- Premium headphones are already a $1 billion + market and growing rapidly.
- Apple's existing operations provide strong manufacturing and other synergies for premium headphones.
- Reported deal economics are fair today, and compelling with continued growth.
According to a report in the Financial Times this week, Apple (NASDAQ:AAPL) is preparing to acquire Beats Audio (Beats) for $3.2 billion. Beats has two main business lines: a series of hardware peripherals, primarily headphones, and a recently introduced music streaming business. Some commentators (an example here) have speculated that Apple is acquiring Beats principally to obtain access to the music streaming business line. Let's quickly examine that hypothesis. First - Apple is a hardware company, with roughly 90% of its revenue derived from the iPhone, iPad, Mac, and iPod business lines in the last quarter. Also, according to 9to5Mac, the Beats streaming business has approximately 200,000 customers. Given a monthly fee ranging from $10-$15, this aggregates into $2 - $3 million per month, or $24 - $36 million per year. Given that the reported price is $3.2 billion, or roughly 100X the midpoint of the revenue range, it is unlikely that a rational investor would allocate a significant portion of the deal value to this business line. Therefore, the rest of this article will focus on the hardware side of the business.
The market for high-end headphones is sizeable and a great fit for Apple
A recent report by the NPD Group sized the premium headphone market in the United States at over $1 billion in 2013, which represented a 21% increase over 2012. In the same study, NPD found that headphone usage is increasingly linked to smartphones and tablets. In 2013, 55% of headphone owners connected to smartphones, as compared to 36% in 2012. Headphone owners using tablets increased from 15% to 35% over the same period. With a year-to-year jump of over 50% for smartphones and over 130% for tablets, the positive trend is both clear and compelling. Moreover, the percentages were even greater for the premium headphone segment, with 61% of premium headphone owners connecting to a smartphone, and 49% to a tablet.
An earlier NPD study explicitly linked the growth in premium headphones to the growth in the tablet market, making headphones a natural adjacency. As stated by NPD:
"As consumers shift more consumption to mobile devices, and tablets in particular, quality headphones are a logical addition to the hardware profile," said Ben Arnold, director of industry analysis at NPD.
Moreover, this same NPD study found that the primary drivers in the premium headphone purchase decision were sound quality at 73%, and brand at 44%. For this customer segment, price was cited by only 10% of respondents. These customer dynamics align closely with the existing core Apple customer, where design, functionality, and brand are stronger considerations than price. Apple also has an existing relationship with Beats, as it is selling these products in retail locations. These sales give Apple a tremendous insight into the current sales, sales trend, and customer demographics.
On its own, Beats has re-defined the headphone category, taking a previously small premium niche in the market and making it mainstream. This process is identical to Apple's previous success in re-inventing the mp3 player with the iPod, the smartphone with the iPhone, and the tablet computer with the iPad. Apple doing the same in the headphone category is completely consistent with how it behaved in these other markets. The unique factor here is that Apple is using an acquisition of an existing business to accelerate its entry into the premium headphone space. A second consideration may be that Apple is acquiring Beats to prevent a competitor from using it to catch up or leapfrog its own entry into the market. Next, we will examine potential synergies between Apple and Beats.
Synergy opportunities between the companies are significant
Since its very early days in manufacturing personal computers, Apple has been known for an intense focus on engineering and design. In recent years, success in its smartphone and tablet lines has also led to extensive research and development in materials. Two complaints about Beats' products are lack of durability and inferior sound quality to other products on the market. With Apple's engineering prowess and the other competencies noted above, both issues can be addressed.
With the millions of smartphones and tablets shipped annually, Apple has also developed a deep and robust supply chain, covering every facet of the manufacturing process. Apple currently does business with over 500 suppliers, with the 2013 top 200 noted here. Apple is a massive purchaser of raw materials, components such as DRAMs and other integrated circuits, and manufacturing and assembly services. These scale purchases position Apple to assist Beats in either lowering the existing bill of materials or improving product quality.
Thus far, in its existence, Beats has done a great job on the marketing front, using its industry relationships and "cool" factor to great effect. Apple's strong balance sheet could be used to leverage this strong position with more advertising, both in terms of a higher number of campaigns, more media outlets and increased frequency. Also, as of the end of its fiscal 2014 second quarter, 169 of Apple's 423 total stores were located outside the United States. Apple also has an extensive internal sales presence supporting all its products. In addition, Apple has existing partnerships with over 200 carriers around the world. The international retail presence, sales team and carrier partnerships can provide a number of additional sales outlets for the Beats products.
Finally, it has been widely rumored (see here and here) that Apple will be introducing a smartwatch in 2014. To the extent that the released product has robust memory capacity, Beats headphones could be a natural companion product, either wired or wirelessly. Music lovers may be more likely to buy the smartwatch if there is a strong music use case tied to the headphones. Having sales and marketing efforts for the two products linked at the smartwatch launch could also lead to greater sales for both.
Deal economics are good with strong upside potential
According to an article in Fast Company, Beats was projected to hit $1.4 billion in 2013 revenue. Other sources point to a 2012 figure of around $1 billion. Using the conservative assumptions that Apple will only capture $1 billion in revenue and achieve its most recent quarter net margin of 22.4% for this business, the net income impact from Beats will be .224 billion. Using the May 9th Yahoo Finance P/E ratio of 14.03, this yields a potential market cap impact of $3.14 billion - almost exactly the reported price of $3.2 billion. It can be argued that buying the Beats revenue stream has an even larger impact, as the P/E ratio above does not exclude the cash on Apple's balance sheet. We should also note that Information Week has reported that Beats marks up some headphones by as much as 1,000%, equivalent to a 90% gross margin. To the extent this is accurate, the above analysis is very conservative, as Apple's gross margins are in the 37-38% range.
Furthermore, Apple would likely not be interested in consummating this transaction if it did not believe that significant upside exists. Gartner projects that by the end of 2014, Apple will have an installed base of 682 million iOS and Mac devices. As shown in the table below, if Apple is able to achieve an average selling price of $150 and a 5% penetration of its installed base annually, the Beats line would generate $5 billion in sales. With an assumption of a $250 ASP and a 10% penetration rate, the annual sales jump to over $17 billion. While both numbers are relatively small by Apple's standards, the $5 billion figure would create a 2013 Fortune 500 company, while the $17 billion figure would rank 169 on a stand-alone basis. Moreover, at $5 billion in revenue and assuming the same net margin and P/E ratio as above, the market cap impact would be over $16 billion, yielding a 5X return on the reported purchase price of $3.2 billion.
Over the past several years, Apple has evaluated a number of potential transactions, and most completed deals have been relatively small, technology-focused ones. The reported potential deal is different as Beats does not appear to have substantial proprietary technology, and the deal size is much larger. In that light, we believe that Apple would not be considering such a transaction if it did not perceive an immediate market opportunity, believe that its strengths could deliver short and long-term synergies, and most importantly, that the economics were compelling.