On Wednesday, Apple (NASDAQ:AAPL) announced it had finalized a long speculated deal for Beats, a headphone maker headed by Dr. Dre and Jimmy Iovine. Apple will pay $3 billion, which is a bit lower than the $3.2 billion that various news outlets had previously reported (press release available here). Apple will pay $2.6 billion in cash and $400 million in equity that will vest over time. This stock portion will help to ensure that Beats' management has an incentive to stay at Apple for several years rather than leave once the acquisition is completed. On that front, it is important to note that both Dr. Dre and Iovine will work for Apple full-time (details from an interview available here).
With over $150 billion in gross cash and $45 billion in annual cash flow, this deal is a relative drop in the bucket for Apple (financial and operating data available here). However, it is still an important deal with several positives and negatives. It is hard to determine a fair valuation for Beats as it is a private company, but at $3 billion, it is being valued at roughly 2x sales, which isn't egregious. CEO Tim Cook also expects the deal to be accretive to EPS next fiscal year. However at the end of the day, this deal isn't about headphones, even though they are the primary driver of Beats' business. The motivation for this deal is three-fold: the cool factor, people, and streaming music.
Under Steve Jobs, Apple was the cool brand with revolutionary products like the iPod, iPhone, and iPad, each of which redefined consumer technology to some degree. With cutting edge technology and a beloved CEO, Apple was the hot brand from about 2002-2010. However since Jobs' passing, Apple's brand has lost some of this "cool factor" as Cook has yet to deliver a new breakthrough product. Now, the diminished "cool factor" is not entirely Cook's fault. Companies like Google (GOOG, GOOGL) and Samsung are more innovative than past Apples foes like BlackBerry (NASDAQ:BBRY), which has given consumers more choice. Apple is also a victim of its own success. Its products are ubiquitous, and a brand just isn't as cool when one's parents use it. The fact seemingly everyone has an iPhone makes it a bit less exclusive.
Beats has captured consumers' imaginations, growing sales to an estimated $1.5 billion in five years. Cultural icons like Lady Gaga and designers like Alexander Wang have designed Beats headphones while athletes like Lebron James are always wearing them. When it comes to headphones, Beats are currently the "cool" brand. Apple will now sell them in Apple stores and alongside Apple products, hoping for a bit of a halo effect. This increased distribution should also benefit Beats' sales. It is important to note that in past years, Apple organically developed its brand and built its own "coolness." Now, Apple is simply buying another brand, which has already built a cultural following. This could increase the concern that Apple is no longer able to develop new products like it was under Jobs. Apple has gone from a revolutionary to an evolutionary company, making incremental changes to existing products rather than creating new ones.
To this end as part of the agreement, Beats' leadership has agreed to work full-time for Apple. Dr. Dre and Jimmy Iovine played critical roles in designing and marketing the Beats headphones, and there was concern that one or both of them would leave in the event of a takeover. However, both have agreed to work full-time at Apple. In other words, there will be no "brain drain" at Beats. They will also provide their perspective into the design of Apple's own products. Apple's products gained traction because Jobs combined good technology with a very sleek design. This is also how Beats achieved its success. This is not an easy thing to do, and Apple is adding employees with a proven track record. Iovine in particular could play a major role in product development to enhance Beats and help Apple itself regain some luster.
Finally, Beats has a nascent music streaming service that uses algorithms and an experienced music team to create individualized playlists for consumers. Thus far, this offering has yet to take off with penetration far lower than competitors like Spotify and Pandora. Tim Cook seems very optimistic about this business: "We get a subscription music service that we believe is the first subscription service that really got it right. They had the insight early on to know how important human curation is. That technology by itself wasn't enough - that it was the marriage of the two that would really be great and produce a feeling in people that we want to produce." With the potential integration into iTunes, there is the possibility that Beats' streaming service grows dramatically. This is a business Apple has wanted to enter for a while, and it now has the perfect opportunity to do so. However once again, we see Apple buying a brand rather than developing its own product internally.
This deal is further evidence Apple is a maturing company, buying growth instead of creating it. However, the deal does not seem financially unwise. It will be accretive to earnings, and Beats could grow dramatically when paired with Apple's massive footprint. Still for shares to reach past highs above $700, Apple needs to show the ability to innovate itself and not merely purchase innovative companies. At $3 billion, Beats is not a major deal, and headphones are unlikely to power significant top-line growth.
I would rather have seen Apple make a major deal for a content or social company, but on its own merits, this deal is a mild positive. If Apple purchased a social platform like Pinterest or even Twitter (NYSE:TWTR), it could have integrated the site into its devices to make the ecosystem stronger and products sticker, ensuring that customers don't switch to Android or other devices. Similarly, a deal for Netflix (NASDAQ:NFLX) would have significantly bolstered the iTunes platform and made an Apple TV a much more viable and enticing offering. Nonetheless, Apple gets a cool brand, people, and a streaming service. On the negative side, this deal suggests Apple feels the need to buy innovation elsewhere. Excluding cash, shares are trading about 12x earnings. This isn't particularly expensive, but Apple will need to show organic growth to power shares much higher. After all, it remains to be seen whether Apple can regain its "cool factor." I would wait for a pullback to around $600 before initiating or adding to a position in AAPL. At $600, AAPL is only 10x 2015 earnings on an ex-cash basis, which provides an ample margin of safety considering its lack of organic growth. If Apple can launch a new popular product, like a smart watch or TV, that could push shares higher. But without one announced, investors would be wise to wait for a pullback to 10x earning. At a $600 valuation, the lack of growth is definitely priced in, making Apple an attractive buy.
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.