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Summary

  • Because Beats Electronics isn't a publicly traded company, there's too little information for anyone outside of Apple to judge if Beats is a good investment.
  • Apple's motivation for the deal is questionable, and what has been offered in the media is flimsy at best.
  • Publicity surrounding discussions between Beats and Apple probably dooms any deal that might have been.

The rumors of Apple's (NASDAQ:AAPL) acquisition of Beats Electronics for $3.2 billion have been warmly received in many circles, with bloggers, analysts and tech writers extolling the virtues of the deal. Few have addressed the issue of whether there actually is a deal, preferring instead to discuss whether the deal would be good or bad for Apple.

Evaluating the Deal (or Not)

On the surface this seems the safer course, since if the reports prove baseless, the writer's credibility is left intact regardless of being for or against the deal. As the story has been developing these past weeks, I've come to the conclusion that this approach is a trap, because there's no way for someone outside of the Apple inner sanctum to evaluate the deal on its merits.

The basic problem with evaluating Beats as an investment for Apple is that it's not a publicly traded company, so we on the outside have very little to go on. We know nothing about Beats' financials, its revenue and earnings. In the face of this ignorance, pro Beats writers have tended to fall back on the simplistic equation one encounters time and again in tech business blogs:

Good Products = Good Investment

I'll concede that Beats has good products, because I think it's beside the point of whether Beats is a good investment for Apple. The information about Beats as a business investment is pretty sketchy. There's the report from July 2013 that Beats might hit $1.4 billion in revenue that year, but no confirmation of whether they hit that number or even got close, let alone turned a profit. The Carlyle Group's (NASDAQ:CG) reported investment of $500 million provides some vote of confidence. In their announcement of the deal, Carlyle also made note of Beats' better than 60% market share for over $100 headphones.

The information about Apple's motivation to buy Beats is equally insubstantial. Basically, it comes down to a pair of Billboard articles. The first, published January 3 of this year, began with the statement "For the first time since the iTunes store opened its doors, the U.S. music industry finished the year with a decrease in digital music sales." Leaving the casual reader with the impression that iTunes music sales had been responsible for the decline, but a careful reading of the rest of the article reveals no specific information about iTunes music sales. Other companies such as Amazon and Google sell digital music, so there's no way of knowing how the decline was distributed among these companies.

The second Billboard article titled "Underwhelming Start to iTunes Radio Lights Fire Under Apple" is just the latest in a long line of media failure declarations that invariably follow the introduction of a new Apple product. The rationale for this particular failure declaration is unbelievably flimsy: only about 1-2% of iTunes Radio listeners buy the songs they listen to. Well of course. If you are listening to advertising supported internet radio, you're probably doing so in order to avoid having to pay for downloaded music.

As poorly substantiated as the Billboard articles were, a number of writers, including David Goldman and Ben Thompson, ran with them in order to support their views that Apple really needs the deal. The motivations ascribed to Apple had an undercurrent of negativity: something was fundamentally broken at Apple that the Beats deal would fix. Lurking behind the Beats rumor was the resurgence of a theme we heard so much last year: Apple is no longer cool. Therefore it made sense that Apple would spend $3.2 billion dollars in order to become cool again. In Ben Thompson's vision in particular, Dr. Dre, Jimmy Iovine, Angela Ahrendts and Jony Ive become Tim Cook's coolness brigade, able to restore Apple's supposedly fading appeal to teens and young adults.

Can $3.2 billion worth of desperation ever really be cool? I doubt it, but then I never accepted the idea that Apple's success derived from an intangible such as coolness. This is just a recycling of the view that Apple doesn't build "real" computers (real computers have keyboards, are difficult to use, etc.), but merely toys, and that the popularity of these toys is a passing fad based on their perceived coolness.

Evaluating the Rumor

If the deal cannot be evaluated on its merits, is it possible to evaluate the rumor? I think it is, based on a little common sense reasoning as well as some relevant contextual information. Let's take it a step at a time:

The Meeting: I'm absolutely certain that the meeting took place as reported. Probably Adrian Perica, Apple's M&A chief, and Eddy Cue were there. We first heard of Adrian Perica, an ex-Goldman Sachs investment banker, in connection with reports that he had met with Elon Musk back in February, fueling speculation that Apple might buy Tesla.

But the fact of the meeting has to be understood in the context of how the venture capital network operates. Money is a magnet. Venture capitalists don't have to seek out start-ups to fund, because there's always a multitude of start-ups on their figurative doorsteps anxious to pitch their ideas.

Apple has the biggest money magnet around, so Perica doesn't have to beat the bushes for companies to acquire; he's probably inundated with proposals every day. With so many prospective start-ups chasing Apple, there has to be more than one level of filtration. The first level is that there has to be some pre-existing involvement by a venture capital firm. Perica would only look at proposals coming through his contacts in the venture capital network. Here, Carlyle Group's investment in Beats was crucial to get the attention of Apple.

The second major stage in the filtration process would be the meeting itself. This is the opportunity for the start-up to make its pitch to Apple, and probably there were several presentations by members of Carlyle Group and Beats covering various aspects of their business and financials. The Apple execs listen intently, ask pertinent questions, and at the end thank the presenters and assure them that their proposal will receive full consideration.

The Aftermath: And that's as far as things usually get. Very few of the proposals that Perica receives are acted upon, for various reasons. We usually don't hear about the meetings because the parties have signed a mutual non-disclosure agreement (NDA) prior to the meeting taking place. In the NDA Apple agrees not to divulge or use any proprietary information of the start-up, and the start-up agrees likewise. Apple isn't likely to reveal any proprietary information on its part, but there is one piece of information that Apple would consider covered by the NDA: the fact that the meeting took place.

The NDAs have the force of a contract, but I've never heard of Apple suing anyone for violating an NDA. Apple doesn't need to. Apple's big stick to enforce the NDA is that violating it jeopardizes the prospective acquisition. Under the circumstances, most candidates for acquisition keep a low profile until the deal is done.

That didn't happen with Beats, and that's the big red flag that calls the acquisition into question. It's not clear what happened, but based on the now infamous Dr. Dre video, the leak probably came from inside Beats. Perhaps the people at Beats assumed on the basis of the meeting that it was a done deal. If so, they shouldn't have. Perhaps Apple rejected the deal outright, and the people at Beats figured that by going public they could drum up enough grass roots support to get Apple to reconsider. If so, that was a miscalculation.

By violating the NDA, the Beats management marked themselves as not fitting in with the Apple culture of secrecy. Beyond that, Apple probably has no choice but to pull the plug on the deal, if only to ensure that future NDAs would be respected.

Is it possible that the deal might still happen? I can't completely rule it out, but given that I don't think Apple was that strongly motivated in the first place, I'm not holding my breath.

Investor Reaction

When it finally sinks in to investors and the general public that the Beats deal isn't going forward, there's bound to be some negative blowback to Apple's stock. We'll start hearing all over again how Apple has lost its mojo, that Apple stumbled badly in not completing the deal, and what a great opportunity Apple has missed. Tim Cook's leadership will of course again be called into question.

Pundits will dust off the Billboard data in order to show that iTunes music sales are in decline, even though there's nothing to indicate that from Apple's financial data. Perhaps they are, but Apple doesn't break out iTunes music revenue from the iTunes Software and Services category. In its latest quarter, revenue in this category was at an all time high of $4.573 billion with y/y growth of 11%.

Whether disappointment (feigned or real) over the Beats non-deal becomes the start of another protracted thrashing of the stock really depends on what Apple shows at WWDC on June 2. The consensus seems to be that Apple won't be showing any fundamentally new hardware products.

I believe that Apple really needs to preview its new products such as the iWatch and new Apple TV in order to get developers working on these new iOS product types. Failure to do so will cause many to question the very existence of these products, and lead to a major drubbing for the stock. I'll have more on my expectations for WWDC in my preview article this week.

Source: Why The Apple/Beats Deal May Be Dead