Potential Beats Buyout Doesn’t Add Up for Apple

By Antonio Perez
Antonio Perez
Antonio Perez
May 12, 2014 Updated: May 11, 2014

Apple Inc. is reportedly close to a $3.2 billion deal to acquire Beats Electronics LLC, a music device maker and music streaming service co-founded by hip-hop mogul Andre Young (aka Dr. Dre).

Bloomberg reported the news last Friday, citing people familiar with the talks. The deal can still collapse and financial terms are not final.

The acquisition, if consummated, would be a coup for the Santa Monica, Calif.-based company started in 2008 by Dr. Dre and music industry veteran Jimmy Iovine. Dr. Dre alluded to the possible deal with a Facebook video post with the announcement “first billionaire in hip-hop.”

While $3.2 billion is only a fraction of the $150 billion Apple holds in cash and short-term investments, the deal would leave investors scratching their heads.

Questionable Rationale

Apple has been mum on the acquisition, particularly its rationale.

Beats headphones resonated with consumers fed up by the low-quality stock headphones shipped with music devices, including Apple’s own iPods and iPhones.

Beats headphones (its main over-the-ear model retails for about $399) are especially popular with the younger segment. According to market research firm NPD Group, Beats has majority share of the $1 billion high-end headphone market, followed by Bose Corp.

Beats headphones are fashionable—and Dr. Dre is a marketing genius, probably second only to Jay-Z in the music industry. Before Beats came along, $400 premium headphones were solely the domain of audiophiles. So Beats essentially does to headphones what Apple does to computers—the ability to pump up margins from marketing efforts.

But Beats is not a leader in sound engineering like Bose. In fact, Apple’s own head of Audio Direction, Tomlinson Holman, is one of the leaders in the field and the inventor of the THX audio standard when he was employed at Lucasfilm.

So the transaction doesn’t add up for Apple, which traditionally doesn’t make huge acquisitions in hardware, preferring to stick with original and in-house designs. Additionally, Beats is mainly a music accessories maker, and accessories make up less than 5 percent of Apple’s annual revenues. It’s unlikely that Tim Cook would attempt to change this product mix now.

All About Streaming?

The likely explanation lies in streaming music. Apple could be attracted to Beats Music, the company’s new music streaming service.

Beats Music, introduced after the company’s acquisition of MOG in 2012, is a new player in the music streaming business, competing with industry giants such as Pandora Media, and Spotify. So far, Beats hasn’t disclosed financial figures, so the growth and profitability of Beats Music is unknown, but it’s estimated to be small.

Apple’s iTunes is the leading digital-music sales and download platform (for single songs and albums), but sales year over year are down and recent trends indicate that the future lies in all-access music. The International Federation of the Phonographic Industry reported that revenues generated from music-streaming surpassed $1 billion for the first time in 2013, increasing threefold since 2010.

However, that doesn’t mean it’s a good idea to sink $3.2 billion into a nascent music streaming service. Apple already has its own music streaming service—iTunes Radio. Sure, there’s scale in the music streaming business model, but because Beats is far from a major player, it’s unclear what the combination of iTunes Radio and Beats Music can achieve for Apple.

If Apple is indeed seeking Beats for its streaming service, then it’s grossly overpaying. Beats’s financial figures are not public, but it’s safe to assume that its valuation is mainly derived from its consumer electronics hardware business selling headphones.

Spotify, one of the biggest players in subscription-based music, was valued at around $4 billion during its last round of funding in November 2013.

New Territory

Investors have long questioned whether Apple’s best days are behind it, and Apple has recently tried to boost investor confidence in several ways.

One such effort to reward shareholders is approaching. On May 15, the company will distribute $2.7 billion to shareholders ($3.29 per share). Last quarter, Apple used $18 billion to buy back shares and authorized another $30 billion in share buybacks over the next two years.

But the Beats acquisition is new territory for Tim Cook and Apple. And this break from tradition will require an explanation to investors.

Antonio Perez
Antonio Perez