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M&A As A Growth Strategy

Merger and acquisition activity drives much more growth than investors realize, and many companies practice mergers and acquisitions or M&A as their main source of growth. Companies such as Google, Microsoft, Facebook, and Constellation Software use M&A as a means to sustain or continue their growth.

Between June and April of 2021, there have been almost 1,000 M&A deals alone, with a total of 964 so far, totaling $208.22 billion. There are two main reasons these deals occur, to increase cost synergies or revenue synergies.

Many of these companies employ M&A activity to expand their services, add additional products or services, or corner the market. Whichever the goal, many CEOs employ M&A as a means of growth, and as the bull market continues, that will only accelerate.

To better understand why companies employ this as a means of growth, it is helpful to understand what drives CEOs and management to pursue these activities and their impacts on the company.

In today’s post, we will learn:

  • Why Companies Acquire Others to Grow
  • Benefits of M&A for Growth
  • Downsides of Using M&A for Growth
  • Examples of Companies Using M&A Activity to Grow
  • Investor Takeaway

Okay, let’s dive in and learn more about using mergers and acquisitions as a growth strategy.

Why Companies Acquire Others to Grow

Many companies pursue M&A as means of growth. A perfect example is Disney; when Bob Iger took over the company, he was asked how he would “turn” around the company, and his answer was M&A activity.

Consider the M&A activity that Disney undertook during Iger’s term as the CEO:

  • Pixar
  • Marvel
  • Lucasfilm
  • 20th Century Fox

Each of those acquisitions brought something different to the table. Pixar brought a state of the art animation, Marvel and Lucasfilms brought tremendous value from their franchises, such as the ability to market Star Wars films, products, and future projects. Then you have the huge backlog of content that 20th Century Fox brought to the table, which has enormous value too.

All of these acquisitions helped Disney broaden its content, now and in the future, with terrific growth abilities. And Disney+ is now benefiting from those current content libraries, plus its enormous libraries and future opportunities.

Where would Disney be currently without those acquisitions?

Probably in a much different place, considering the tremendous impact Covid had on the company’s parks, which were, before the pandemic, the leading driver for Disney.

Disney is the perfect example of M&A as a growth strategy.

Most M&A falls into two camps:

  • Strategic
  • Financial

Disney certainly used its strategic plan of acquiring different companies to acquire additional content for its libraries, plus Pixar’s technical expertise to elevate its animated movies, a Disney hallmark. Imagine life without Frozen and its impact on Disney’s financials; they certainly go hand in hand.

To back up a just a moment.

Strategic M&A means that a company will buy or merge with others that fit a strategic need. Let’s say that a company is moving to a subscription-based system to offer its services. Then the company will look for products or services that help it move towards that subscription offering, whether technical or platform-based.

Financial M&A is a means of acquiring additional companies that help increase their cash flows or revenues to boost their bottom line or grow their organic growth.

It doesn’t mean that both acquisition goals don’t or shouldn’t happen; they do, as exemplified by the Disney example above.

Benefits of M&A for Growth

As the Disney example shows, a well-planned M&A strategy can work extremely well to generate business growth.

Not every business leader can be the absolute best in every single field they compete in; even leaders such as Amazon, Microsoft, and Google in the cloud, acquire companies that help them develop new capabilities to continue their growth.

Here is a list of benefits to companies utilizing M&A as a growth strategy:

  • A huge benefit to utilizing M&A as a growth strategy is the time and effort it saves a company. Many times developing new products and services takes time and money, sometimes a lot. And to shortcut that, many companies use M&A as a means to arrive at the same place, with less effort and money spent.
  • Companies can quickly access new markets. By acquiring businesses with a presence in a particular market, the acquirer can quickly enter that market, which in the past took many years considering the effort to market and sell your products.
  • Enter new markets with legitimacy by piggybacking on the benefit above, especially in a market full of additional competitors. Success in oversaturated markets often comes from being the big-name leader.
  • Creates greater diversity in products and services by expanding on the offerings the company already offers. These expansions can lead to tremendous revenue opportunities or growth beyond the current market. It can also help a company transition to another market to protect itself from a maturing market. For example, Coke acquiring Odwalla to move towards a healthier choice as more Americans become healthier.
  • Allows competitors to acquire intellectual property such as patents, trademarks, or copyrights. These nonphysical assets can lead to additional growth; imagine what you could do if you acquired Nike’s brand?
  • M&A is a top way to acquire top talent, especially in the tech world. Acquiring top programmers in the tech world allows a company to stay on top of leading trends or the edge of innovation in tech. All of which leads to more growth opportunities from new products or services.
  • M&A is another way to remove or reduce competition in a sector. One of the leading benefits of acquiring or merging with other companies is the ability to lower your business costs, which leads to greater profitability. Depending on the industry, it also lowers your prices, leading to greater revenues or growth opportunities, reducing competition.
  • M&A can create more value for shareholders by utilizing the above benefits, driving more value for the company and shareholders. New products, assets, or revenue growth are offshoots of M&A activity, and all of these activities can drive value in the long run. And they are creating value for the shareholders and the company in a virtuous circle.

Downsides of Using M&A for Growth

As with all strategies, there are downsides to utilizing M&A for growth. Not every M&A ends in butterflies and rainbows, far from it. According to a recent Harvard Business Review report, 70 to 90% of all mergers and acquisitions fail. Consider that in 2015 Microsoft wrote off 96% of the value of its handset business they acquired from Nokia for $7.9 billion in 2014. Yikes!! Google sold its handset business for $2.9 billion after purchasing it from Motorola for $12.5 billion in 2012.

So what are some of the reasons M&A activity could go south?

Here are a few reasons why M&A strategies might not work for growth:

  • The M&A deal has no logical strategic or financial benefit. Verizon purchasing AOL years ago appears to fit this mold, and the company finally saw the writing on the wall and sold those assets for a loss of $4 billion, from its purchase price of $9 billion.
  • The acquiring company is too small, has little to no experience in M&A, and struggles to fold the acquired company into their business.
  • The acquiring company is on the struggle bus financially or faces issues raising funding to finalize the acquisition. If a company already carries a heavy debt load or continues to dilute its equity to take on more acquisitions, they run the risk of hitting the wall if the acquisition doesn’t turn out well.
  • The potential deal comes with multiple red flags or adds additional risk to the acquirer. If a company takes on another failing company, it risks that acquisition becoming an anchor to the acquirer.
  • The M&A team of the acquirer is only looking for targets based on their compensation packages or the possible rewards they will receive.

Littering the M&A world are deals that have gone south, many because the acquirers failed to realize the anticipated synergies, typically because they overestimated the ability to realize revenue synergies.

A few examples:

  • America Online buying Time Warner for $165 billion in 2001, at the height of the dot-com bubble. After the bubble burst, AOL reported a $99 billion loss in goodwill to write down the next year, still the largest ever annual net loss recorded.
  • Sprint and Nextel merged in 2005 for $35 billion in a stock purchase. Shortly after the acquisition, Nextel management and employees started leaving in droves, citing cultural differences. The cultural issues led to serious integration problems and ultimately to a write-off of $30 billion by 2008.

Those are just two examples of how M&A activity as a growth strategy went awry, but these failures litter the M&A landscape, which is why it is important to understand the benefits and risks and carefully read through why management believes this time it will be different.

Examples of Companies Using M&A Activity to Grow

Many of the most successful investments out there are companies that use M&A as a growth strategy. Countless companies throughout the S&P 500 utilize this strategy to grow and innovate to stay on top.

Let’s take a closer look at several companies that utilize M&A activity as a part of their continued growth.

Google

It might surprise many to learn that Google is one of the leading acquirers in the S&P 500. In fact, founded in 1998, it uses M&A activity to add on other functions or technology to increase its services and offerings.

Over the years, Google has made 232 acquisitions totaling $20.32 billion.

Here are some of the notable acquisitions the company has made:

  • Nest for $3.2 billion in 2010
  • Double Click for $3.1 billion in 1996
  • Looker for $2.6 billion in 2011
  • Fitbit for $2.1 billion in 2007
  • YouTube for $1.65 billion in 2005
  • Waze for $1.3 billion in 2007
  • Admob for $750 million in 2006
  • Android OS for $50 million in 2005

Let’s consider some of these moves. Android is the most popular mobile operating system globally, and it is stunning to think they paid only $50 million for that system. Google buying YouTube changed the way we watch videos and brought us endless entertainment from cat videos, and provided Google with endless revenue opportunities that the company is now embracing. And finally, Double Click led to Google’s largest revenue driver, ads.

Additional services and products that Google offers, such as Google Docs, came from humble beginnings. The online word processor that morphed into Google Docs started at Upstartle, which Google acquired in 2006. The Google spreadsheet Sheets was acquired too, from 2Web Technologies. These products were put together using technology from AppJet, which Google acquired, bringing all of these technologies together online.

Google has a well-earned reputation for technological innovation, but they have also used M&A as a growth strategy, allowing them to acquire technology that they could engineer to fulfill their needs.

Looking at a snapshot of different financial metrics and revenues, we see this works out quite well for Google.

Revenue 10-Year CAGR

20.1%

Free Cash Flow 10-Year CAGR

19.8%

EPS 10-Year CAGR

16.1%

ROIC

15.2%

10-Year CAGR Return

26.61%

Microsoft

Microsoft, one of the leading cloud providers and computing services, is also a serial acquirer. The company, which went public in 1986, founded by Bill Gates and Paul Allen, bought its first company in 1987; it has averaged almost six acquisitions a year and purchased more than ten a year between 2005 and 2008.

Over the years, Microsoft has acquired over 225 companies, with the ten largest deals totaling over $63 billion.

Below is a list of some of the more successful acquisitions over the years:

  • LinkedIn for $26.2 billion in 2016
  • Skype for $8.5 billion in 2011
  • Github for $7.5 billion in 2018
  • Mojang for $2.5 billion in 2014
  • Visio for $1.4 billion in 1999

Many of those acquisitions were transformative to the company. Minecraft wouldn’t exist as we know it today without Mojang, with over 144 million copies sold, second behind Tetris. Microsoft acquired Hotmail, one of the early leaders in free web email services, in 1997 for $400 million.

But one of the most important acquisitions was the 1987 purchase of Forethought for $14 million in cash. Forethought’s key product, PowerPoint, was soon included in the Microsoft Office bundle, which allowed Microsoft to dominate the presentation software market for decades.

Microsoft Excel and Word were enhanced in their early development from acquisitions and other programs included in Microsoft Office, one of its main offerings.

As with Google, Microsoft has had some financial success over the years:

Revenue 10-year CAGR

9.2%

Free Cash Flow 10-Year CAGR

8.6%

EPS 10-Year CAGR

11.6%

ROIC

22.0%

Stock Return 10-Year CAGR

31.34%

Other companies besides Microsoft and Google have utilized M&A as a growth strategy.

A couple that pop to mind is:

  • Constellation Software – the Canadian software provider that spends the majority of its free cash flow on acquisitions. The company has had a 42.7% stock return CAGR over the last ten years.
  • Roper Technologies – the US software provider and conglomerate uses M&A as a growth strategy and has a 22.8% stock return CAGR over the last ten years.
  • SS&C – a software provider, among different services, has had a 26.25% CAGR return over the last ten years, and they spend most of their cash flow on acquisitions as a growth strategy.

Investor Takeaway

The bottom line is M&A as a growth strategy works well for many companies. As investors, we need to understand the reasons for companies buying others and how those acquisitions impact the company’s future returns.

The most important decision every CEO has is what to do with their capital?

Mergers and acquisitions have accelerated to over $3.6 trillion globally in 2021, and many expect that acceleration to continue into 2022. Historically, M&A activity only increases the longer a bull market continues, and with the current bull market continuing without any signs of slowing down; M&A as a growth strategy is likely to continue.

We can measure the impacts of M&A by looking at the before and after financials, using ratios such as ROIC, and by looking at the stock returns of the company we are analyzing. It is also beneficial to analyze the company’s past efforts using M&A as a growth strategy because those successes will hopefully lead to future successes.

Typically, CEOs that have had success in the past will have success in the future regarding integrating M&A activity. And seeking out CEOs that do well using M&A as a growth strategy is a necessary part of any stock analysis.

And with that, we will wrap up our discussion for today.

As always, thank you for taking the time to read today’s post, and I hope you find something of value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave