This article is the first of a two-part series that will explore the wisdom behind Apple's acquisition of Beats Electronics for $3.2bn.
The news that Apple (NASDAQ:AAPL) was buying Beats Electronics for $3.2 billion sent shockwaves throughout the tech community, as it was a departure for the long adored company that made sleek, beautiful devices and innovative advances in technology its image. In stark contrast, Beats founder and rapper Dr Dre has presented Beats as an extension of the hip-hop and streetwise rapping community, which proudly disconnects itself from the mainstream, delivering lower basses in their line-up of premium headphones as its primary marketing identity. It seemed like an odd marriage, to say the least.
So why is Apple buying Beats at all, much less to the exorbitant tune of $3.2 billion? Assuming Tim Cook was making a rational decision and not merely fulfilling a lost bet at billionaire poker, Apple's management must be assuming that the headphones company is worth what Apple is paying for it. To be fair, other recent tech acquisitions, such as Facebook (NASDAQ:FB) paying $16 billion for the practically revenue-less chat messaging service Whatsapp, and Google's (NASDAQ:GOOG) $3.2 billion deal for digital thermometer company Nest makes Apple's consideration look somewhat down to earth. But the fact remains that Beats' primary revenue generating source is its premium headphones, and at first glance it appears puzzling why Apple would spend $3.2 billion on it.
A full history of material events revolving around Beats can be found in this Venturebeat article.
To understand the rationale behind Apple's acquisition, I'll take a brief look at the history of Beats Electronics. Formed in 2008 at Santa Monica, California, Beats Electronics ambushed the traditionally serene premium headphone market with a vivid outpouring of colour, celebrities and the now-famous bass impression on its premium line-up of over-the-ear headphones. Before Beats came into the scene, it was only the audiophile community who generally concerned themselves with headphones over the $100 price range, and discussions revolved around the material composition of wires, ancillary equipment such as vacuum tubes, and minute differences in sound quality. However, Beats' presence introduced a completely new identity to the category with flashy advertisements and an affinity towards brand recognition, effectively redefining the old landscape forever.
While unconventional, it appears as if this assertive strategy has worked for Beats, as the company's financials have been markedly impressive for a fairly young 5 year old company. While accurate financial information of the company's performance is lacking due to Beats' status as a private company, a few conclusions can be drawn from the events which have surrounded its history. Firstly, it is estimated that Beats occupies up to 64% of the premium over-$100 headphone category's market share, which itself has recently surpassed the $1 billion mark in 2013 in the US alone according to NPD. Giving consideration to inaccuracies in data, a logical extrapolation would mean Beats draws in a conservative estimate of $600 million in revenue from its premium headphones business in the US.
There is consensus that the global stereo headphone market rose 11% to $2.3 billion in 2013 from various sources, and with Beats claiming a 43% share of that as its prize, this brings its estimated total revenue from headphones to $989 million. Applying an appropriate margin of safety, that means its international share of revenues from the segment for the year was approximately $350 million.
In 2013, NYTimes reported that Beats was well on its way to achieve $1.4 billion - $1.5 billion in revenue. This claim is shared by other reputable sources such as BusinessWeek, Guardian, Fast Company, although some have been more conservative by saying the figure is "more than one billion". The Guardian post also highlights Beats as having generated slightly less than $1 billion in revenue in 2012, while Financial Times cites Beats as bringing in $598 million in 2012 and $298 million in 2011. Given a conservative $1.3 billion achieved in 2013 and $1 billion in 2012, that's at least an impressive 30% in year-on-year revenue growth.
Beats also has an affiliate company which participates in delivering a music streaming subscription service called Beats Music. However, unlike what has been reported extensively in the media, the expected revenue derived from this segment should not be materially substantial. According to Statista, Beats Music does not appear among the top 10 music streaming services, likely implying that it has less than 1% in market share. Some breakthrough is to be expected with the newly reported bundling deal with AT&T, which has supposedly gained it 200,000 subscribers by giving out free trials; but even accounting for the overall $1 billion online streaming market in 2013, that's just an upper limit estimation of $10 million in revenue.
That still leaves a monster $340 million in revenue that's going unaccounted for. Quite honestly, I was quite surprised to see such a large gap existing between estimated sales of its primary line-up and its total estimated revenues. A quick browse on their website reveals that Beats does not carry a very wide product line, so it's unlikely that I've been negligent to the point of missing out an entire product category. Beats by Dre also has a non-premium earphone range which sells for less than $100, however the segment is not pushed as much as the premium headphone range and is not expected to have contributed materially to revenue. In the interests of comprehensiveness, I'm going to assume their ancillary product segments, including this category and others like HDMI cables and the new Pillbox range, contributes a generous $40 million to their top line.
Even then, that still leaves $300 million in mystery revenue unaccounted for, a little less than a quarter of its cumulative revenue. What could be contributing to this staggering amount? One possible explanation is that Beats has been actively involved in incorporating its BeatsAudio technology into products of well-known partner brands such as HP (NYSE:HPQ), Chrysler, and HTC; and that they are still receiving royalty payments or equivalent benefits. Alternatively, it might be receiving payments from rights of use from record labels such as Universal, Warner or Sony to promote their headphones in their marketing material. Or it could be both. It's unlikely that these incomes are the result of one-off accounting recognitions such as a sale of property, as Beats has been demonstrating consistent revenue growth since its inception.
This mysterious slice of pie does put Apple's high acquisition tag into perspective. If this segment can be expected to contribute to such a large proportion of revenues to a reliable degree, and if it can continue to demonstrate a strong growth rate, it might well make sense for Apple to acquire them.
(Source: Created by the author.)
Estimating profit can be a little trickier as one needs to figure out the margins involved in the respective product segments. This New York Times article quotes Monster Products founder Noel Lee claiming that each premium headphone has material costs of about "$40 and up". For the purposes of this analysis, I'm going to use $50 as material costs.
SG&A (selling, general and administrative) expenses per electronic product for headphones have typically been about 20%-30% of the final selling price. While I respect that such expenses for a Beats headphones are different from those of lower-tier headphones, for the purpose of this analysis I'll be using it as a proxy. At its widely recognized average price of $300 per headphone, SG&A expenses of 30% per headphone come up to $90.
Other costs including labour, wholesale-to-retail markup and apportioned R&D expenses should not take up more than 20% of the final selling price, or $60. Therefore, this back-of-the-envelope calculation estimates that the cost of each headphone to the company is a conservative $50 + $90 + $60 = $200. This leaves a final profit of $300 - $200 = $100 to the company, which arrives at an impressive operating profit margin of 33% for its premium headphones. This is not incongruent with the profit margins of similar premium products such as the iPhone 5S and the Galaxy S4 which rely on an exclusive brand and top-tier technology to market themselves, with Apple showing a 22.7% net profit margin and Samsung Electronics demonstrating a 17% operating profit margin respectively (both companies rely on their flagship smartphones, the iPhone 5S and the Galaxy S line, to contribute to approximately 70% of their top lines).
Labor, retail markup and R&D expenses
Total cost per headphone
(Source: Created by the author.)
Using the revenue figures of $950 million as estimated in the previous section, 33% of $950 million yields $313 million in net profits for the Beats by Dre segment. For simplicity's sake, I'm going to assume that both the streaming and ancillary segments yield a negligible profit. That brings the total profit for all presently accountable segments to $313 million.
Estimating profits from the mystery segment is a little harder. If they are indeed from intangible sources such as royalties or sponsors, then their cost of sales should be insignificant. However, this cannot be said for certain, as the income could potentially be from tangible sources. At present, their contributions to the bottom line shall continue to remain a mystery.
To provide a semi-solution to this, let's take a look at some previous acquisition figures by other parties who have had the privilege to study its balance sheet. In August 2011, HTC bought a 50.1% stake in Beats Electronics for $300 million, valuing the company at $600 million; which as seen earlier, was done on the back of 2011 revenues of $298 million. HTC would later sell its stake in two deals over the next 2 years. In September 2013, the third largest private equity firm in the world Carlyle Group LP, invested $500 million for 50% of the company, valuing the company at $1 billion. This was done when estimated revenues were $1.3 billion as observed earlier.
It follows that a potential acquirer would not overpay for a company which is worth less than that, while existing shareholders would not accept a deal which undervalues their company. While HTC's acquisition price may have been influenced by an expectation of synergy with its own handset business, Carlyle Group's offer certainly was not. For it to value the company at $1 billion, Beats must have already been generating sufficient profits to justify the price tag. If the $313 million of profit per year as calculated above is accurate, it would be selling at a P/E ratio of about 3:1, which all things considered is fair for an established private business. (this figure has yet to take into account the profits of the mystery slice of revenue, so it might be lower)
This raises the question why the existing shareholders at Beats would want to sell off their stake in a very profitable company to Carlyle Group. One reason might be that the estimated operating profit margin of 33% which I calculated earlier is grossly inaccurate, and it actually only makes for instance half of that. In my humble opinion, a 33% operating profit margin does not seem unrealistic for a company which is able to charge a hefty premium on its products due to its brand. In addition, this Slate article makes it clear that Universal Interscope, the major record label behind its marketing efforts, is ready and willing to help market Beats hardware without burdening it with ordinarily substantial promotional costs (which may have something to do with Jimmy Iovine being the chairman of Interscope).On top of that, many reputable sources such as The Verge and ExtremeTech agree with the assessment that the build and audio quality of the headphones do not match competitors in their price range, so the profit margin on these headphones can be maximized.
The other possibility might be that the companies have extremely high expenses in other unrelated areas which cannot be matched to revenue. For instance, executives drawing high salaries might be an example of expenses which cannot be matched to a revenue source. Reuters reports Dr Dre as earning $100m in pre-tax earnings from Beats in 2012. As majority shareholders of a private company, Jimmy and Dre are free to draw profits out of the company as they see fit. Alternatively, uncapitalized R&D expenses for prototypes which failed to reach the market or impairment in the values of assets held can also lead to large expenses without matching revenues. If this is true, these can be easily addressed or restricted by future investors, such as Apple.
Of course, the most likely reason might have nothing to do with profits at all. It may be that Beats needed the money for further capital expansion, perhaps to fund the building of additional manufacturing plants to meet expected demand after its fallout with Monster in early 2012, which was exclusively involved in producing Beats' headphones on behalf of Beats. As you will observe in the following section on growth, demand for premium headphones is expected to continue to grow at impressive rates. If Jimmy and Dre still see themselves in start-up mode and expect future profits to more than double its current earnings with the additional investment, it would make accepting the investment in exchange for 50% of the company a wise decision.
It may also be possible that Beats Electronics, the parent company selling headphones, is investing in Beats Audio, its affiliate in the music streaming subscription industry. Or it might just be as benign as a transfer of partial ownership from HTC, who at the time desperately needed to sell its 25% ownership in Beats to avoid posting a second quarterly loss in a row.
Overall, there do not appear to be any internal inconsistencies within this analysis, and profits as estimated appear to be solid, reliable and recurring.
The premium headphone market grew by 21% to surpass the $1 billion mark in 2013 compared to the same period a year ago, having jumped 84% in the previous year between September 2011 and September 2012. The premium headphone market currently makes up 43% of all headphone sales, which is projected to grow to $14.9 billion by 2017.
Over 90% of all headphone revenue growth in the US in 2013 came from the premium headphone segment, signalling the need for manufacturers to shift towards premium headphones and away from traditional earphones in order to maintain bottom line growth. And while traditional headphone brands Philips, Sony, JVC, Sennheiser and Skullcandy combined accounted for 45% of global headphone volumes in 2012, Beats by Dre alone accounted for 23% of global revenues.
On top of that, the number of premium headphones connected to a smartphone was 69%, while those connected to a tablet was 49%. FutureSource cites the headphone market as "booming" with the proliferation of portable devices as the primary music player, citing soaring portable device ownership as the main contributor to forecasts of 330 million units being sold by 2016. In the context of an acquisition by Apple, this can be interpreted as potential for synergistic incentives to fuel the iPhone and iPad's growth, both of which are instrumental to Apple's bottom line.
Dealerscope cites exercise as one of the main contributors to headphone use, with 2/3 of all people who exercise wearing headphones, rising to 3/4 when observing the treasured 18-34 year old segment. In line with Apple's rumoured push into health and Samsung's recent inclusion of a heart rate monitor on its flagship Samsung Galaxy S5, it would appear that headphones have a role to play in the overall market for digital fitness.
Competition is seen to be negligible for Beats by Dre. Its nearest competitor, Bose, has merely 21% in market share in the premium headphone segment, while Beats occupies over 50% of the market. This is increasingly interpreted as brand defining the drivers of premium headphone sales over build quality, which if true is encouraging for Beats, as US teens seem to prefer Beats by Dre over Bose by nearly 15 times more.
In Part 2 of this analysis, I'll look at how the premium headphones business ties into Apple's strategy, estimate the balance sheet of Beats Electronics, and hazard a guess at the company's valuation.
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.