commentary is more likely to point to one in the healthcare space rather than those called out above. To this point we remind members that we view Epic Systems as a strong candidate given its ability to play into Apple's goal of democratizing healthcare. Members can view our take on the healthcare opportunity here and checkout Jim's case on why Epic Systems makes sense for Apple here.