News of merger talks between Apple Inc. (AAPL) and Time Warner Inc (TWX) have resurfaced again. The Financial Times reports that at the end of last year, Apple executive Eddy Cue, who is in charge of iTunes, iCloud and Apple music, had met with Olaf Olafsson, director of corporate strategy at Time Warner, to discuss a possible merger.
The news comes at a challenging time for AAPL. Apple stock has been down more than 20% from its 2016 highs as fears over declining iPhone sales mount.
AAPL has been diversifying its revenue towards content through streaming music, but thus far, a deal to secure streaming video content has been unsuccessful. But a merger with TWX stock would change the game entirely. In the “game of thrones” over content dominance, Apple stock could suddenly gain major dominance.
Time Warner has under its umbrella highly valuable assets such as HBO, Warner Bros. studios and Turner, which owns broadcasting rights for the NBA and several other channels including CNN, Cartoon Network and TNT.
And yet, TWX stock has its own challenges to face. Revenues for Q1 grew by 2.5% year over year in Q1 2016 and earnings per share for the quarter smashed estimates, hitting $1.49 vs $1.30 expected. TWX stock is down by 13% from a year ago. Meanwhile activist investors pressure the company to put itself up for sale or spin off part of its assets to maximize returns.
The question is, should Apple take that chance and buy Time Warner? Or should it look for smaller targets?
The Pros of an AAPL/TWX Merger
Starting with pure investment rationale…
Apple stock currently holds mountains of cash, and generated $70 billion in free cash flow in 2015 alone. This cash creates meager returns. Meanwhile, TWX stock trades at mere X15 times earnings and has a return on equity of 17% on a 12 months trailing basis.
Rather than have cash lying around with no yield, Apple can take over Time Warner and get much higher returns. And at a fair price, TWX ‘s price-to-earnings ratio of X15 times is lower than the industry average of X17 times and much lower than the Netflix, Inc. (NFLX) P/E of X355.
Then comes the business logic. So far, AAPL has failed to secure a bundle of streaming TV channels that would rival cable companies and secure cheap packages for Apple TV users.
Why did Apple fail? Because the content “kings,” like Walt Disney Co (DIS) and Twenty-First Century Fox Inc (FOXA) were not willing to cede power to Apple.
And if studios flex their muscle and block Apple’s way into the content world, Apple should turn more aggressive. Because without it, Apple could lose market share and slide to the sidelines — it’s that simple.
Streaming music is great and devices will continue to make money, but content is not only king, it’s the future. The content business could feed the devices business and vice versa. AAPL stock could finally gain a new engine of growth.
The Cons of an Apple Stock/Time Warner Merger
In order to make the most of the merger, Apple will need to slice up Time Warner and get rid of the segments unsuitable for its strategy. For example HBO and Warner Bros are perfect fits for streaming, but many channels under Turner, dependent mostly on advertising for income, are much less attractive.
And let’s face it, Apple is not an advertising company and needn’t be.
To spin off the undesired parts will not be simple; TWX stock is a $50 billion-plus giant, and it will require a high level of experience in the media business to perform such a complicated task.
Eddy Cue, managing iTunes for all its glory, does not have that kind of experience. Apple will need to hire a dedicated, highly experienced executive from the media business.
At the moment, TWX stock has lower margins, and if Apple does not execute the merger well and spin off the redundant sectors, it will compromise AAPL’s profit margins. Moreover, it could turn Apple stock into some kind of a sluggish conglomerate stock, too slow and too complicated to grow.
The Bottom Line
Overall, weighing the pros and cons, Apple should still push for the merger despite the risks. It’s challenging and complicated but Apple stock needs to take advantage of its leverage while it’s still highly dominant, has mountains of cash and its core business, the iPhone, is still highly lucrative.
TWX stock is cheap enough to be worth the risk and big enough to revive growth in Apple.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.
