What the Beats is Going on? Thoughts on Apple Acquiring Beats

Apple is reportedly interested in acquiring Beats for $3.2 billion. 

Here’s what I’m thinking:

1) Separate the rumored deal price from the transaction.  It’s a lot of money for Apple and in many ways focusing too much on the money will make it difficult to focus on the underlining acquisition target. 

2) What is Beats?  While everyone seems to have a different answer, to me Beats is a start-up music company that is after one thing: music mind share. Think of music and Beats comes to mind, right? No? Well give it a few more years and the growing popularity of those “obnoxiously large” headphones may change things.  Co-founded by intelligent musicians (and businessmen) who “get” music, Beats knows what it is doing and more importantly what it’s after.  Headphones, stereo equipment, music streaming service, and the list goes on. Beats wants to own music. 

3) Apple is Afraid. I suspect Apple feels threatened as its mind share for music is declining. The iPod died on behalf of its older sibling, the iPhone, and following its death, the grip Apple had on music has started to slip. Think of digital music, and Pandora or Spotify may come to mind. Beats could very well be on the same path of music stardom. This past holiday shopping season, Beats headphones were everywhere (and people were buying them in droves). Walk down the street and you could tell when someone was wearing Beats. For the first time, the white EarPod was being threatened. Who knows what things would look like in a few years. Apple would be looking to change that with this acquisition. I suspect Apple is interested in buying Beats to gain music mind share.  

4) Similar Cultures. Beats and Apple share similar cultures where passion is the ultimate driver. While there would undoubtedly be segments or pieces of Beats that Apple will shutter, Beats could very easily represent a decently sized (fewer than 200 people) division within the Apple system. Sure, this would mark a departure from the way things have been, but judging from Disney’s success, sometimes you have to let the past go and embrace the future. 

5) Let’s go back to price. I think Apple is overpaying for Beats. Recent valuations pegged the music streaming service at around $100 million with the entire company worth a reportedly $1 billion last year. While additional details may come out in the coming days I suspect Apple is overpaying to avoid others from coming in and competing over price. It’s a lot of money for any company, and regardless of how much cash Apple has in its bank account, it’s still a lot of money. To me this means Apple is serious about this bet.  

6) Lots of unanswered questions.

- Will Apple actually promote the Beats brand post acquisition? Such an idea is still hard to grasp, but maybe they would have to in order to maintain a gripe on the music mind share they are acquiring.  Is the reason Beats headphones are popular because they aren’t Apple branded?  If I had to bet I would say Apple walks a thin line introducing new Apple-branded music product, while also keeping the Beats brand around.  Such an idea is still hard to swallow though…

- Will there be a Beats brain drain (employees leave) and does it even matter?

- How will this impact future Apple products? I suspect we are going to see Apple attempt a very significant push at a true music streaming service where I can have any song, when I want it (NOT RADIO), wherever I want it…and it would be free for iOS users signed up for Apple’s new mobile payment system.  

- Will this open the floodgates to additional Apple acquisitions?  If the answer is yes, then we may be entering a new era in tech M&A as the biggest tech company in existence is officially an acquirer (I don’t think this is the case though). 

Acquiring Beats would be a new type of transaction for Apple. While there are similarities to previous acquisitions, there are just as many differences and for the first time we may be seeing Apple “doing what is right” - fighting for its survival. Apple wants to own music. 

14 hour update: After plenty of Twitter discussions and thought, the only additional comments I have include:

1) Jimmy Iovine may play a big role. If the $3.2 billion price tag holds up, it becomes obvious that Apple is paying for intangibles (branding, music industry relationships) and not current products or services.   In essence, Apple would be buying the music industry - something that Apple would not be able to do organically. Iovine has been critical of iTunes and it’s possible Apple wants him to revamp iTunes and bring the service into a new era (with the full support of the music industry).  

2) Would Apple replace the iTunes brand with Beats? Is it possible for a declining consumer electronics brand (iTunes) to turn around and regain its strength? Maybe the only way for Apple to regain its grip on music is to update its branding from iTunes to Beats (among other things).  In such a case, a $3 billion price tag doesn’t seem as crazy. 

Apple 1Q13 Review; Thoughts on Guidance and AAPL

1Q13 Review

Apple’s 1Q13 results were largely in-line with my expectations.

• Revenues beat ($54.5 billion vs. my $53.1 billion)
• Margin beat (38.6% vs. my 37.9%)
• EPS beat ($13.81 vs. my $12.75)
• iPhone was an exact match (47.8 million - equal to my estimate)
• iPad was slightly stronger than expected (22.9 million vs. my 22.4 million)

While I was pleased with the quarter, my estimates were considered somewhat bearish compared to the crowd; so needless to say, there were more disappointed faces than smiles.  Apple reported healthy growth metrics for iPhone and iPad, while iPhone ASP remained strong and iPad ASP declined due to the iPad mini.  

2Q13 Guidance

Management altered the way guidance is presented. While the reasoning was not disclosed, I don’t think its much of a stretch to assume its management’s way of ending analysts’ nasty habit of severely overestimating guidance.  When Apple’s earnings report was initially released, the stock was trading in the $490-$495 range.  Guidance seemed to be of Apple’s conservative nature - in that case, guidance was O.K.  When Apple clarified that it would no longer give EPS guidance, but instead release ranges (including upper limits) for several line-items used to reach EPS, the stock quickly fell to the $460-$465 range as guidance was considered NOT O.K. (it can be debated what management meant by guidance ranges, but I am assuming Apple’s actual results will fall within these ranges). 

I didn’t find Apple’s 2Q13 guidance (with the new ranges) to be overly concerning. Going into the quarter, I knew 2Q13 was going to be tough due to difficult year-over-year comparisons to 2Q12. Judging from the stock’s decline, I guess I was in the minority. 

Did Anything Actually Change? 

Taking a step back from all of the earnings noise, I didn’t learn much new about Apple. Both iPhone and iPad unit growth is slowing, margin remains pressured due to newer products, and EPS growth will be difficult to achieve in 2013.  Minor details such as the iPhone 4 remaining supply-constrained (most likely due to limited resources and parts allocated to iPhone 4 production), iPad mini coming into supply/demand balance by the end of this quarter, and the mix between new and old iPhones remaining constant weren’t exactly market-moving data points.  

AAPL 

It is interesting to read the differing opinions on Apple’s quarter between the Valley’s reaction and that of Wall Street.  In the Valley’s eyes, Apple did great and is firing on all cylinders, but according to Wall Street, AAPL stock is broken as growth is slowing. I think reality is somewhere in the middle of those two extremes.  

AAPL has now been in a 4-month tailspin, including widespread shareholder rotation (meaning many of Apple’s shareholders as of the end of September are selling and being replaced by new shareholders). Such a rotation is often quite volatile, resulting in lower stock prices as the new shareholder base has different priorities and expectations for Apple (often of a lesser nature).  

Back in January 2012, the consensus view on Apple was that EPS from iPhone and iPad would plateau around $60. An additional premium for Apple optionality (i.e. new products) may push EPS to $70. P/E multiple and dividend payout ratios were then calculated accordingly.  Things certainly have changed.  The consensus view is now of Apple EPS topping out around $40. It’s tough for a stock labeled as *the* momentum tech growth story to keep its luster when EPS expectations are cut by 30%. Of course, investors and traders love to panic and overreact, so not only is Apple’s EPS problematic, but Apple’s business model is apparently broken, management is clueless, and the company is the new Microsoft. It is what it is and I don’t see a reason to fight it. 

Investors buying AAPL today (or for that matter - the past year) should not be buying it on iPhone and iPad predictions, but rather Apple’s ability to disrupt itself and introduce new product categories. Not surprisingly, when things are good and AAPL is up, everyone assumes Apple is in great shape. When AAPL is down, management is assumed to be inept; unable to innovate and remain relevant. 

Looking ahead, I think it will be difficult for Apple to report EPS growth in 2Q13 and 3Q13, due to tough year-over-year comparisons related to margins. Modest growth should come back in 4Q13 and moving into 2014.  I am assuming anyone with an earnings model is well aware of these trends, but judging from today’s stock price action, I may be too generous in my assumptions.  Catalysts such as China Mobile selling the iPhone (not in my model) or new products are most likely not being contemplated by Wall Street and one can argue even if catalysts come to fruition, many will simply brush them off as a non-event.  Just as funds had to own AAPL last year to beat certain performance benchmarks, many funds now have to sell AAPL because the stock is down. 

Many are trying to find rational answers with AAPL’s price action, but since the following statements are often true, I’m not sure how many answers are actually out there:

A stock often goes up because it has been going up. 

A stock often goes down because it has been going down. 

A stock’s valuation matters only when valuations start to matter. 

Fundamentals are important only when fundamentals become important. 

AAPL 1Q12 Estimate

Revenue: $39.4 billion (AAPL guidance: $37 billion/Consensus: $37.9 billion) 

I expect iPad and iPhone to represent nearly 70% of Apple’s quarterly revenue.  My projected revenue is 38% higher than any previous quarter (closest was $28.6 billion revenue reported in 3Q11). 

GM: 41.3%  (AAPL guidance: 40%/Consensus: 41.6%)

Apple’s margin in 2011 ranged from 38.5% to 41.7%.  A higher iPhone mix during 1Q12 (including 3GS and 4 models) should benefit overall GM with component pricing remaining largely unchanged from previous quarters. 

EPS: $10.50  (AAPL guidance: $9.30/Consensus: $9.72) 

I expect Apple to report 63% yoy earnings growth.

Product Unit Sales and Commentary

Macs: 5.2 million (25% yoy growth)

Mac experienced 22% yoy growth in 2011 (34% growth in portables and 1% in desktops) and I expect similar growth during 1Q12 as consumers flock to the MacBook Air.  Apple will continue to take market share from Windows (early stages of 5-10+ year trend). As the PC market struggles to grow (thanks in part to the proliferation of smartphones and iPad), I view long-term Mac growth near 10% as very respectable. 

iPad: 14.7 million (100% yoy growth)

iPad supply/demand returned to equilibrium during 4Q11 with Apple reporting an average weekly sales rate of 925,000 iPads.  My 14.7 million iPad estimate assumes an average 1.1 million iPad weekly (13 weeks) sales rate (higher than 4Q11 due primarily to holiday shopping). I am not forecasting any significant change to the iPad channel.  While there have been many rumors and reports indicating softening iPad demand, I think some of that is the reduction of overly optimistic iPad expectations towards a more conservative consensus expectation.  I think iPad will remain a top holiday gift. My 100% yoy growth does contain some conservatism when compared to 334% yoy iPad growth reported in 2011. 

iPod: 16.5 million (15% yoy decline)

Continued strong iPod touch sales will partially offset the continued decline in Apple’s other iPod models.  Apple refreshed the iPod line-up in 4Q11 and iPods do make great stocking stuffers, so my 15% yoy decline is slightly higher than the 20% and 27% yoy declines registered in 3Q11 and 4Q11, respectively.

iPhone: 28.4 million (75% yoy growth)

iPhone 4S sales are off to a fast start with 4 million devices sold during opening weekend, a 1-2 week backlog on Apple’s online store (my iPhone 4S ordered from Apple took 15 days to arrive), and continued extended shipping waits at mobile carriers. It is clear that iPhone 4S supply/demand is not in equilibrium. iPhone 3GS (and iPhone 4) price reductions should also benefit 1Q12 sales. Apple’s largest iPhone quarter prior to 1Q12 was 20.3 million sold during 3Q11 (average of 1.7 million per week). My 28.4 million estimate reflects an average 2.2 million per week sales rate, but I admit that sales will be limited to Apple’s iPhone production levels. Another way to conceptualize my estimate: I am assuming 4 million iPhone 4S devices sold during opening weekend and then a subsequent 2 million units sold each following week (not out of the question given continued stockouts and the impact from 3GS and 4 models). 

Questions can be addressed to me through twitter. 

Final Thoughts on Apple's 4Q11

iPhone. We Still Don’t Know How People Buy Phones. 

While everyone has been quick to blame unrealistic expectations for Apple’s 4Q11 “miss”, I think the rare earnings disappointment was partially due to a lack of understanding on how iPhone demand fluctuates and how people buy phones. Apple just became a much harder company to model.

It is incorrect to say that analysts never considered people waiting to buy iPhones ahead of a rumored iPhone refresh. Almost every analyst note published in the past three months mentioned an iPhone refresh and the tendency for pent-up demand to build as consumers wait on iPhone purchases.  Apple management forewarned the same scenario on Apple’s 3Q11 earnings call. People were expecting it.  Even my analysis was based on the idea that a slowdown in iPhone 4 sales in countries that typically get the new iPhone on launch would be offset by continued strong iPhone 4 sales in countries where the new iPhone would take months to reach. That didn’t happen.

Instead, the world pretty much stopped buying iPhones in September.  I don’t think it’s much of an exaggeration to say that iPhone sales almost came to a screeching halt towards the end of September. Apple specifically mentioned that sales slowed further in the second half of the quarter.  Running rough calculations, I estimate iPhone sales may have been tracking down 20-40% yoy in the U.S. towards the end of September. Pretty remarkable. I wonder if Apple retail stores saw this noticeable decline in demand? Analysts underestimated how many people were aware of iPhone rumors and were waiting to buy. Apple was surprised too, with both Tim Cook and Peter Oppenheimer mentioning “rumors” as one cause for weak iPhone sales.  Anecdotally, I talked with quite a few BlackBerry and Android users over the summer, all of whom were well aware of a new iPhone coming out sometime in the fall. I assumed there were other people still buying iPhones.

The iPhone miss (and let me be clear, the iPhone number was pretty negative at only 21% yoy growth) came as a huge surprise with analysts and the investment community thinking the iPhone demand cycle had become independent of product transitions. We thought that sequential quarterly iPhone growth is the new normal, regardless of how a new iPhone impacts deferred sales. Apple’s significant 3Q11 iPhone beat cemented the idea of sequential quarterly growth. Ironically, many analysts thought the new iPhone was going to be unveiled at WWDC and had modeled for declining iPhone sales in 3Q11 due to deferred sales (people waiting). Instead, Apple beat everyone’s iPhone estimate by a mile as iPhone rumors really didn’t grow until August. Independent Apple analysts (including myself) concluded it would be unlikely that Apple would report a sequential quarterly decline in iPhone shipments in 4Q, which meant Apple would sell more than 20.3 million iPhones (their 3Q11 total). We weren’t necessary making a call on growth assumptions, or at least I wasn’t. Some analysts did get it right. Goldman Sachs modeled 16.9 million iPhones – essentially spot on. Still wondering why Goldman was picked first for Apple’s earnings Q&A?

I don’t think our iPhone expectations were overly optimistic though as our previous demand forecasts have now shifted to 1Q12. Our annual iPhone sales estimates remain largely unchanged. Instead, our timing was wrong. I think iPhone’s increasing demand complexity was the main culprit for the iPhone miss. Even Apple management thought they would sell more iPhones in 4Q11.* We still don’t understand how consumers buy phones. For many, buying a phone is categorized as “the big purchase” even though the actual cost of the phone is spread over 2 years. A $110 monthly cell phone bill 17 months from now is not as important as the difference between a free subsidized phone and a $199 subsidized phone today. People wait to buy phones until their contract is up and - this is key - they are willing to wait after their contract is up to take advantage of the carrier’s subsidy and buy a phone that they really want, even if it means holding off on a new cellphone for an extra 4 or 5 months. This trend will only grow as smart phones flourish.

Reports of record iPhone 4 sales over opening weekend (including positive commentary from AT&T, Verizon, and Sprint) are evidence that iPhone demand is back. Going forward, analysts should model a slowdown in iPhone sales during product transitions. If a new iPhone is rumored for October 2012, one should assume people will stop buying iPhones in September. Seems obvious now, but many got it wrong. In addition, a new form factor will also lead to difficultly in meeting initial supply, which could hurt early sales.

iPad. The Wild West. 

Apple sold 11.1 million iPads in 4Q11. I expected 11.7 million and I had originally expected 11.1 million, so iPad is performing near my expectations. Unfortunately, many independent analysts have been running with extremely aggressive iPad expectations. I do think these expectations need to come down.  Apple noted iPad supply and demand is now in balance. Apple sold every iPad that consumers desired; 11.1 million/quarter.  I still get nervous with iPad because it is such a young product.  What if demand really isn’t as good as we think? It doesn’t mean the product is a failure, instead maybe people just haven’t yet become comfortable with tablet computing. Sales fluctuations will occur and people need to plan for it. I found it interesting that Tim Cook made the claim that iPad could turn out to be larger than the PC market. In the past, Apple’s remarks were more vague and general. Apple wants to set the tone for iPad. This is the bet. This is the future.

Mac. Steady as She Goes. 

Apple’s forgotten child (at least in many investor’s eyes) continues to do well, taking market share from Windows with both hands. Strong 37% yoy growth in portables (thank you Macbook Air) speaks well of Apple’s growing brand in the traditional PC market. Yet compared to iPad and iPhone, Mac’s influence is just too small to impact earnings to any large degree.

iPod. Out to Pasture.

Declining iPod sales are now normal and to be expected. In fact, iPod declines are accelerating. Sure, the “newer” iPods might change this trend a bit in the near term, but when excluding iPod Touch, the iPod is only a fraction of its former self.

Guidance. Strong. 

Apple’s 1Q12 guidance was very strong, near current consensus (which is very rare). Management indicated they will sell a record number of iPhones and iPads during the holiday quarter (not that shocking). Since Apple “missed” earnings, analysts will be more conservative with their forward expectations, unsure of how much cushion Apple built into its guidance. Many analysts were already running with conservative assumptions so the 4Q11 “miss” should not weigh much on forward EPS estimates.  

Thoughts on Apple. Quarterly Results Rarely Matter For Superior Management Teams

Earnings misses are not the end of the world.  They can be healthy, serving as a foundation for further gains. Misses act as a reset for increasingly lofty expectations. Problems arise though when people look for answers to an earnings miss and are quick to make incorrect assumptions.  A prime example is Apple’s retail store trends. Same store sales were down approximately 10% (which means that your local Apple store reported 10% less revenue, on average, this past quarter vs. last year – a pretty sizable decline). Well, hello, iPhone sales were miserable. With an ASP of over $600 and a concentration of Apple retail stores in the U.S., a slowdown in iPhone sales (maybe as much as 30-40% in September in the U.S.) will have an impact on total retail store revenue. It doesn’t take a genius to figure that out. 

Apple will get penalized in the near-term because of its earnings “miss”. People will remain more cautious on iPhone and iPad growth.  Expectations are being reduced (especially among the independents).  Apple bears are getting louder. People are wondering. People are asking. Earlier this week, the biggest question was how high the stock would gap up after earnings. Now people are thinking of the “what ifs”, what if people stop buying iPhones, what if iPad sales slow down. While such questions might seem silly to think given the technicalities of Apple’s “miss”, its nevertheless happening.

Good companies sometimes have “bad” earnings reports (who would have thought 50% EPS growth would be considered bad). In such circumstances, time is your friend. For long-term investors, quarterly results shouldn’t even matter much, instead attention should be given to the current management team and its ability to innovate.  

*UPDATE: Thanks to @adamthompson32 for pointing out that Apple actually said 4Q11 iPhone sales were better than expected. Tim Cook: “And as we have predicted…(iPhone) sell-through decline did occur in the quarter, but not nearly to the extent that we thought and therefore, we significantly beat our guidance.” 

Tim Cook. The Architect.

While some have responded to Steve’s resignation as Apple CEO by recalling personal stories involving Steve or Apple, others have focused on how Apple’s culture will handle a different leader.  Let’s take a step back and reassess Apple’s current situation. 

Current Products

I have extreme confidence that Apple will successfully update its flagship products in the near-term. As I previously wrote, Apple’s start-up structure assures resources are allocated to a product in the months leading up to a refresh; breaking down the “walls” between executives and workers - the same walls that often destroy other technology companies. Having executives involved in seemingly detailed and mundane aspects of a product is the difference between having a product be “magical” or “good”. Tim Cook will continue to hash out aggressive business contracts with Apple friends and foes. Apple’s expanding supply and distribution channels will continue to be run with the dedication and intelligence that have put competitors to shame. As a prime example of how much confidence I have in Apple’s ability to execute in the near-term, I have no intention in lowering my forecasts for Mac, iPod, iPhone, or iPad sales in my AAPL earnings model following Steve’s resignation. 

Future Products 

Apple will continue to innovate and brainstorm ideas that will change the world.  While it is difficult to pinpoint why the iPod, iPhone, and iPad have been so successful, it is important for Apple to continue to make similar industry-changing strides.  I think this is where Apple will face its first significant challenge with Steve no longer at the helm.  What makes Apple so great is its willingness to take abnormally large risks and essentially bet the farm on those risks.  Apple is able to translate a big idea (big bet) into reality with very little friction and inefficiency. The biggest risk enters the equation on the demand side - whether consumers want the product. Steve made bets. Big ones. Will Tim be able, or willing, to take similar big risks?

At this time, I do think Tim is capable of such responsibility.  Tim isn’t some young gun who has been thrown into the game. Observing how the world has changed (and where it will go) is an art not a science, and while Steve mastered that art so successfully, Tim was in a perfect position to watch the master perfect his art, giving him a  significant  advantage over everyone else in Silicon Valley.  Apple will lose on some bets, but will still be able to strive to new heights if more is wagered on winning bets. 

Face of Apple

Apple is Steve and Steve is Apple and that will not change. However, there is now a debate as to who will become the new face of Apple or if Apple even needs a singular public representative given Apple’s size and power.  I do think the entire Apple executive team will gain more exposure with some SVPs acquiring new affiliations with consumers. Forstall as Mr. iPhone and iPad,  Jony as Mr. Apple Design, Schiller as Mr. Apple Brand,  while Tim remains the “Big Dad”.  Great brands create emotional connections between users and products.  People will want to connect with Apple and its leadership in new ways. When Apple is ready to unveil its next big thing, we will most likely have a few members of the Apple team explain why the world needs this new product, whereas up to now, only Steve has had the honor. 

AAPL

Concerning financials and other AAPL stock decisions, I would expect no significant changes or speed bumps with Tim as CEO.  In addition, an internal CEO promotion often results in minimal changes to prevailing capital philosophies concerning dividends and share buybacks.  

The Architect

At the end of the day, Steve built the foundation for a magnificent castle and Tim is a great architect. As I wrote back in December: "As long as most of the risk variables are monitored and marginalized to a certain extent by upper management (and Steve  Tim) - the consumer is left as the biggest risks. Apple can then rely on its brand power to turn the odds in its favor.”