Cheap vs affordable, Apple edition: James Saft

May 29, 2014

May 29 (Reuters) – Apple’s $3 billion purchase of
headphones and music business Beats shows exactly how foggy our
thinking about the distinction between ‘cheap’ and ‘affordable’
has become.

At first glance the deal, which values Beats at about three
times more than when it sold a roughly 50 percent stake in
itself to the Carlyle Group in September, appears to be at a
very rich valuation.

And yet in analyzing the deal, media and analyst reports lay
stress on how the deal is only about 0.5 percent of Apple’s
massive market cap. Or better yet, that the $2.6 billion cash
portion of the deal is only 1.7 percent of Apple’s $151 billion
cash hoard as at the end of March.

Seriously, people, that’s how percentages work: if you take
a large number like, say, $3 billion and compare it to a very
large number like $151 billion you will come up with a small
percentage. That does not imply, however, that because one is
small in comparison to the other it is cheap or even a good
deal, only that it is affordable.

This kind of thinking is rife in the markets for tech assets
which are bubbly, and may really only demonstrate that things
are out of whack.

Following the announcement of Facebook’s $19 billion
acquisition of WhatsApp we saw some similar reasoning.

Benedict Evans, of Andreessen Horowitz, a Facebook investor,
said in a blog post the correct question was not about the $19
billion sticker price but rather “is this worth 10 percent of
Facebook?”

In that instance, because the deal was mostly in Facebook
stock, this logic has a certain perverse truth to it. If you
posit that Facebook stock is overpriced, or should we say has a
highly uncertain relationship to its ability to create profits,
you might conclude that taking a flyer on a new area is worth a
tenth of that.

During the gold rush in California in the 19th century
miners in the goldfields often paid 10 to 20 times the
Sacramento or San Francisco price for coffee or meat. That was
the cost of remaining on site and hopefully getting more gold.
When the gold ran out, however, the prices dropped.

LESS WILD

To be sure, there are huge differences between the
Facebook/WhatsApp and Apple/Beats deals. Though the figures are
not public, Apple appears to be paying something like three
times annual revenue for Beats.

Profitability at Beats is uncertain, with the headphones
portion, which is more mature, thought to generate high margins
but perhaps also subsidizing losses in the streaming music
business. Apple, for its part, believes the deal can be
accretive to profits as early as 2015, though whether it
accretes enough to make $3 billion seem reasonable is another
matter.

Also at issue here is tax, with some observers suggesting
that, as Beats has tax residency in Ireland, Apple may be able
to use cash held offshore for some or all of the purchase price.
That would effectively reduce the price to Apple as repatriating
that money would incur hefty U.S. taxes.

But what both deals have in common is that the acquirer is
paying a pretty sizable premium to get access to a new area they
haven’t been able to crack. In Facebook’s case it was the
‘network’ of millions of users who use WhatsApp to communicate.
For Apple it is streaming music, an area which is eating away at
its traditional strength of music downloads and in which its
attempts to compete have produced mixed results.

Paying up to get that may well make sense. For Facebook
every new network is a potential existential threat (remember
Myspace?). For Apple, its franchise value is about the
acquisition and consumption of content over its devices.

Apple’s far less lofty share price valuation might make you
think it is less vulnerable but only, I think, if you are not
familiar with the story of Blackberry. Some of the
vulnerability demonstrated by Blackberry is already very likely
in Apple’s share price.

That, not the fact that Apple can easily afford dozens of
Beats, may be the real reason, and perhaps valid justification,
for the deal.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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