Apple's (NASDAQ:AAPL) reported efforts to buy Beats Electronics for $3.2 billion have been the subject of endless speculation since it was first reported Thursday. We don't know Apple's actual reason for interest - or even if the deal will happen - since Apple has yet to make any official announcement. (As with all such leaks, this leak seems intended to influence the deal - presumably by the sellers to force Apple to follow through.)
Certainly this is out of character for Apple, since its largest previous deal was $0.4 billion to buy NeXT, the basis of its OS X. But the press frenzy about how precedented the deal is seems a bit exaggerated. After all, there's always a first time for anything, including its successful acquisitions such as the purchase of NeXT, PA Semi, and Siri. (Google (GOOG, GOOGL) got a lot of flack in 2006 for spending $1.65 billion to buy YouTube).
Is the acquisition a good idea? When we (i.e. strategy professors) teach related diversification by acquisition, there is a standard list of pros and cons.
On the pro side, an acquisition is usually about time to market - accomplishing something more quickly than you could do on your own. It can acquire technology, customers, distribution, products and people. For the latter, Silicon Valley normally thinks in terms of engineers. However, an acquisition can also bring new executives: the NeXT purchase brought in the new management team of Apple - not only Steve Jobs, but essentially it's entire management team other than the CFO that Gil Amelio installed (Fred Anderson) and the COO Jobs stole from Compaq (Tim Cook).
Finally, there is the opportunity for the newly acquired company to be more successful under its new owner than as a stand-alone company. This might be due to better management, better distribution or more available capital. For example, in our recently completed business plan competition at KGI, most of the proposed startups would sell out to a large pharma or biotech company before bringing products to market, rather than build a global retail sales force from scratch.
On the con side, there is the question of strategic fit: do the new assets fit with the organization, how will the products, people and culture be integrated - and are the business models compatible? The post-acquisition integration can be a huge distraction (but usually when buying a larger company, as with Microsoft (NASDAQ:MSFT)-Nokia (NYSE:NOK), Oracle (NASDAQ:ORCL)-Sun or HP (NYSE:HPQ)-Compaq).
And with any acquisition, there's always the risk of over-paying. Perhaps the assets are valuable, but CEOs have a tendency to overpay - whether to put their mark on their company, grab the headlines or just to run a larger company.
In Beats Electronics, Apple is buying two lines of business. One is Beats by Dre, the headphones division that has nearly two-thirds (61.7%) of the U.S. premium headphone market - nearly 3x that of Bose, which created the segment. It's a monstrously successful brand, but there's little technology there. The two music industry execs who formed Beats outsourced their initial headset design to the father-son team that runs Monster Cable Products (which, lacking negotiating savvy, failed to get an equity stake in the venture they helped create). The success of the company (even more so than for Bose) is based on marketing rather than technology:
"They certainly don't need the headphone company, which makes second rate headphones based on marketing," says music industry analyst Bob Lefsetz. He thinks Apple would be a lot more interested in Beats' music streaming service. Steve Jobs famously opposed the subscription music model and, instead, championed iTunes' current model, where you buy a song outright.
This points to its other line of business. The nascent Beats Music steaming service leverages the value of the Beats brand with teens, but (like Apple and Amazon (NASDAQ:AMZN)) is far behind market leader Spotify.
By one standard, Apple is certainly overpaying. The company's exponential growth is not sustainable and its revenues are less than $2 billion. As a company with little technology and strong emphasis on style and brand, Beats is essentially a fashion company. Any fashion acquisition is a risky acquisition.
Will Beats by Apple seem as authentic or appealing to teens as Beats by Dre (when Dre was still the owner)? For that matter, how many fashion companies are able to sustain their position of a period of decades? In my adult lifetime, I can only think of one firm that has been successful: Nike (NYSE:NKE).
Which brings us to the final possible value of Beats. The company has shown it has been able to understand teen fashion and create markets that didn't exist. Is that because of the cofounders, Dr. Dre (aka Andre Romelle Young) and music mogul Jimmy Iovine? Or is there a depth of marketing - both market sensing and market creating - within Beats that could help Apple better sell unnecessary luxuries to middle class teens and college students?
Although it's a large deal for Apple, it's essentially a minor bet - hardly on the scale of Google buying YouTube or WhatsApp, let alone Microsoft's purchase of Nokia. Apple has more than $150 billion in cash (mostly offshore), and has few other options to create meaningful growth. With annual revenues of more than $170 billion, the Beats sales would not be material to Apple any time in the near future - if ever.
So if Apple gains an additional window into the soul of the 13-25 year-old set - or rebuilds its foothold in the music industry - then the deal could prove to be a shrewd one. As it is, it's a gamble - but Apple didn't get to where it is without taking gambles (such as the iPhone). It may be Tim Cook's largest gamble to date, but it won't be the last one he takes as CEO.
Disclosure: Long AAPL