The Real Reason Apple Is Acquiring Beats For $3.2B - Part 2

| About: Apple Inc. (AAPL)

Summary

Apple is acquiring Beats with a long-term view towards dominating the highly attractive premium headphones market.

An honest attempt to value the young company based on estimated profits and growth trajectories.

Hidden behind its flashy advertisements and soulful identity is a miracle balance sheet for investors.

In Part 1 of this analysis, I attempted to estimate the revenues and profits of Beats Electronics, and discovered a few diamonds in the rough. Now in Part 2, I'll wrap things up by looking at the company's growth trajectory, contrast its intrinsic value to the $3.2bn acquisition price, and mull over its position in Apple's future.

Valuation

In Part 1 of this analysis, we saw that Beats Electronics was a reliable profit-generating cash cow in a market with respectable growth prospects. But was the $3.2 billion acquisition price tag paid by Apple (NASDAQ:AAPL) a sensible investment or simply throwing darts in the dark? I'll consider that in this section.

Worldwide retail value of the headphone market is predicted to grow by a variable margin depending on whose sources you consult, with one end of the spectrum predicting a pessimistic 5% CAGR from 2013 to 2017; and the other end forecasting an optimistic forward CAGR of 20.43% from 2014-2018 (sources: BusinessWire, Reuters and PRNewsWire). As I've observed in Part 1 of this analysis, performance of the premium headphone market between 2012 and 2013 mirrored this forecast with 21% year-on-year growth, so it's not entirely outside the realms of possibility.

In the interests of objectivity, I'll use a conservative mid-point of 13% for the expected CAGR of revenues and profits until 2017, when sales are expected to streamline due to a predicted industry saturation of 1:6.6 headphones to audio device ratio. Thereafter, growth will be assumed to resume at the industry standard of 5% per annum into perpetuity, represented by a further 20 years until 2038. (further profits are considered negligible)

Arriving at an estimate for the opportunity cost of capital of not acquiring Beats is a little trickier. If further investments into the iPhone is used as a comparator, then the opportunity cost of capital might well be the same as investing in T-bills (2%), since the market for smartphones is presently saturated and relies on grabbing market share from competitors for growth; an effort which has largely been static since 2011. The iPad might present better opportunities for investment, but judging by the investment in Beats and its recent acquisitions, it doesn't appear to play a key incremental role in Apple's focus on strategy besides supplementing cash flows. Estimates for growth from possible entries into new markets (e.g. TV, health, fashion, etc.) are all over the place, so I won't be relying on them before they can prove to carry a modicum of certainty.

After a lot of consideration, I felt the fairest representation of a cost of capital would be to draw a contrast against its hefty share buyback program. Apple has committed to returning over $130 billion of profits to shareholders over a similar timeline as I'm considering, by issuing debt to mimic the repatriation of overseas profits without the tax consequences. At an approximate share price of $600, which is a fair average price since the program began in 2013 (when the share price was at a low of $393), that represents a 21.67% return. Let's call it a 20% return after factoring in the blended rate of the cost of issuing debt securities across various maturities of 1.85%.

Discounted cash flow analysis of Beats by Dre segment:

Year

Profit at 13% growth

Discount rate (20%)

Present value ($'000)

2013 (excluded)

313000

-

-

2014

353690

0.833

294742

2015

399670

0.694

277548

2016

451627

0.579

261358

2017

510338

0.482

246112

2018 - perpetuity

-

-

1147590*

Net Present Value

2,227,351

Click to enlarge

*The present value for the years 2018 - perpetuity is the net present value of free cash flows for 20 years (2018 - 2038), calculated by subtracting the present value of a growing annuity at 5% CAGR from now up to 2018 from a similar one one up to 2038.

(Source: Created by the author.)

Performing a standard discounted cash flow analysis, we arrive at $2.22 billion for the value of the Beats by Dre premium headphones segment.

Of the acquisition tag of $3.2 billion, that leaves about $980 million unaccounted for. This is where I hit a wall. It's next to impossible to put a figure to the intrinsic value of Beats when the source of the cash flows from the large mystery $300 million of revenues is unclear. It could just as likely be zero as it could rival the earnings from the premium headphones segment. Henceforth, I shall try to assess this $980 million premium by applying more qualitative approaches.

Business

There have been many rumours floating around the web about why Apple is choosing to acquire Beats, given the stark difference which exists between the two in the eyes of both the tech community and general public. Perhaps the most popular opinion is that Apple has been eyeing a slice of the online streaming industry, a darling star which has popped out of nowhere to emerge as a $1 billion industry as of 2013. Other rationales include Apple buying Beats for the brand, planning to merge it with its existing product range to become a marketing powerhouse. Still, other reasons include buying Beats for its proprietary audio know-how and technology, which has transformed the word "bass" from a frequency into a concept, and merging it with its expected push into wearables.

Most of these rumours fail when put to the acid test. For the streaming suggestion, it's unlikely Apple bought Beats to bolster its music subscription segment as Beats Music only has about 200,000 subscribers. It may have some unique technology, such as its popular Right Now playlist, but that's unlikely to put a dent in profits when it occupies less than 1% of the streaming industry as observed earlier. Moreover, Apple itself already possesses a monster streaming platform in the form of iTunes Radio, the 3rd largest audio streaming service by market share, and thus has no need for Beats Music to enter the streaming market. This Forbes article paints a similar brush over concerns with the idea that Apple bought Beats exclusively for its streaming platform.

Secondly, nobody in the tech community - or who has followed Apple for an extensive amount of time - believes that Apple will allow the Beats brand to thrive within its product line. There may be a partnership effort, perhaps like "iBeats", but it'd be a huge departure from Apple's style to acquire a company and allow it to run independently from the mother ship. Historically, Apple has acquired companies mainly to obtain their proprietary technology or as part of a knowledge hire process where Apple wanted to assimilate the employees of the targeted company into their team.

Thirdly, the theory that Apple wants to obtain the proprietary technology of Beats doesn't really hold water. For one, it is an open secret that Beats headphones do not possess higher audio fidelity than other competitor headphones in its price range. Audiophiles have not held back from criticizing their over-affinity to the bass end of the spectrum, effectively negating the original reason to splurge on expensive headphones, which was to represent the original studio recording as accurately as possible. This Gizmodo article has Monster's de-facto CEO Kevin Lee, which was the exclusive manufacturer of Beats' headphones during its infant years, admit, "Kids did go into a Best Buy and bought Beats not because it sounded cool, but because it made them look cool." It would be hard pressed to imagine Apple possessing less advanced audio technology than Beats with their colossal line-up of iPods over the years.

If Apple isn't acquiring Beats for the above reasons, what other reasons could it be shelling out $3.2 billion for? Could it possibly be for the expected profits from the headphones themselves?

My answer? It's not out of the question.

As you may have observed, one thing which most analysts miss in their observation of the acquisition is how exceedingly profitable the Beats brand is. By itself, in its current form, my admittedly back-of-the-envelope calculation reveals that it's expected to raise $2.22 billion in free cash flow over the life of the company - under the extremely conservative assumptions that the premium headphone market will only grow by 13% per year for the next 5 years (having grown 21% in 2013); and that the expected yield of 20% from Apple's share buyback program will be accurately reflected in its share price. Suppose the actual CAGR for the market is 17% and Apple's share price only increases by 10% over the same period - that's a significantly higher net present value scenario. Of course the reverse could also be true, but you get the gist.

Assuming the $2.22 billion net present value holds true, this figure can only be expected to increase with the massive synergies to be found in merging Beats' operations with Apple's intimidatingly capable value chain. For one, Apple has a monster manufacturing partner in the form of Foxconn, which churns out hundreds of thousands of iPhones and iPads daily like clockwork. Early last year, Beats revealed its plans to expand its assembly line significantly in order to meet demand, which might have been the reason for seeking equity financing from the Carlyle Group. With Apple behind its back, it can effectively ramp up production without worrying about cash flow and immediately enjoy the economies of scale that come with producing millions of units, further reducing material costs. There's also no question that stamping an Apple logo on the back of their headphones will give Beats the credibility it desires so much to connect with presently unattainable market segments, such as businessmen or baby boomers, who would not regularly consider premium headphones as a purchase or who simply have no stake in the music scene.

On top of that, Tim Cook has been increasingly vocal about Apple finally breaching a new product category, one which would rival the iPhone and iPad in breadth as well as sales. Some parties have asserted that it will be a push into wearables, while others have speculated on the claim that Apple will release an Apple TV. However, both wearables and TVs have been tried before, and they have not been exceedingly successful. The memories of Google TV's failure to capture the imagination of the masses with its "smart TV" is still painfully etched in the minds of the tech community; while Samsung's Galaxy Gear smartwatches haven't generated the buzz that most people were expecting, with other followers seemingly destined for the same fate. While Apple's valuable brand has some leverage over its competitors, it still isn't exceedingly clear how they could turn the aforementioned product categories into Apple's next cash cow.

But what if the new product category which Tim Cook has been so excited about is the premium headphone? It may not mesh perfectly with Apple's present identity as a devices company, but neither did the iPhone to 2007's Apple as a music company, nor did the iPod to 1997's Apple as a computer company. Looking at Apple's varied history in reinventing themselves, it really isn't too farfetched to imagine Apple somehow redefining the identity of the headphone to impress the masses again. Perhaps it will come to be recognized as an intermediary between the smartphone and the user, or as a fashion piece analogous to an alligator leather handbag or a nice pair of shoes. Now, I'm not claiming to be an expert on the subject, but in its short lifespan of 38 years Apple has managed to redefine the mouse, the MP3 player, the phone and the tablet. It wouldn't be a stretch to imagine they could redefine the headphone.

I imagine the flow of events happening like this: Tim Cook started by exploring a suitable new electronic product category for Apple to pursue -> he came across the premium headphones industry and noticed its skyrocketing growth and impressive margins -> he decided he wanted Apple to pursue the premium headphones category -> however, there was one problem, Beats. Apple had no guarantee it could upset the throne despite leveraging on its strong brand -> Tim decided to kill two birds with one stone by acquiring Beats; firstly by allowing Apple to dive headfirst into the business, and secondly, by removing its only significant competitor.

Cash Flow & Balance Sheet

But that's not the real reason why I'm excited for this acquisition. What's really enamouring is that Beats by Dre has passed the test of time by demonstrating itself to be a reliable cash generating machine with a widely-recognized product with amazing margins. In a short 5 years, Beats has gone from being an obscure company with a penchant for being overpriced to a company earning over $1 billion in revenues per year, gaining an image recognized as the preferred brand of teenagers in the US in the process. That's impressive enough for a popular software company which scales quickly - Reuters reports that Facebook 's revenue was $800 million when it was 5 years old in 2009 - it's even more impressive for a hardware company which requires significant capital commitments to scale effectively. Obviously, this is comparing apples to oranges, as Beats had Interscope's backing with privileged appearances in its diverse arsenal of music videos, but the end result is still the same - Apple is obtaining a humungous cash cow with amazing margins, an enormously reputable brand and exciting growth prospects.

And if you think the past was good to Beats, you should take a look at its future - it has in excess of a 50% chokehold (64%) on the amazingly high growth premium headphone market, which grew 21% last year and is only expected to compound the feat until 2017. It has practically no material competitors as seen earlier, with its nearest competitor being Bose, which has a 21% market share and none of the brand assets which propelled Beats to the top. On top of that, with the partnership with Apple, it's not hard to imagine them further increasing their market share and possibly raising revenues to $5 billion by 2017, whereby it will become another cash cow like the iPhone contributing steady cash flows into perpetuity.

Lest we forget, let us be reminded that the mystery slice of revenues still hasn't been accounted for, which if my estimates are correct sat at the tune of $300 million in 2013. If earnings from that segment are even a third of the Beats by Dre segment, that's an extra $100 million in earnings to be compounded all the way to the year 2038, and to be added to the net present value figure which was derived above. Not to mention the immense liquidation value of the assets and intellectual property it possesses; I'd imagine the Beats brand would be worth a hefty amount - which I shall leave to your imagination - to a competitor like Bose.

On the liabilities side, I have not found any hint of significant liabilities since its inception besides a $225 million loan note from HTC in August 2011. While this cannot be said for sure, it's unlikely that it had incurred other substantial liabilities in between August 2011 and September 2013, after which the Carlyle Group entered the picture. The NYTimes reports that a $150 million note held by HTC was repaid following the $500 million financing round with the Carlyle Group. This one-time $85 million profit which appeared on HTC's 1st quarterly earnings of 2014 could possibly reflect a bulk interest payment on settlement of the aforementioned loans. For all practical purposes, I'd interpret this as a full settlement of its 2011 obligation to HTC.

All in all, this appears to be a well-funded company with a strong asset base, little to no liabilities, strong cash flows and an amazing product. Tack on an acquisition premium, and suddenly the $3.2 billion price tag doesn't seem so crazy anymore.

People

Besides the obvious synergies involved, other developments at Apple give us an idea about where Tim Cook plans to steer the ship. The recent hire of former Burberry CEO Angela Ahrendst as retail chief sent tongues wagging as she did not hail from a tech background; Apple has long relied on the principle that if it focused on building great devices customers would come, and that there was no need to pursue them.

However, this Fast Company article does a very in-depth job of uncovering the rationale behind her hiring and it makes sense. It walks us through Angela's tenure at Burberry, where she transformed Burberry's retail image by merging the idiosyncratic relationship between the online retail experience and the brick-and-mortar retail experience, providing the customer with a seamless retail impression whether they were browsing for clothes online or walking through the doors of Burberry's shops. Apple seems to be uniquely positioned to take advantage of her experience, as the same article mentions that an internal memo by Tim Cook revealed that only 20% of iPhones were sold through their brick-and-mortar stores. Angela also demonstrates a detailed understanding of delivering a sense of luxury to the Burberry brand, telling the Harvard Business Review about her experience of treading the thin line between ubiquity and exclusivity, where she stresses the importance of striking a balance between omnipresent accessibility and retaining a sense of privilege for the customer - a problem Apple is facing today.

If Apple's future lies in taking its identity as the recognizable face of luxury in the electronics industry, then Jimmy Iovine and Dr Dre could contribute their significant experience from the music industry in marketing and brand building, where success arguably lies in successful execution rather than product quality. By partnering with Beats, Apple also gains access to Interscope's diverse roster of well-known celebrities for its promotional purposes, likely at a steep discount. And if my assumptions about making premium headphones as a primary product category are true, then the inclusion of Jimmy and Dre in designing strategy could prove to be a pivotal point to Apple's future.

The Beats acquisition may also not be restricted to operations revolving around the headphones business. The Verge quotes its sources as saying that Jimmy Iovine will be handed the keys to Apple's music empire, which will involve responsibilities such as redesigning the music experience and handling relationships with record labels and music producers. This could lead to a crucial reimagining of iTunes Radio, which is the online streaming service (unlike Beats Music) which might ultimately stand a chance of toppling Pandora's seat on the throne and grabbing a share of the envied streaming industry's $1 billion in revenues.

Conclusion

To wrap up, I'm going to summarize the key points to take away from my observation. Firstly, rumours about Apple acquiring Beats for its streaming service, Beats Music; or to begin a push into wearable technologies, do not realistically consider the financial challenges of pursuing such efforts. At best, there is no guarantee that pursuing these segments would earn a satisfactory return on investment in a reasonable amount of time.

Secondly, more than two-thirds of the acquisition price is justified by the acquisition a highly profitable, cash flow positive, premium headphones business with a net present value of $2.22 billion, an arguably conservative estimate which could rise depending on acceptable changes in certain factors. This makes the acquisition somewhat more sensible than Wall Street's comparison of the acquisition to Facebook's acquisition of Whatsapp, a company which had minimal revenues and was likely acquired wholly for strategic purposes.

Thirdly, Beats has a mystery revenue segment which I was unable to identify, which itself might be contributing to additional earnings on top of its premium headphones segment. While this claim has to be taken with a large grain of salt, the probabilities of a moderately profitable business existing under the hood are not fatalistic.

Fourth, the premium headphones business of Beats has extremely wide margins (33%) and is wildly profitable, contributing a reliable stream of cash flows to the company. Outlook for the sector is favourable with a 21% year-on-year increase in 2013, and growth is expected to maintain its pace until it tapers in 2017. Beats also has a wide moat by claiming more than 50% of the premium headphones industry in terms of market value, and has practically no competitors except for Bose which holds less than half of its market share at 21%.

Fifth, little is known about the capital structure of Beats. However, from what little I have been able to piece together, it possesses extremely valuable assets in the form of its brand assets and key connections with record labels like Universal Interscope (where Jimmy is Chairman), and has no significant liabilities which may present a threat to its going concern. Jimmy Iovine and Dr Dre also presumably have so much confidence in its growth, that they were willing to exchange a 50% stake in the company (with the 3rd largest private equity firm in the world) to pursue additional capital expansion in order to meet future demand. If I'm interpreting it correctly, that means they're expecting future profits to more than double what they are now.

Sixth, the merger of Beats with Apple will generate significant economies of scale and marketing leverage, which will likely boost margins further. The former will reduce labour costs and material costs, while the latter will reintroduce Beats headphones to presently unattainable market segments, such as businessmen and baby boomers, by raising the credibility profile of the cans with the Apple logo.

Finally, the pursuit of the premium headphones business ties into a long stream of recent developments at Apple. It's an electronic product that Apple understands well; it's forecasted to be very profitable and thus suitable as a new product category; and the acquisition fits into the story of its CEO's vision to boost the luxury profile of the company, as observed by the recent hire of Angela Ahrendst. On top of that, Jimmy Iovine's rumoured helm at Apple's music empire makes far more sense than utilizing Beats Music to overtake the streaming industry.

Obviously, liberties were taken in making assumptions about the company and its direction, but I've strived to be as objective as possible by avoiding conjecture, providing sources from third parties whenever possible, and applying a sufficient margin of safety to my estimations. In my honest opinion, I think what I've presented is a much better attempt at guessing the rationale behind the acquisition than what's presently being reported by most media outlets and blogs on the Internet. If I'm wrong, there's still a wide margin of safety; $3.2 billion is a drop in the bucket next to its colossal cash reserves of $159 billion, which is more than the reserves held by the country of Malaysia. But if I'm approximately right, and Apple is indeed considering making the premium headphone its new product category, then the positive implications could be huge.

Do I have a beat on the pulse? You tell me.

Disclosure: I am long AAPL. 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.