COLUMN-Cheap vs affordable, Apple edition: James Saft

Fri May 30, 2014 2:16am IST

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(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

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)