With $28 billion in the bank and Steve Jobs no longer at the helm, some argue that the time is ripe for Apple (NASDAQ:AAPL) to go on a "strategic acquisition" spree to expand its product portfolio. Other technology companies have done this in the past, including Cisco Systems (NASDAQ:CSCO), Hewlett-Packard (NYSE:HPQ), and recently Google (NASDAQ:GOOG).
We believe this strategy—a departure from Apple’s strategy of internal innovation—is the wrong one for the company to pursue. Acquisitions of small companies with new products by larger companies may work well for pharmaceutical and consumer staple sectors, e.g. Pfizer (NYSE:PFE), and Procter & Gamble (NYSE:PG), as they create synergies that allow these companies to achieve economies of scope, but not that well for technology companies, for a number of reasons:
First, the technology sector is a fast-moving sector -- especially consumer electronics -- and acquired companies may already be in declining business. HP’s acquisition of Compaq Computer is a case in point. Compaq Computer was supposed to provide HP with the scale advantage in the PC market to compete effectively against Dell Computer (NASDAQ:DELL), IBM (NYSE:IBM), and all sorts of emerging Asian competitors. The problem, however, is that the PC market was already saturated and ravaged by price wars, as the PC was turning into a commodity.
Second, acquired companies are usually followers, rather than leaders, in their industry. This means that they do very little to help the acquirer achieve sustainable competitive advantage. HP’s acquisition of Palm is a case in point. The merger was supposed to help the company enter the fast-growing market for mobile devices that began to replace PCs. The problem, however, was that Hewlett-Packard was a follower, not a leader, in this market. It went up against Apple, which enjoyed the first-mover advantage.
Third, strategic acquisitions usually come at a hefty price, as their owners auction them to the highest bidder. Cisco’s string of acquisitions is a case in point. Over the period 1993-2000, Cisco acquired 70 companies, including Crescendo Communications (1993), Newport Systems Solutions (1994), Network Translation (1995), Netsys Technologies (1996), Net Speed (1998), and Growth Networks (1999), etc. The problem with this strategy, however, is that owners of these smaller companies demand higher and higher premiums to compensate them for the risks they assume — Cisco ended up paying top prices for Net Speed and Growth Networks, which were acquired at the peak of the high-tech bubble.
Fourth, strategic acquisitions further end up being dilutive to existing stockholders when paid with the issuing of new stock — that's how Cisco ended up with 5.5 billion shares.
The bottom line: Apple should resist the temptation to go on an acquisition spree. It didn’t work for Cisco Systems and Hewlett-Packard, and it won’t work for Apple.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.