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This Is Frightening News for Apple Shareholders

By Alex Dumortier, CFA - May 27, 2016 at 12:54PM

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In a development that ought to raise a big red flag for shareholders, a top Apple Inc. executive broached the idea of acquiring Time Warner Inc.

U.S. stocks are little changed in early afternoon trading on Friday, with the S&P 500 (^GSPC -0.42%) and the Dow Jones Industrial Average (^DJI -0.52%) (DJINDICES: $INDU) up 0.31% and 0.20%, respectively, at 12:45 p.m. EDT.

"A full wallet is like a full bladder," Warren Buffett quipped at last month's Berkshire Hathaway Inc. annual meeting, "the urge is to very quickly pee it away." With nearly $60 billion in cash weighing on Berkshire Hathaway's bladder as the end of March, Buffett knows something about this urge. Imagine, then, the pressure on Apple Inc. CEO Tim Cook, who must manage a balance sheet bulging with over $230 billion in cash, short-term investments, and other marketable securities (and billions more coming in every quarter).

Discipline has paid off

To date, Apple has been remarkably disciplined in its M&A strategy, acquiring small companies for a specific technology that it folds into its products. The only deal of any significant size, which followed a different template, was the $3 billion purchase of Beats Music and Beats Electronics in 2014.

Still, it's possible management's discipline will slip as the allure of doing a large deal increases. This allure increases along with the size of the cash pile, but also with pressure from Wall Street. A month ago, Apple reported quarterly revenues that fell for the first time since 2003, as the company sold fewer iPhones than it had in year-ago quarter -- another "first" it would have preferred to avoid. Furthermore, management indicated revenues will also decline in the current quarter, by 15% (using the midpoint of its guidance range).

Those results have provoked much hand-wringing among analysts, investors, and financial journalists, who speculate that the company may be unable to come up with a blockbuster product that will take the baton from the iPhone and drive the next phase of Apple's growth.

The wrong Cue

A big deal would address both issues simultaneously (the cash pile and the quest for growth). Perhaps that explains why a high-profile member of Apple's executive team raised the possibility of Apple acquiring Time Warner Inc. in a meeting with the media group's head of corporate strategy, according to a report published in the Financial Times this week.

The executive in question, Eddy Cue, is responsible for Apple's content stores, which include iTunes and the App Store, as well as the iCloud service. A few hours after Apple announced the Beats acquisition, Cue appeared with Beats co-founder Jimmy Iovine at the Code Conference to discuss the deal.

There's no arguing with the fact that Time Warner owns some attractive assets, including HBO, which sets the standard in term of developing high-quality content (such as hit show Game of Thrones). And once you add, say, a 40% control premium to Time Warner's $59 billion market capitalization, you could really put a dent in Apple's cash pile.

Focus on your strengths

My issue is with the premise behind a deal like this: that Apple should vertically integrate content creation into its portfolio of products and services. Doing so would be a significant departure for Apple from the strengths that are behind its competitive advantage: outstanding brand marketing and industrial design, and a well-integrated suite of services on a seamless common platform.

Thankfully, the notion of an acquisition of Time Warner never went beyond a preliminary stage, but it suggests that Apple's executive team is toying with the idea of a "transformational" deal, which ought to be a matter of some concern to shareholders (the problem being what, exactly, you end up transforming into).

If the company were to go down this road, the only potential target active in the area of content creation that would even begin to make sense is Netflix, in my opinion. The online video leader would significantly expand Apple's content delivery platform and is infinitely closer to Apple in terms of culture than any traditional media company.

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