You will continue to see acquisitions and some of which we'll try to keep quiet and some of which are impossible to keep quiet.
- Tim Cook (4/24/14)
Many analysts, in their summation of this potential purchase, have focused on a small portion of the overall deal; whether it be Beats' audio quality or the unprecedented size of the deal. In all of these articles I have been frustrated by the lack of thorough and clearheaded analysis on the matter. In this article I will attempt to breakdown the major factors which should be considered prior to drawing a conclusion regarding the overall promise of this rumored deal.
Apple's Largest Deal Ever
Whereas previous smartphone manufacturers tried (and failed) to use Beats' technology as the main draw of their phones, Apple (NASDAQ:AAPL) is simply incorporating them into a product which most consumers already consider a good buy. Apple is increasing the value of a tremendously popular product as they have previously done with the introduction of Siri and TouchID.
Although the $3.2B deal would be Apple's largest acquisition to date, I take Tim Cook at his word when he claimed on Apple's most recent quarterly earnings call that "we don't have a rule that says we can't spend a lot or whatever we'll spend what we think is a fair price...What's important to us is that strategically it makes sense and that it ends up adding value to our shareholders over the long haul." With a ~$150B war chest, and having already laid out their plan for increased buybacks and dividends, expect Apple to start putting the remaining money to use with larger acquisitions. Lots of people have been wondering where this rumored $3.2B valuation came from. Beats' previous valuation at $1B is likely low considering their increasing revenue and the fact that HTC desperately needed cash and likely took a haircut on the sale of their stake to The Carlyle Group. Given Beats' revenue record of $1B in 2012 and an estimated $1.4B in 2013, Apple will be facing a rather short payback period of ~2.5 years at current revenue rates.
The fact that Beats' products, in the event of a deal, would assuredly be given a new prominent spot in Apple's 424 stores would only serve to further increase these sales rates going forward. With the talented Angela Ahrendts taking over control of Apple's retail business, I feel that reinvigorated store sales combined with a more prominent in-store spotlight will only serve to further increase this sales bump. It's not out of the question that Apple could break even on this transaction in under two years. Given the trend of paying much higher prices (looking at you FB) for unprofitable companies, I find it unsettling that many consider this purchase overpriced given Beats' profitability, value add and excellent margins.
A purchase of an established player like Pandora (NYSE:P), which many have suggested would be a better use of cash, would likely cost much more than the Beats deal (given Pandora's ~$4.6B market cap) while leaving out the revenue, hardware and industry experience which Apple would gain from a purchase of Beats.
I see Apple likely following this up with smaller additions to their nascent streaming projects, of which I believe Rdio is an excellent prospect (small size, skilled team). Many people have treated the purchase of Beats as a binary position, precluding the possibility of Apple making additional related purchases. Apple's acquisition strategy has often shown they acquire similar companies when focused on a new endeavor as the acquisitions of HopStop, Embark and Locationary have shown in their effort to increase the functionality of their Maps app.
Massive Value Add in Multiple Product Areas
Putting aside Beats' highly profitable hardware business for the moment, I will focus on another main driver of this deal; Beats' paid audio streaming platform. Beats' streaming app relies primarily on "curated" music lists created by humans, which is something that Pandora and Spotify do not currently have. Although the current number of subscribers to the Beats app (~200,000 mostly due to a partnership with AT&T) is minute when compared to Pandora and Spotify, Apple has ~800 million credit cards already on file via iTunes/App Store accounts. If Apple can convince even a fraction of these customers to migrate over to a new paid streaming service, it could easily grow to rival the more established players. If Apple gave away a free couple month subscription to the app with the purchase of a new iPhone or Beats headphones it would increase exposure and could serve to boost subscriptions.
Apple is not looking to buy Beats based on their current subscriber numbers, Apple values Beats' technology, potential and talent behind the platform. Despite the perceived lackluster launch of iTunes Radio it is still the third largest music streaming service and is likely to surpass second place iHeartRadio (which holds a 1% lead) in the near future. In my opinion, the relative lack of adoption is due to a currently undifferentiated product, which the integration of Beats' curated approach to music would fix.
Although hard to quantify, the likelihood of Beats co-founder Jimmy Iovine joining Apple cannot be seen as anything but a tremendous pick-up. He is widely regarded as one of the most business savvy figures in the industry (who happens to have a bullish outlook on music streaming to boot). I feel that Apple's clout, when combined with the addition of industry insiders Iovine and Dre, will quickly work to ensure all of Beats' current content providers make the switch to the new Apple platform. Additionally, the business acumen of these two industry veterans will likely enable Apple to bring new and more profitable iTunes Radio sponsors on board. Although most of the spotlight has been focused on these two Beats executives, it is undeniable that Beats' marketing team is talented and knows what they are doing, the same goes for their product designers.
This deal will also serve to expand Apple's demographic reach. Dr. Dre did something that few other entrepreneurs, with the notable exception of Michael Jordan, have ever done; convince those with limited disposable income to desire and spend money on a seemingly overpriced product. Young low-wage urban groups have been shown to favor large-screen Android phones at a higher rate than other demographics. This urban demographic, coincidentally, has been the main focus of Beats' high powered marketing campaigns. The release of Apple's upcoming larger screen phone when combined with the appeal of integrated Beats products and marketing from celebrities (the likes of Lil Wayne, Nicki Minaj, Kendrick Lamar, Richard Sherman, and Lebron James have already appeared in Beats ads) should serve to bring a significant share of this previously underrepresented group into the Apple fold.
A further area where I see great potential synergy between the two companies is with Apple's recently launched Carplay initiative. Sixteen automakers have already pledged support for the platform and I feel this number could be expanded upon with the addition of Beats to Apple's roster. Beats has recently launched their own auto initiative, incorporating their audio technology in cars from Chrysler, Fiat and Dodge. It's hard not to see the increase in persuasiveness that Apple will have with a turnkey integrated audio + technology option for carmakers. This package would appeal to premium buyers familiar with the quality of Apple products as well as technology loving youth. This, to me, seems like a perfect match.
Addressing Beats' Sound Quality
While audiophiles can nitpick about dynamic range and sound reproduction, the fact is that, for better or worse, Beats are an unabashed success. With premium $100+ headphones almost exclusively driving the increase in headphone sales, Beats has a commanding 60%-plus share of this market segment. This is a great example of where an acquisition of an established player makes more sense than trying to internally develop and launch a competing product. Many have brought up the valid point that Apple could have simply purchased an audio-technology focused company for a mere fraction of the Beats deal. A smaller audio company simply does not bring the "bang for the buck" value that Beats does in terms of market share, revenue or brand awareness. In regards to audio quality, Apple has been subject to criticism for decades from people claiming their products are overpriced and focus on form over function. As almost anyone who owns an Apple product will tell you: this is simply not true. I am confident Apple is aware of this perception around Beats and I expect Apple to address these naysayers by working to meaningfully improve audio quality.
Although demand for Apple's iPhone will not likely be a problem in the upcoming quarters, given unprecedented demand for iPhone 6, Apple is still heavily reliant on iPhone sales for the majority of their income. The addition of Beats products' impressive revenue will provide an additional cash stream to smooth out seasonal fluctuations in iPhone demand.
In addition to headphones, Bluetooth speakers have been very popular. Beats' Pill is a competitor in this market and I think that Apple will look to improve upon it.
Regarding brand integration, I look forward to seeing how Apple will approach the matter. Will they go with the change to iBeats as some have suggested? It seems like a reasonable middle ground to me, incorporating the Apple nomenclature with the powerful Beats brand name. Along these lines it will be interesting to see how smoothly the integration of the Beats team plays out given Jony Ive's iron grip over the design of Apple's products. I simply can't see him allowing an autonomous group of workers within Apple to design their own products.
There is no doubt that Apple is in a transitional stage, metaphorically treading water as they monitor and predict where the next major opportunity is in an increasingly dynamic technology sector. They have been riding on the success of their existing stable, with no new major product lines since the 2010 launch of the iPad. From the tone of many analysts, it seems they have taken this to mean Apple has given up on new innovation. I believe Tim Cook and Co. are smart enough to take their time and meticulously plan Apple's next product(s); he has expressed as much saying in an April interview with the Wall St. Journal: "You want to take the time to get it right. Our objective has never been to be first. It's to be the best. To do things really well, it takes time...We don't do very many things so we spend a lot of time on every detail and that part of Apple isn't changing." It's simply ignorant given Apple's amazing track record and continual earnings growth to postulate that they are in any sort of decline.
An acquisition of Beats will create billions in additional revenue through headphone sales, increase market penetration in previously lacking demographics, add critical talent to Apple's flatlining iTunes business and position them to launch a very successful paid streaming media platform going forward. For all the hype this deal has been getting I think it will play a relatively small role in Apple's overall 2014 product strategy. With the launch of larger-screen phones, an Apple TV likely to incorporate motion control (via their acquisition of PrimeSense) and introduction of new product categories later this year (aka the highly rumored iWatch), I think Apple is poised for tremendous growth and because of this am quite bullish.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.