Christensen's Thoughts on M&A
Clayton Christensen says the main reasons to do an acquisition are:
(1) acquiring resources that permit a company to meaningfully differentiate a product and thereby increase price;
(2) acquiring resources to increase scale and efficiency, so that costs can be distributed over more customers or more resources (e.g., acquiring an adjacent oil field so that existing fixed assets/costs can be utilized with two fields instead of just one, or buying a company to acquire customers in the same geographic area so that fixed shipping assets/costs can be distributed over a larger customer base); and
(3) acquiring a simpler, more affordable business model, and then operating the new model as a separate company (with the expectation of significant future growth and future upmarket product moves). See Harvard Business Review, "The New M&A Playbook," by Clayton Christensen, Richard Alton, Curtis Rising, and Andrew Waldeck (March, 2011); also see Concepts page and list of sources and recommended reading.
With resource-based acquisitions (reasons one and two), the acquired company's resources are integrated into the acquiring company’s existing operations. In the course of integration the processes and priorities of the acquired company typically disappear.
With a business model-based acquisition (reason three), Christensen says the acquired company should generally be operated as a separate entity from the acquiring company. Otherwise the acquiring company can end up destroying the processes and priorities that make the acquired company’s disruptive business model unique and profitable.
Christensen says the most compelling reason for an acquisition is the opportunity to pursue a new business model, which can often be a source of tremendous future growth for the acquiring company. Resource-based acquisitions can produce a one time bump in profitability, but are usually not long term sources of future growth.
Christensen says that companies often overpay for resource-based acquisitions, but that companies should be looking for, and paying more for, opportunities to acquire new business models. Because of growth prospects, new business model acquisitions are worth far more than the typical resource-based acquisition. See Harvard Business Review, "The New M&A Playbook," by Clayton Christensen, Richard Alton, Curtis Rising, and Andrew Waldeck (March, 2011).
Apple and Beats
Apple’s prospective acquisition of Beats seems both resource-based and business model-based. This kind of acquisition would give Apple new resources in the form of Beats Music and Beats headphones, including algorithmic search, human curation, contracts and relationships with the music industry, headphone design/engineering/manufacturing, and the Beats brand.
Beats Music would also give Apple a new business model very different from iTunes, in the form of profit-based music subscription/streaming services. Apple makes iTunes and its other services available at close to break-even so it can sell highly profitable hardware. If Apple acquires Beats — or more specifically Beats Music -- it’s acquiring a profit-based music subscription/services model.
If you apply Christensen’s recommendations, Apple should run Beats Music as a separate company to insure the survival of the processes/priorities that make Beats Music a unique, profitable business model. If Apple tries to integrate Beats Music into iTunes and makes it a break-even service (kind of like iTunes Radio), then Apple may derail the innovation and unique processes/priorities that make Beats Music a profitable service.* (see Addendum below).
Conversely, it should be fairly easy for Apple to integrate profitable Beats headphones, and headphone resources, into its existing business, possibly as a sub-brand. Beats headphones are just profitable hardware, which is identical to Apple’s business model of selling profitable hardware.
The Downsides of Asymmetric Competition
The prospective Beats acquisition highlights one of the fundamental downsides of asymmetric competition, where a company gives away one product at break-even to generate profitable sales from a related product (e.g., Amazon selling Kindle Fires to sell profitable electronic content, Apple giving away services to sell profitable hardware, Google giving away hardware to drive data collection and sell profitable ads). At some point the product or service being given away becomes pretty crappy/mediocre, despite the indirect benefits of driving profitable sales of a related service/product.
With the Beats acquisition, Apple is: (1) addressing the weaknesses in a break-even iTunes product and (2) taking advantage of technological improvements in music discovery, curation, and streaming (faster broadband, expert curation, the future possibility of high quality streaming audio, etc.). The Beats acquisition allows Apple to "catch up" in music services. But the underlying reason Apple has to catch up is because break-even, asymmetric products/services like iTunes often trend toward mediocrity over time, especially relative to products from motivated competitors who are trying to create simpler, profit-based alternatives (like Beats Music).
Some of Apple's services have become mediocre or overly complex/cumbersome — iTunes especially -- because profits aren’t needed for the service to survive. Apple’s hardware provides the profits needed to sustain iTunes. For Apple this is often a strength: Apple is famous for a functional structure rather than a product division structure, meaning the company has "one P&L" and can offer proprietary, break-even services to increase the profitability and "stickiness" of Apple's hardware and overall ecosystem. The downside is that there’s no direct incentive to make meaningful upmarket improvements to break-even services/products, since the whole point of an upmarket improvement is to improve profit margins. See Concepts page and discussion of Clayton Christensen. When the product or service is an asymmetric giveaway, profits aren’t critical and neither are improved profit margins.
Another downside of any asymmetric giveaway, regardless of enhanced ecosystem/product stickiness, is that the giveaway product tends to stagnate over time, since continued product innovation and improvement aren't needed for the product to survive. A company selling a profitable competing product is highly motivated to out-innovate a company giving its product away, and is also motivated to make upmarket product improvements that make the giveaway product an inferior or obsolete choice (as Beats Music is arguably doing to break-even iTunes, and as the iPad is arguably doing to the break-even Kindle Fire).
And this is what’s really interesting about Apple’s reported purchase of Beats and Beats Music. Beats Music is excellent — and improving -- because Beats must build a profitable user base to survive. If Apple successfully operates Beats Music as a separate, profitable service, it may start trying to generate profits from other Apple services. Apple may reduce the number of giveaways and start trying to create proprietary, profitable services that are really good and worthy of upmarket improvements.
It makes sense for Apple to insist on a profitable service when a break-even service that was formerly good enough (like iTunes) becomes inferior or obsolete due to technological advances that permit a better solution to a job that needs done (in this case simple and convenient music discovery, curation, and streaming).
When a break-even product/service is no longer good enough due to technological advances, a profit-based business model can help inspire the innovation and upmarket improvements needed to create a better, more competitive offering. By applying profit-based business models to hardware and services that have become inadequate, or aren't yet good enough, Apple can make its services as strong as its hardware.
* Addendum (added 5/21/2014): This article assumes Beats and Beats Music are profitable business models or will become profitable business models. Financial statements for Beats aren't publicly available, so there is no way of verifying this assumption.
The author owns stock shares of Apple.