Apple Beats By Dre Is Schooling These Nerds

| About: Apple Inc. (AAPL)


Apple may be in talks to purchase Beats by Dre for $3.2 billion.

Beats by Dre would be a smart addition to Apple's existing product mix.

Apple shares still deserve a buy rating.

On May 9, 2014, actor and rhythm and blues singer Tyrese Gibson posted a somewhat bizarre video to his Facebook (NASDAQ:FB) page. The lede into the video boasted that Apple (NASDAQ:AAPL) was in talks to purchase Beats by Dre for $3.2 billion. The video then promptly segued into a drunken Andre Young, also known as rapper-producer Dr. Dre, pointing at the camera, while Tyrese Crip walked through the recording studio. At the time, the two assumed that Dr. Dre was set to become the first billionaire of hip-hop. Although Tyrese has already deleted this video from his Facebook page, multiple recordings of the account promptly showed up on YouTube. The original Facebook post may have violated Securities and Exchange Commission Regulation Fair Disclosure. Regulation FD states that all material information must be simultaneously and publicly disclosed to all shareholders.

In any event, the explosion of scuttlebutt surrounding any looming Beats by Dre buyout has exposed the various warring factions within the Apple camp. Throughout its history, Apple has been tasked with balancing the contradictory demands of staid, button-down financiers, tech geeks, and urbane hipsters. This collective, often heckled as "fan boys," should laud the proposed Beats by Dre purchase as a logical extension of the Apple Empire. Warren Buffett may opine that Apple has fortified its business moat.

The Apple Business Model






Q2 2014

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The Apple ecosystem is literally a walled garden of integrated hardware and software for computing, telecommunications, and entertainment. For now, the Apple ecosystem's locus of control begins and ends at the iPhone. The iPhone, which hit shelves on June 29, 2007, grew to account for 57.2% of Q2 2014 sales at Apple. For the sake of comparison, the Mac and iPod once accounted for 37.7% and 22.1% of 2009 total net sales at Apple. In more recent times, the iPod generated only $461 million in Q2 2014 revenue, which accounted for a mere 1% of Apple's total quarterly net sales. Meanwhile, year-over-year iPad related revenue did decline by 13% through this latest quarter. Be advised, however, that Apple iTunes, Software, and Services sales have consistently remained near 10% of company revenue for the past several years.

Apple has built its empire largely through the cannibalization of its own products. To date, relatively flat iTunes, Software, and Services sales may serve as further evidence that consumers have refused to exit the iOS ecosystem. The iPhone, of course, easily converts into a device for downloading, playing, and sharing music, which has literally rendered the iPod obsolete. Beyond iTunes, popular third-party applications out of both Spotify and Pandora (NYSE:P) are available for both paid subscription access to catalogues and free, streaming music. To compete, Apple recently rolled out an iTunes Radio product of its very own. Christopher Breen and Mac World, however, promptly dismissed iTunes Radio as "poor" and "frustrating." Beats, of course, has been building out its own subscription radio service.

Each iPhone and iPod unit, of course, arrives pre-packaged with standard, white earbuds. The Apple EarPods, which first shipped with the iPhone 5, also retail independently for $29.00. The Apple EarPod sets include built-in microphones and remotes and are compatible with several generations of iPhone handsets, iPad tablets, and iPod music players. Apple still promotes its EarPods for offering up "high-quality" audio on par with the more expensive brands. Mario Aguilar and Gizmodo, however, immediately dismissed that Apple EarPods as "garbage," upon launch. Aguilar then claimed that the EarPods should be reserved for naïve consumers "who don't know any better." Interestingly, the Apple-Beats by Dre scuttlebutt has uncovered a distinct subset of haughty audiophiles.

Integrating Beats By Dre

Separate models of Beats by Dre headphones now retail for between $169.95 and $399.95 at the Apple Store. The Apple Store also sells Bose and Sennheiser audio gear within this same price range. The premium $399.95 Beats Pro headphones have been engineered for what Apple has described as "heavy duty" studio and nightclub use. "Heavy duty" may have emerged as a Beats by Dre descriptor largely due in part to the steel and aluminum construction of these headphones. Certainly, hipsters would acknowledge the idea that Beats by Dre headphones, MacBook computers, and Pro Tools mixing software are now ubiquitous staples driving the disc jockey and underground music scenes.

Beats by Dre critics, or haters, often dismiss these headphones as stylish, but of middling quality. Audiophiles have made claims that Beats by Dre products amplify pounding bass beats, while distorting the highs of the musical scale. Heavy bass, of course, is a signature staple of hip-hop, dance, and pop music. As such, young hipsters have gravitated towards the Beats brand, while the more mature set clamors for Bose and Sennheiser. In any event, Beats by Dre guerilla marketing tactics via USA Basketball have tapped into a new subset of audiophiles. If anything, Beats and Apple have both mastered the art of creating self-sustaining markets out of nothing.

Ironically, the Beats by Dre haters have made similar arguments to those technocrats who have historically praised the likes of Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Nokia (NYSE:NOK), and even BlackBerry (NASDAQ:BBRY) technologies, about the wares being distributed out of Cupertino. Former Microsoft CEO Steve Ballmer once snickered incredulously at the idea of a $500.00 phone. Shortly thereafter, a misguided Mike Lazaridis declared that Apple's "amateur hour" was over, upon the initial release of his now defunct BlackBerry Playbook tablet. The haters do not understand Apple. On Main Street, Apple may be praised as cool. On Wall Street, analysts would agree that Apple leverages billions of dollars in goodwill to create real shareholder wealth. This time, the looming Beats by Dre closeout will be no different.

The Bottom Line

On August 10, 2011, smartphone company HTC (OTC:HTCKF) announced that it would be investing $300 million into a 50% stake of Beats by Dre. One year later, HTC sold half of this initial investment back to Beats for $150 million. On September 27, 2013, The Wall Street Journal reported that HTC would be disposing of its final 24.84% stake in Beats for $265 million. At that time, the staid Carlyle Group (NASDAQ:CG) put up $500 million for a position in Beats by Dre. Last year, Beats was therefore worth roughly $1 billion on paper, while also generating $1 billion in revenue. For $3.2 billion, Apple would largely be paying a premium to bring Jimmy Iovine, Hollywood rainmaker, into the fold. Within the past year, Carlyle Group would have tripled its initial investment, while rapper Dr. Dre might end up just short of the billionaire boys club.

Be further advised that Apple closed out its latest Q2 2014 with $150.6 billion in cash and investments above a mere $85.8 billion in total liabilities on the balance sheet. Of this amount, $8.3 billion in deferred revenue will eventually transition over to the income statement. This March 29, 2014 balance sheet also included $17 billion in long-term debt that will help finance Apple's ambitious $130 billion capital return program. The clean financials are largely the result of Apple having generated $36.2 billion in cash flow from operations through the first half of fiscal 2014. In any event, a $3.2 billion Beats by Dre acquisition would be but a drop in the bucket for Apple.

Going forward, the prospective rewards of the Beats by Dre deal far outweigh the financial risks. Apple would still trade for a relatively cheap twelve times estimated earnings, after backing out its liquidity position. Billionaire financier Carl Icahn may agree to any decision to load up upon Apple shares as a "no brainer." The Apple haters will get schooled, yet again.

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.