When growing up, nobody wants to be like their elders, but it's inevitable. Maybe technology companies face a similar path. Is Apple (NASDAQ:AAPL) destined to become like IBM (NYSE:IBM) and Microsoft (NASDAQ:MSFT), relying on market power and balance-sheet intervention rather than game-changing innovation to drive its stock price higher?
Either way, the Beats acquisition, if it happens, will bring Apple one step closer to being Big Blue. But it's also good for investors.
For those of you who haven't heard, Dr. Dre posted a YouTube video laughing his way to the bank and announcing himself as the first hip-hop billionaire, assuming the Beats acquisition closes. I'm not going to include the link, but it's worth watching if you haven't seen it. Whether or not the $3.2 billion number is right, this is a hefty figure for technology that Apple should be able to build rather than buy. So why would the company do it?
Songs on the cheap?
Apple released iTunes Radio last September. It competes with Pandora, but does not allow you to pick and choose specific music in the style of Spotify or Beats. It's possible that music labels did not want to give Apple favorable rates or the same level of access as an industry insider, which is why it chose to move in the direction of radio versus playlist. However, this pro songwriter website leaked a document that supposedly shows the minute royalties being paid to songwriters through the Beats Music relationship. If Apple were to roll this out to its millions of iTunes listeners, it might have a cost advantage that could make a business that loses money for Spotify and Pandora profitable. It's possible that Apple is paying up for Beats to buy a cost advantage.
Shorts won't win trading against Apple
Two years ago, if Apple pursued this kind of acquisition for this price, the shares would have been hammered. The stock did trade off $10 the morning following the rumor leak but didn't stay down for long. Why? The company is using its balance sheet for buybacks, and investors who would normally short the stock know that there isn't enough gain for the risk. Short sellers can't win trading against Apple. There's a limited amount of money a person can make shorting a successful company that offers a good dividend and buys back its shares.
The balance sheet can create shareholder value
There's a very good lesson in this for investors. Balance sheets can drive shareholder value even when existing product lines are not enough. Investors typically put a multiple of 10-30 times earnings on a technology company, but cash doesn't get a multiple. When a company is left for dead, as BlackBerry was two years ago, it typically bottoms out at two times cash. Looking at those two ranges, it simply doesn't make sense for a profitable technology company to keep a large chunk of cash on its books.
Small acquisitions still contribute cash flow
So, like IBM buying Kenexa or Microsoft buying Visio, Apple is now using its balance sheet to buy a profit-generating asset with a call option on a high-profile data service. IBM bought Kenexa, a human capital software platform for $1.4 billion in 2012. Microsoft bought Visio, a wholesale drawing company, in 2000 for $1.4 billion. Both of these products were adjacent to the product lines of the respective acquirer and represented incremental revenue for the company.
Beats will do the same for Apple. Even though these acquisitions didn't make a tremendous impact on the bottom line for IBM or Microsoft, each contributed to growth in a small way. In Apple's case, each penny of earnings produced by an acquisition will be multiplied by 14 times to boost the share price, if current valuations hold into the future. This is much better for investors, since the company is not being rewarded for holding cash.
Here's Apple's next big thing that could render my thesis moot
If you thought the iPod, the iPhone, and the iPad were amazing, just wait until you see this. One hundred of Apple's top engineers are busy building one in a secret lab. And an ABI Research report predicts 485 million of them could be sold over the next decade. But you can invest in it right now... for just a fraction of the price of AAPL stock. Click here to get the full story in this eye-opening new report.
David Eller has no position in any stocks mentioned. The Motley Fool recommends Apple and Pandora Media. The Motley Fool owns shares of Apple, International Business Machines, Microsoft, and Pandora Media. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.