Overlooked Upside Potential In Apple's Acquisition Of Beats Electronics

Jun.11.14 | About: Apple Inc. (AAPL)

Summary

Beats is below 1% of the total market capitalization for Apple. Hence, it presents less downside risk, but higher upside potential if successful.

We are witnessing a paradigm shift from utilitarian functionality to cultural relevance – a shift that will determine products that sell and those that sit on shelves for ages.

Apple is going back to the basics by leaning towards artistic creativity as seen by the caliber of its recent recruits (repeating Steve Jobs' legacy of artistic admiration).

Apple opens Beats to new markets at little cost and Beats opens Apple to a younger and a more culturally active (trend followers & trend makers) consumer base.

Consumers are positioned to benefit the most from this deal. Music streaming is destined to go mainstream and ignite serious competition, and ultimately spur innovation, better prices and services.

Introduction

Apple (NASDAQ:AAPL) managed to turn the boring computer showroom floor into a sleek playroom filled with gadgets in an effort to give shoppers reasons to go to stores rather than shop online. This turnaround of Apple's retail stores was under the then head of Apple's retail stores, Ron Johnson. Under Mr. Johnson, Apple built a formidable retail empire, with higher sales per square foot than any other publicly traded retailer, including luxury names like Tiffany & Co. However, competitors have copied Apple's products in terms of design and functionality including its brightly lit retail spaces. And for the nine months ended June 30, sales per square foot in Apple's stores fell 4.5%, according to Customer Growth Partners. But Eli Portnoy, head of the branding strategy firm CultureRanch, said Apple stores have changed from a place of wonder into a sea of people. "There's a sense of excitement that's gone," he said. "Romance needs to come back to the store experience." Apple has, in the past few months, taken initiatives that I believe will inevitably reignite the aforementioned romance.

To start with, the shift from merely focusing on product functionality to incorporating cultural trends in product design has and will shape the future of which products sell and which do not. This idea is best illustrated from a quote by one of Beats founding partners will.i.am (Real name William Adams):

You can go into any consumer electronics store and you're going to see tons and tons of things on the shelf and the things that you are pulled to are the ones … that skew to culture. And there's a very thin line between the ones that did it right and the ones that just sit on the shelf. The ones that sit on the shelf are the ones that have no connection to culture and the pulse of things: pop, popular culture.

Times change and so do people's tastes. Apple is the master of design; Beats the master of style - this is one of the reasons that makes Apple and Beats a perfect combination. To rephrase the words of Forbes contributor, Kurt Marko, having perfected design and usability, the next problem for a consumer technology company is getting buyers to not only embrace and evangelize its products, but to transform them from utilitarian solution into cultural fashion statement. Apple excels at the former - slick designs and user-friendly features - while Beats has mastered the latter: turning a mundane product into a reflection of one's values and identity. The Beats acquisition was a very good deal because:

  • Beats Electronics represents high upside potential, but very low downward risk for Apple. Apple Inc.'s market capitalization is $537.51 Billion as of 05/29/2014, therefore the $3 Billion acquisition of the headphone maker Beats Electronics, represents approximately 0.6% of Apple's total market value. Hence, in the bigger picture Beats Electronic cannot have enough momentum to pull Apple down if it fails. The risk here is very low. Though I believe in Beats and its future, if Beats loses its market share, the loss will be like a speeding ticket - no effect in the long run.
  • Beats Electronics fits perfectly well into Apple's corporate brand. Beats Electronics has high end products. Established about 8 years ago, Beats Electronics comprises the Beats by Dr. Dre's family of premium consumer headphones, earphones, and speakers as well as patented Beats Audio software technology and streaming music subscription service Beats Music. Since its establishment, Beats' products have become ubiquitous in the high-end audio market. Spurred by solid design and branding, interminable celebrity endorsements, and a portfolio of high quality products. Beats' product portfolio is exclusive, expensive and high quality and nothing screams APPLE than that.
  • The deal positions Apple in a lucrative and in a growing new market of music streaming.

iTunes Radio, which launched last September as an ad-supported offering, has grown quickly to become the third most used music streaming service in the US after Pandora and iHeartRadio, but its failure to entice music fans to hit the buy button appears to have become a source of serious concern for Apple executives.

Consequently, Apple needs to revamp its iTunes Radio launched last September in order to increase income from iTunes. Since the service has not been popular, Apple's acquisition of Beats should enable it to gain popularity among teenagers and young adults and hopefully entice music fans to hit the buy button often. The growing popularity of music streaming services such as Pandora and Spotify has been reducing sales of songs and albums, a business that iTunes has dominated for the past decade. U.S. sales of downloaded songs slipped 1% last year to $2.8 billion, while streaming music revenue surged 39% to $1.4 billion, according to the Recording Industry Association of America. "This deal will make music streaming go mainstream," said Billboard deputy editor Yinka Adegoke. "You just have to think about Apple's access to 800 million credit card accounts, hundreds of millions of devices, the iOS ecosystem". By acquiring Beats Electronics, Apple's iTunes together with the streaming music subscription service Beats Music, Apple is positioned to benefit substantially from this synergy.

In addition, the synergy is not only meant to benefit Apple, it is also beneficial for the consumers. Competition is always good; it spurs innovation, better prices and better products. Apple is a brilliant design company working to create a lifestyle, working to sync their products with pop culture. By entering into new markets, they are likely to create good competition.

Conclusion

Apple loves tastemakers. In addition to Dr. Dre and Mr. Iovine, the firm recently hired Angela Ahrendts, the former chief executive of Burberry, to lead its retail division. Last year, it hired Paul Deneve, who used to run the fashion house Yves Saint Laurent, to work on unspecified special projects. It also scooped up Ben Shaffer, who led the team that designed Nike's innovative Flyknit running shoe. And at the top of this pyramid sits Jonathan Ive, Apple's celebrated design chief, who now oversees both hardware and software design across the firm's product lineup. This recent changes are a clear sign for Apple's new corporate direction. My interpretation of Apple's decisions in favor of pop culture and fashion is a clear statement that we are witnessing an inevitable reinvention, the first clear signs of what the company might become after the death of Steve Jobs. In addition, this growing concern for connecting with current trends is a significant sneak peak into Tim Cook's personality. If you look around at technology companies that thrive and stick around for a long time, you will realize that they are ones that keep changing in accordance to current trends of their time. These companies innovate to cater to new changes and fulfill new problems consumers face overtime - these are the companies that follow culture, and while they innovate; they never forget to understand what consumers need.

On the downside, Beats Electronics is unlikely to cause any drastic changes, whether successful or not. However, it is the idea towards culture - the belief in artistic creativity, the direction they are taking and the possibilities this could bring that fascinates me the most.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.