Apple: Why Netflix Could Follow Beats

| About: Apple Inc. (AAPL)
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The Beats acquisition points to negative motivations for Apple: the need to reverse declines in iTunes sales and its appeal to young people.

I expect the acquisition to deal effectively with these issues, as well as provide a valuable subscription music service and line of audio accessories.

The streaming music service points to the need for Apple to acquire or develop a similar streaming video service.

As the market and brand leader with well established youth appeal, acquiring Netflix is a logical path to such a service, but not the only path.

Since I stated in my last post that I thought the Beats deal was probably dead, I'm sure everyone wants to know my reaction to the news. My reaction is that apparently Apple (NASDAQ:AAPL) was more strongly motivated than I realized, and that motivation derives somewhat from negative factors. In my article, I had dismissed the implications that Apple was motivated to buy Beats in order to improve its youth appeal and iTunes music business. Ascribing these motives to Apple was, I maintained, part and parcel to a negative view of the success of Apple's products as mere fads.

Checking the Talent and Technology Boxes

The events of yesterday have forced me to revisit this. In addition to the announcement itself, there was the publication by Philip Elmer-DeWitt of some research by Katy Huberty, whom I consider one of the best Apple analysts around. Huberty found that spending for iTunes was down 24% per account in calendar Q1 compared to the previous year. This was the first reliable evidence I've seen that Apple was suffering declines in the iTunes business.

Some caveats: I'm not sure P.E.D. got this number right, since it doesn't agree with Huberty's chart, which seems to show a ~35% decline. Also, the number of iTunes accounts has grown by 40%, from 575 million in June 2013 to 800 million as of April of this year, so the decline in total iTunes spending (if at all) wouldn't have been as great as the per account number.

The growing popularity of streaming services for music and video, combined with declines in per account spending, probably does have Apple management very concerned.

The other negative factor, a shift away from young people in the demographics of Apple's customer base, would have been easily discerned by Apple management from its user account data. The fact of Angela Ahrendts being brought in to run Apple Retail is probably more than enough confirmation of this. Ahrendts' turn around of Burberry is textbook youth marketing, as Burberry's site makes plain. Dre and Iovine have shown themselves adept not only at marketing to young people, but also at creating targeted products for them, skills Apple would want.

Tim Cook has repeatedly stated that Apple looks for talent and technology in its acquisitions. With Dre and Iovine, the talent box has been checked, but what about technology? I don't think there's any technology in the Beats headphones that Apple couldn't have easily duplicated and surpassed, but clearly Apple thought very highly of the Beats Music service and saw in that something it couldn't easily duplicate. Technology box - checked.

One motive that I don't think played an important role is a desire for Beats' revenue stream. Many bloggers have focused on the reports of Beats' $1.5 billion annual revenue and presumed profits to show that Beats is a cash cow. Cook has repeatedly stated that Apple isn't interested in getting bigger for the sake of bigness, and I think that's probably still true. Ben Thompson speculated that future growth for Apple might reside in accessories such as Beats headphones, but I don't see a way to grow accessories into a business rivaling device sales. Beats as a source of significant revenue growth just doesn't cut it as a motivation.

How successful will the Beats acquisition be for Apple? It's too early to tell, but my impression is that if Apple's motivations are as I've described, it probably couldn't have a better team to deal with those issues than Dre, Iovine and Ahrendts. Success is not guaranteed, however.

iTunes Disrupted

The digital content business (including video as well as music) is facing severe disruption from the likes of Netflix (NASDAQ:NFLX), YouTube, and various music services. DRM protected digital content has always had a staleness problem: after you listened to the music or watched the video X times, it ceased to have much value, but there was no way to sell the content and recover some of the purchase price, unlike with physical media. Granted, this was more of a problem for video than for music.

Streaming services address the staleness problem in a way that's very cost effective for consumers, which is why they're increasingly popular. If the purchase of Beats says anything about Apple, it says that they're not going to try to fight this trend. Apple was already moving in this direction with iTunes radio. Can a subscription video streaming service be far behind? I think such a service is absolutely essential for Apple and iTunes, and it's just a matter of time.

How Apple would go about building such a service is the most interesting question. The fact that Apple was willing to shell out $3.2 billion for Beats suggests that an acquisition of a subscription video service is quite conceivable. If Apple wants the brand and market leader in streaming subscription video, there really is no other choice but Netflix. As of their latest quarterly earnings report, Netflix had total paid membership of 34.24 million. In contrast, Hulu is reported to have passed 5 million subscribers as of the end of last year. Netflix is also enormously popular among young people.

I know, Netflix is so overpriced, but even with an acquisition premium on top of Neflix's market cap of $20.6 billion, Netflix is still affordable. Buying Netflix might also make much more sense than pitting a homegrown Apple service against it. That could be a very long uphill slog.

As always, an acquisition by Apple is very much conditioned by whether the acquisition target wants to be bought. Apple isn't in the business of hostile takeovers. As Iovine has made clear, Beats was more than happy to be bought by Apple. Would Reed Hastings want to sell? He might. Joining with Apple solves a lot of problems for Netflix. It gives Netflix the deepest pockets imaginable to expand original content production as well as its overseas operations. Overseas expansion could be greatly accelerated by integration of Netflix into iTunes, since iTunes is available in 119 countries (although not always with video downloads).

Perhaps best of all, Apple's servers could host Netflix in the U.S., prying this business out of the hands of Amazon (NASDAQ:AMZN) Web Services. Apple is also rumored to be building its own content distribution network, which could help Netflix get around the distribution tax recently levied by Comcast (NASDAQ:CMCSA).

Investor Reaction

Investors have generally viewed the acquisition of Beats favorably, with Apple's share price up 7% since the news leaked on May 8. In comparison, a Netflix acquisition would be electrifying. Netflix is a much larger business with $1.27 billion in revenue in the most recent quarter, up 24% y/y. Operating income also increased explosively at 200% y/y to $97.6 million.

Once again, I don't think Apple is looking for the revenue stream per se, but Netflix also checks the technology and talent boxes as well as gives Apple another great brand.

There are still many uncertainties, not the least of which is how well Reed Hastings would fit into Apple. But I'm absolutely certain that Apple has to move into or develop a video subscription service. How Apple goes about that will have a major bearing on the revenue performance of its iTunes, Software and Services segment as well as investors' perceptions of Apple's value.

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.