Apple is to buy Beats Electronics for $3 billion, which is not only the largest acquisition in the Cupertino-based company’s history, but also its most high-profile strategic investment to date. The deal comes after handset competitor HTC recently sold the remaining half of its $309 million, 50.1% controlling interest of Beats back to the company for $265 million in September 2013.

In terms of immediate products and services Apple gains:

  • The Beats audio product line, comprised of headphones, earbuds, and portable speakers
  • Beats Music, the US focused on-demand music service

 In addition, Apple gains executive talent; Beats co-founders Jimmy Iovine and Dr. Dre will join Apple in as-yet unspecified senior roles reporting to iTunes head Eddy Cue. And it will also get a fresh, music-focused brand in Beats, which will co-exist with the core Apple brand for the foreseeable future.

The deal is subject to regulatory approval and is expected to close in Q4 2014.

Our Take:

The Beats acquisition was the subject of substantial curiosity and discussion in the weeks prior to the formal announcement, with many puzzled as to the fit between the two companies.  Given the size of the deal for the company, there are questions regarding to what degree Beats can contribute to Apple’s fortunes tactically and strategically that would justify the cost of acquisition.

While it is tempting to think of the Beats brand as younger and fresher than the Apple brand, in reality the picture is more nuanced. It is certainly the case that Beats has a strong association with hip-hop, thanks to the involvement of Dr. Dre, but in reality its line of audio products fall into the same ’affordable luxury’ category as most of Apple’s products and an quick IHS survey of Apple stores in Northern California revealed that Beats has between 30-40% of the space on the headphone display units, implying strong overlap between the two audiences. Consequently, while we do believe that the addition of the Beats brand will help to refresh and extend Apple’s customer base, it is very easy for this effect to be overestimated.

There are two remaining important facets of this acquisition that raise questions and merit further strategic examination: products and services,.

Products

Within the CE industry, headphones, particularly high-end headphones, have been healthily experiencing double digit unit and revenue growth over the past couple of years. Wirelessly-connected speakers have also been a growth category within the industry in recent history. Both categories have benefited substantially from consumer shifts in media consumption habits towards mobile platforms.  It is therefore unsurprising that Apple is interested in venturing into both headphones and speakers. Beats has been quite successful in driving and growing the high end headphone market, and owns the majority of the revenue in the category. Worth watching is the evolution of Beats’ products and resulting consumer response, as Apple has now terminated the company’s relationship with Ammunition, the design firm responsible for the iconic Beats product designs that have proven so popular with the market. Apple’s in-house talent will now take over design duties.

Acquiring Beats nets Apple a solidly profitable audio hardware line, and a brand whose association is purely with music and agnostic in terms of devices and operating systems. Nonetheless, it does not seem that Apple legitimately needed Beats’ product line or brand in order to successfully branch out into headphones and portable speakers.

Apple has a larger, more recognized global brand than Beats, and Apple’s brand is already associated with high-end products. The company also has far greater supply chain power, deeper major retailer distribution, immense cash reserves, and strong loyalty from its iOS mobile device user base. There does not appear to be any significant need for Apple to acquire the Beats line of higher-end-focused headphones/speaker products versus profitably developing and selling Apple-branded high-end audio accessories that pair well with its mobile devices.

Music Services

iTunes remains the global leader for digital music purchasing. However, the market is evolving, and download sales in 2013 declined year-on-year in many leading markets. At the same time personalized radio and on-demand services saw significant growth. For example, Spotify added 4 million paying subscribers for its on-demand service between March 2013 and May 2014. However, the growth in so-called ‘streaming’ services has been driven by ad-supported offers, which often build on some sort of radio license rather than offering on-demand functionality. For example, 60% of Spotify’s 30 million active listeners remain on a free tier; Pandora had 75.3 million active listeners as of March 2014, up from 70.1 million in April 2013 and Apple’s own iTunes Radio service, which is limited to Apple devices, launched in the second half of 2013 and has attracted 40 million listeners despite a roll out that is limited to the US and Australia, although there are some questions about how engaged those users are.

Beats Music launched its paid, on-demand music service in January 2014, and now claims 250,000 paying subscribers. Some of these will have been carried over from Mog, the service Beats acquired in 2012, and others will come under the auspices of Beats and AT&T’s family plan ,which allows for multiple users within a single subscription. Beats’ cross-platform service, built on top of the Medianet platform, is available on Android and Windows Phone as well as through Sonos audio equipment.  Apple has announced that the service will remain cross-platform after the acquisition, in much the same way that the iTunes media player and entertainment store are available on Windows PCs. In this context, it seems unlikely that Apple’s interest in Beats Music comes from either the number of subscribers, or the underlying technical platform, as much of the latter comes from a third party.

Nor do we believe that Beats had significantly preferential content deals in place, and, if such deals had existed, Apple would be able to take advantage of them after the acquisition. Beats, similar to rivals Spotify and Rhapsody, has music labels in an equity position. The labels are unlikely to give favorable treatment to any one service over others in the market. Also, all contracts are highly likely to require permission to assign the contracts in the event of an ownership change, so even if Beats or its principals had managed to secure preferential treatment, this treatment is certain to disappear under Apple ownership.

As IHS has observed before it is, in theory, possible to turn an on-demand music subscription business into a profitable service. However, becoming profitable requires significant scale and careful cost management. Few, if any, on-demand music services have achieved this scale. Consequently, Beats is in a position that Apple is very familiar with; combining profitable hardware with content service that is either loss making or operating around break even. This was how iPod-plus-iTunes operated for years, before the App Store. Put another way, to Apple buying Beats makes more sense buying than Spotify or Rhapsody because of the company’s profitability from its high margin consumer electronics business. In pure financial terms, the deal should work for Apple over a relatively short period of time. 

Apple, Beats and the Future

What the above analysis illustrates is that at the moment the Beats audio equipment and Beats Music offers are relatively disconnected propositions, united by a common music-focused brand. In this regard they could not be more different than Apple’s old approach to iPod-plus-iTunes, which saw the music service provide a key part of the value proposition for the hardware. As the company evolves two branded product lines going forward it will be interesting to see how the relationship between product and service evolves.

Overall, the eventual value derived from Apple from the Beats acquisition beyond an immediate injection of life into the Apple brand will take time to visibly manifest. At this time it remains unclear as to whether that value will be worth the $3 billion cost, and whether it will primarily stem from the evolution of its streaming music services, additional revenue derived from Beats product sales and bundling. What is clear, though, is that for Apple we have entered uncharted territory as the company completes its largest acquisition and now has the option to adopt a more portfolio-driven approach to its consumer brands, extending the appeal of its products even though many of its core customers remain the same (much as the original Xbox stood apart from other Microsoft brands like Office and Windows).

 

Geography
USA
Organization
Apple Inc. Pandora Spotify
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