Is Apple’s $3 Billion Beats Deal Risky?

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On May 9, 2014, acclaimed entertainer Tyrese Gibson uploaded a shocking video onto his Facebook (NASDAQ:FB) page. The now infamous still shots of the video prominently featured Tyrese alongside Andre Young, also known as rapper-producer Dr. Dre, mean mugging for the camera. One clause within the video introduction simply read “Apple = Beats 3.2 Billion!” The video was to promptly degenerate into drunken rants peppered with explicit language and Crip walking. A boastful Dr. Dre, of course, was to award himself the “first billionaire in hip hop” title. Within minutes, the technology commentariat exploded to deconstruct what then appeared to be Apple’s (NASDAQ:AAPL) looming $3.2 billion Beats by Dre acquisition.

New Markets for Apple

The major players involved within this Beats deal would include Dr. Dre, Jimmy Iovine, Apple managers, and The Carlyle Group. Apple, of course, is notable for its sphinx-like quiet and secrecy, while The Carlyle Group is the epitome of a white shoe, old money institution. Certainly high ranking executives at both Carlyle and Apple were left aghast at the bravado of Dr. Dre and Tyrese Gibson. Gibson was to promptly remove the video from his Facebook page, as the post may have been in violation of SEC Regulation Fair Disclosure, which states that material information must be disclosed to all shareholders at the same time. In any event, the spontaneous studio antics of Tyrese Gibson and Dr. Dre will live on somewhat in infamy via YouTube and various reposts.

Critics, however, were to immediately dismiss the deal as being dead, within the few short days of watching the initial Gibson-Dre recording. According to various reports, Apple executives were beside themselves at Dr. Dre’s “drunk off Heineken” boasts and questioned whether the rapper-producer would be a welcome fit at their Cupertino base.

In retrospect, however, the dead deal scuttlebutt may have proven to be much ado about nothing. On May 29, 2014, The Wall Street Journal reported that Apple had confirmed it was set to purchase Beats for $3 billion. The deal broke down further into an exchange of $2.6 billion in cash and $400 million in equity for Beats by Dre. Jimmy Iovine, co-founder of both Interscope Records and Beats by Dre, has also agreed to work full-time at Apple.

Going forward, Jimmy Iovine will be the straw that stirs the drink in this deal. Certainly, Iovine and his Hollywood connections will help bolster iTunes, Software, and Services sales at Apple. Be advised that this particular operating segment has steadily held out at roughly 10 percent of total net sales for several years running. The likes of Pandora and Spotify, however, have emerged as viable threats to iTunes, through the streaming of music and subscription radio services. The Pandora base for its free radio now stands at 70 million users. Beyond music, The Wall Street Journal has also speculated that Apple will leverage Iovine’s connections to break new ground in television show and movie distribution.

The Bottom Line

For Apple, the $3 billion Beats by Dre acquisition will be a mere drop in the bucket. Apple closed out its latest Q2 2014 having left $150.6 billion in cash and securities on the March 29, 2014 balance sheet. This hefty cash pile was more than enough to back Apple’s $85.8 billion in Q2 2014 total liabilities. The clean balance sheet was largely the result of Apple having generated $36.2 billion in cash flow from operations during this latest quarter.

Be advised that the Apple liabilities did include $8.3 billion in deferred revenue alongside $17.0 billion in long-term debt. The $8.3 billion in deferred revenue will ultimately be recognized upon the income statement, while the $17 billion in debt is part of an ongoing plan to return more than $130 billion back to shareholders through buybacks and dividends by the end of 2015. Apple stock last traded hands at $624.01 at the end of the May 28, 2014 trading session. Of this amount, the cash and securities on hand alone accounted for roughly $175 per share. For its part, the Beats by Dre acquisition exposes Apple to minimal downside risks, while also opening up the possibilities of new markets to explore.

Apple shares deserve a buy rating.