Apple and Beats: What Apple gains from the biggest deal in its history

13th June 2014

After a month’s worth of rumour and speculation, Apple finally confirmed its purchase of the Beats headphone and streaming business (or, to give it its full name, Beats Electronics) this week for a staggering $3bn (about £1.85bn). The deal, which is expected to be completed before the end of the year, is made up of $400m in Apple Stock and $2.6bn in cash.
Although not entirely unexpected, the deal has got many in the M&A world scratching our heads. Why would the world’s biggest technology firm pay three billion dollars for a maker of blingy headphones? Of course, in this sense, it’s a classic Apple move – something that leaves tech scene observers rather bemused, and Apple’s rivals rather fearful.

This is by far and away the biggest acquisition Apple has ever made in its 38-year history. It has always preferred to develop products in-house and its acquisitions have in the past been small – no more than a few hundred million dollars. Before this, its biggest buy was NeXT Computer in 1997, for $400m (about $760m in today’s money). But the deal is actually small beer for Apple, which is sitting on a cash pile of more that $150bn.

But this particularly deal is, I think, indicative of Apple’s ability – even post-Jobs – to think long term and potentially disruptively (as it did with the iPod, iPhone and iPad). This is about much more than headphones or speakers, which Beats also sells.

Apple is, through its iTunes store, the world’s biggest music retailer. But its dominance was built over a decade ago in offering the ability to purchase an approved digital music download. Now the model has changed. The rise of smartphones, tablets and systems such as Sonos, coupled with faster broadband, has enabled music streaming providers such as Spotify, Napster and now Google Play to thrive. Streaming is – outside of a small but vocal community devoted to physical formats such as vinyl – the new way to consume music.

Why own music when you can rent it? The same thing goes for streamed media products, such as Netflix and LoveFilm, which have largely killed off high-street video rental stores.

Apple has tried to get into streaming before, with Ping and iTunes Radio, but has never quite cracked it, and now has to play catch-up with the likes of Spotify and Pandora. It has been marginally more successful with Apple TV (again, via iTunes), but this service is commonly perceived as being behind LoveFilm or Netflix.

Now, playing catch-up is not something Apple likes to do. But at a stroke it has acquired a number of things. First of all, it has acquired the world’s most high-profile headphones brand. Beats by Dr Dre may not meet the standards demanded by audiophiles, but they are definitely the ‘phones to be seen with, and they carry a huge amount of brand equity. They are, particularly among a young demographic willing to shell out cash for this kind of thing, “cool” – a patina which Apple itself may have lost over the past few years as its products became more ubiquitous; they are beloved, and used by, high-profile music and sports stars, who provide crucial brand endorsement. Beats ‘phones are also premium-priced, high-margin products in an increasingly commodified tech hardware market. In fact, the company had revenues of $1.2bn last year.

As well as a brand, Apple is also buying “talent”, always an important factor in any acquisition. In this case the talent is Dr Dre (himself a brand) and perhaps more importantly, legendary producer/music mogul Jimmy Iovine, the man who helped turn Bruce Springsteen, Meat Loaf and Lady Gaga into megastars.

And finally, Apple is buying into streaming; Beats doesn’t just make headphones, it also launched a US-only music subscription service, Beats Music, in January this year. In the first quarter of 2014, it attracted about 250,000 paying users (this is way, way behind Spotify’s 10+ million subscribers).

But one of the things that differentiates Beats streaming from, say, Pandora or Spotify, is that it is based on a “curation” model, rather than computer algorithms. Now algorithms can be wonderful things (where would Google, and the rest of us, be without complex algorithms?) but one thing they are not is human. And with something as human, as subjective, as musical taste, they fail dismally. Either their recommendations are annoyingly random, or else they are completely inappropriate. Tastes these days tend to be more eclectic than they used to be, but there is no real reason why fans of Bring Me The Horizon would want to listen to The Eagles or folk-rocker Jack Johnson – which has been the kind of disconnect that plagues all algorithmically-driven music services, and Apple’s in particular.

Beats Music can be launched internationally and could become the market leader. And, given that there is a generation for whom the idea of paying for music is anathema, and for whom the idea of listening to ads in return for freebies is near second-nature, there is the possibility of an advertising-funded streaming service which, given iTunes has well over 600 million users, could easily eclipse Spotify’s 40 million registered users. In short, Beats/Apple could become to streaming what iTunes is to downloads.

Most importantly of all, it seems that the deal has the near-unanimous support of the music industry (in effect the big three international conglomerates, Universal, Sony BMG and Warners). Record companies love streaming, because they get to keep ownership of the music, rather than having to worry about easily-hacked DRM protocols or people passing on digital files. The “biz” knows and (to a degree) trusts Apple: it’s been dealing with the Cupertino behemoth for almost 15 years, and in the spirit of “better the devil you know”, would rather deal with an established company than an upstart. It knows that while Apple may play hardball, based on its past record it guarantees sustained and sustainable long-term income.

So, what does this mean for the world’s most valuable tech company? As I mentioned earlier, Apple is always the kind of firm to do the unexpected; it doesn’t always get things right, but when it does, it changes entire industries. I think this will be another game changer for Apple and for the music industry. There are strong rumours that Apple may be about to unveil some sort of “smart home” system (perhaps as early as next month’s Apple World Wide Developers’ Conference) that will allow you to control a huge range of home devices and services from an iOS device, and music streaming will play an important part of this planned iOS-centric world.

And one more thing – although it is sitting on a $150bn cash hoard, Apple’s traditional revenue streams are starting to decline. It will need to start spending more of that money to get revenues growing again, otherwise shareholders will start demanding some of that dosh for themselves. I think we will start seeing Apple embark on a spending spree that will put Google and Facebook’s cash-flashing of the past few months in the shade. After all, albeit I say this with my tongue firmly in my cheek, this is a company that could buy up Sony, WPP, Omnicom, Publicis, IPG, Dentsu, Havas, Panasonic and Hewlett-Packard with money to spare… exciting times ahead, methinks.