Apple Buying Beats May Have A Strong Risk/Reward Profile

| About: Apple Inc. (AAPL)


It was recently announced that Apple is in discussion with Beats about acquiring the audio component maker for $3.2 billion.

Such a deal would be the largest ever for Apple, and possibly indicate the start of a buying spree.

While a buying spree would probably be a bad thing, Beats adds high margin audio components and music content that both complement Apple's business model.

Last week, discussion over whether Apple Inc. (NASDAQ:AAPL) might purchase Beats Electronics LLC hit the street. In particular, it is believed that Apple might pay $3.2 billion for the headphone and music service. Given Apple's over $500 billion market valuation and last reported $150 billion in cash, such a purchase may appear rather immaterial. Nonetheless, such a move would also be a substantial diversion from the company's prior practices, and if such a deal were to occur, it might be indicative of future uses for the massive cash hoard.

At first blush, such a deal appears to be rather contrary to Apple's usual style, where the mega-cap has never paid as much as even $1 billion to acquire a company. Further, Apple's acquisitions are usually of companies that offer it some technological or manufacturing advantage. A deal for Beats does not appear to bring with it any advancement, but rather branded products. To that extent, this would be unlike any other deal Apple has ever done, both in terms of price and product.

If such a deal were to occur, it would appear to indicate a new era for Apple, where it might use its ample cash on hand to acquire products, and possibly content. Potential acquisitions could include entities that may appear likely to benefit from mobile growth, such as OpenTable (NASDAQ:OPEN), Twitter (NYSE:TWTR) and Yelp (NYSE:YELP), as well as component makers like ARM Holdings (NASDAQ:ARMH) and Cirrus Logic (NASDAQ:CRUS). Apple currently has the cash to acquire all of these entities, though having the ability to do so does not mean it is the best or even a proper use for the cash.

The largest price tag for an Apple acquisition that was made public was $400 million, which Apple paid to buy Next Computer Inc. in 1997. It is unlikely that Apple will find any deals like that one again. The Next deal was rather important for Apple, as it brought Steve Jobs back to the company and also an operating system that was shortly thereafter developed into X.

One thing that such a new era of deals appears likely to do is signify a new era for Apple under Tim Cook. It is certainly the case that Cook has already changed the company, but mostly in paper terms through the introduction of dividends and massive share buybacks. Apple has also made efforts to improve its environmental footprint and the labor conditions for its largely Chinese supply chain.

Most of Cook's endeavors have had broad shareholder approval, while the acquisition of a brand such as Beats seems to be far more controversial. There are many arguments that can be made against Beats, but the primary one appears to be that it is merely a brand, and though it does happen to have a large portion of the mid-to-high-end headphone market, there is no technological advantage to its products and there is the potential for significant competition to emerge, including margin contraction. Similarly, the strongest argument in favor of such a deal would appear to be that Beats is a strong brand that has established itself as a default option for non-audiophiles that want either a designer or above-average quality headphone. Beats has also recently launched a music streaming service in which Apple may see some value.

While such a deal may mark a major shift for Apple's use of cash, it does seem that the deal cannot possibly provide significant top-line growth. Apple had revenue of about $171 billion in the prior fiscal year, while Beats had revenue of about $1 billion. Nonetheless, Beats is a fairly new brand and it is rather possible that its branding can be applied to numerous other products. Of course, the same could likely be said for adding the Apple logo to so many other products.

For a while, music has been one of the keys to Apple's business. Apple's iTunes store sprung into a position of strength ever since the iPod, and the company continues to sell content for mobile devices and computers through the service. More recently, Apple developed iTunes Radio, an advertising-based streaming service that competes with Pandora Media (NYSE:P) and Spotify.

Music downloading has softened as consumers adopt a greater use of streaming services, and Beats' recent foray into streaming music could help bolster Apple's endeavors to strengthen iTunes. While hardware is nice to sell, it is generally the case that software and content have better margins. Streaming services also allow for recurring revenue streams. Further, it is entirely possible that Beats co-founder Jimmy Iovine (and to a lesser extent, co-founder Dr. Dre) might help Apple strengthen its position in media sales and streaming. Iovine is a music producer and was involved in Jobs' initial move into the music business via iTunes. The business may be due for yet another transformation, or for iTunes to tighten its grip upon it.

While the price tag for this deal does appear high, it would cost Apple a little over three percent of its current cash and may be one of the most cost effective methods of both bolstering iTunes and adding a young but growing brand that complements the mobile device businesses in which Apple competes. In comparison to Apple's buying back $14 billion in shares after reporting earnings in January, if the deal were to occur, it is unlikely to make a substantial change to earnings per share in the near term. Similarly, Apple spends multiples of such a deal in the production, distribution and marketing of any new product or version of an existing product.

Apple's continuing efforts to cement its position as a provider of designer or luxury products should help it maintain a relatively high profit margin, as well as prompt consumers to aspire towards Apple ownership. Apple appears to have sufficiently entrenched itself into the space, and it seems it would take a significant change in technology and consumer sentiment to alter its position. Adding another aspirational brand should not hurt its position, and may also help it brand new wearable devices that Apple might not feel warrant the Apple brand, or possibly to offer yet another price point.

To that extent, there is minimal risk to Apple beyond the cost of acquisition of Beats, while the brand may fortify Apple's position as a provider of aspirational technology. As such, and given Apple's cash and overall size, such a deal may have good risk/reward characteristics over the longer term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.