Apple’s Beats Acquisition

How Apple is using cash to pay off risk.

There’s been a lot of buzz recently about Apple’s Beats Acquisition—at $3.2 billion, it trumps all of Apple’s acquisition purchases in 2013 combined by a good $2.7 billion. This is such a huge sum of money and so uncharacteristic that I was pretty shocked. My tweet at the time was: “Don’t do it—this is as overpriced of a deal as the headphones themselves.” My opinion hasn’t really changed about the deal as a whole—I think it is grossly overpriced—but Apple knows exactly what it doing. As a company that has $100 billion laying around, cash honestly doesn’t mean much to them: the Beats acquisition is a risk mitigation strategy for entering the music streaming industry and if they can pay to reduce risk at the tune of $3.2 billion, they’ll most definitely do it.

I’ll look at the Beats acquisition through two primary lenses—the first is the acquisition of Beats’ headphone division and the second, the acquisition of Beats’ nascent streaming service.

As I mentioned, I do not personally believe Beats headphone division to be worth a significant amount of the acquisition sum. Beats headphones make up half of global sales in premium headphones but also have a reputation for having terrible sound quality for the price.

The importance of brand to Beats headphones mirrors Apple in a lot of ways; Apple is able to get away with insanely high prices because of perceived quality of its products and its luxury appeal. Honestly, Apple is in many ways a fashion brand (as reinforced by the fact that the CEO of Burberry recently jumped ship to join Apple)—luckily, it actually has a beautiful and usable product to back its brand up. Beats lacks this—it is notorious for poor sound quality at a huge price premium.

If Apple is paying a significant amount for goodwill, I think that this money is really poorly spent;Apple will not be able to transform this goodwill into material returns beyond Beats current profit margins. Beats headphones will feel right at home on an Apple Store wall along with other overpriced accessories but Apple will likely never brand their iPhones with the Beats logo. Just as Apple never deigned to put the “Intel Inside” label on its phones; it would NEVER put the Beats logo on its phones. As Forbes writer Pascal-Emmanuel Gobry writes, the strength of Apple is its brand—it wouldn’t make sense to dilute it with another brand, nor does Apple need to as its own brand speaks for itself. Beats headphone division is a business that, like Apple, is bolstered by its brand image, however it has significantly less technical expertise to back it up.

I fail to see significant synergies here in terms of increasing Beats current profit margins; perhaps, one could argue that the complementarity of the goods could increase sales volume (customers purchase replacement Beats headphones with a higher profit margin than Apple Earpods); however, this is not nearly worth $3.2 billion.

I see Beats streaming service as the real deal breaker here. Apple’s taking a real option and paying large sums for the POTENTIAL that they can turn Beats streaming service into a Spotify-killer. Music streaming accounted for 21% of revenue in the U.S. Music Industry last year; as this number rises, Apple would be a fool to not enter music streaming, especially since growth of music streaming directly cuts into iTunes sales. Apple’s Beats acquisition is actually an extremely cautious way to go.

Apple honestly hasn’t even given the internally developed iTunes Radio a good shot yet—it was released at their DEVELOPER’s conference to a DEVELOPER audience and was not marketed heavily to the public. Apple decided to fold it into the existing iTunes app (instead of spinning it out as its own app) where honestly no one would see it. As it stands, Apple didn’t push iTunes Radio past what, in the startup world, would be considered a beta test. Despite this, iTunes Radio already has 8% market share of music streaming.

http://www.macrumors.com/2014/03/11/itunes-radio-third-most-popular-us-music-service/

Apple did not give iTunes Radio an honest push to the general public and clearly doesn’t plan to.

It’s favoring the much more cautious approach of bringing in Beats to make sure it enters the music streaming industry right. Ultimately, Apple’s acquisition of Beats streaming is a risk mitigation strategy. Apple wants to give itself every advantage possible moving into the industry because it can’t afford to botch it up. This is both because iTunes currently represents a huge portion of their revenue (and times are changing to favor cloud-based streaming over actual content owning), and because they want to avoid the PR disaster that another high profile embarrassment like Apple Maps would cause if Apple were to genuinely push a terrible iTunes streaming service.

Apple functions, in many ways, extremely differently from Google. Google has diversified into so many products that even a high profile failure like Google+ doesn’t really matter to them. Google likes to release things on the cutting edge, to an audience of engineers; if they fail, no worries, people still think they are cool for trying. Apple, on the other hand, releases products to an audience of consumers; it releases very few lines of products and when it releases them, they better be absolutely damn perfect because the general public/non-techies are using them. Thus, there IS a perfectionism complex; that’s why the Apple Maps release still hurts so badly. Apple wants to get its foray into the music streaming industry right the first time.

Beats streaming is nascent but a pretty decent acquisition target. It doesn’t have as huge of a market share as Spotify or Rdio. However, it does have an extremely unique user acquisition strategy. Beats has been pushing its service through cellphone service providers, offering AT&T subscribers free trials of the service. With this strategy, Beats is able to transform 7 out of 10 free users into paying users. This is beyond impressive in the music streaming industry; Spotify’s user rate is hovering at about 5 million paid users out of 20-24 million total users (20-25%), which is not even close to this number. Obviously, we can expect this number to drop significantly as Beats continues to grow (as it could be due simply to Beats’s current small size). However, it still is an extremely interesting and successful model for user acquisition. Spotify would do well to launch a similar cellphone service provider tactic (or one with a cellphone manufacturer in order to come preinstalled on phones). One barrier to doing so, at least in the US, is their lack of connections and clout here as a Swedish company. It should definitely look into this tactic in the UK and other areas of Europe, though, as it should have easy connections there. I personally don’t think Apple had to BUY Beats to use this strategy, since Apple has so much clout it could easily have dialed up AT&T and asked for a similar arrangement for its own service. But again, viewing Apple’s acquisition of Beats as a risk mitigation strategy, this deal just eases everyone’s anxiety.

Apple-Beats has a huge leg up against players like Spotify due to size, connections and cash, but Apple has to move fast in this game of catch-up or risk losing the industry. Three things that could break Spotify are (1) its lack of positive returns, (2) its rocky relationships with the music industry, and (3) failure to capture a sufficient number of users.

Spotify has never had positive returns; poor cash flows give it a huge disadvantage against a giant like Apple, which, has billions and billions to burn. Apple has huge cash cows it can milk to subsidize its streaming service, if need be, while Spotify lacks this completely.

The second issue is particularly important given the immense power that record labels have in the music streaming industry. As content providers, they could choose to boycott a service if they do not feel like they are getting compensated enough, choosing to launch their new albums exclusively on iTunes. Currently, artists do not seem very happy with Spotify’s compensation scheme—offered a better deal with a familiar face like Apple, and they could very well jump ship. Apple already has extremely strong connections to the music industry, an international presence for iTunes in Europe and emerging markets, significant amounts of money to burn, and now, the added industry expertise and connections of the Beats team. Apple could break Spotify by starving Spotify of its supply of music.

On the last point, Spotify is already pushing user acquisition, rapidly gaining a loyal user base in Europe and pushing hard for younger users, offering $4.99/month premium plans for college students. And by all rights, it should be HEAVILY pushing marketing and user acquisition. Spotify has done all the heavy lifting—it has a beautiful, solidly engineered product and a huge collection of songs—scaling to more users is marginally cheap in comparison. That conversion number is also extremely important. Similar to the gaming industry, where a small fraction of users actually bring in a significant amount of money, the number of paid users is key to sustained profits while Spotify is likely simply breaking even on free users. Only time will tell how well Apple-Beats is able to maintain Beats’s current user acquisition rates. However, the model of targeted contracts with cellphone service providers seems like a really strong model, and one that Spotify would have trouble imitating as explained above.

Overall, I’m not super impressed with the Beats acquisition—however, I can understand why Apple is doing it and, if it works, Apple will have taken a good real option and solidified its place as the relayer of music to the (rich, upper-middle class) masses.

Apple cannot afford to lose in the music streaming industry nor can it stand another Apple Maps but it is sitting on a good $100 billion in cash and it can damn well afford to buy super overpriced Beats headphones if it means it’ll win them an advantage in music streaming.