Apple + Beats Doesn't Make Sense

Apple reportedly plans to buy Beats Audio, maker of headphones and operator of a music streaming service. What's unclear is how Apple will benefit from the deal.

Apple is prepared to acquire Beats Audio for $3.2 billion, according to a report in Financial Times. Beats Audio, founded by hiphop star Dr. Dre and music mogul Jimmy Iovine, has risen quickly since it launched six years ago, but it is difficult to see how it will add value to one of the most valuable brands in the world.

There's plenty to like about Beats. The company generated about $1 billion in revenue in 2013. That makes the $3.2 billion sale price -- while not cheap by any stretch -- about right in terms of Beats' valuation and what it should sell for. Beats also has a commanding lead in the high-end headphone market, producing 59% of all headphones costing more than $99. (A variety of other companies have a solid grip on the under-$99 headphone market.) Though true audiophiles know to stick with brands such as Bose, Shure, Etymotic Research, and Klipsch for real high-end audio, Beats has developed demand for its high-cost headphones thanks to something Bose and the others don't have: street cred.

Beats is a marketing machine. With Dr. Dre adding cachet to the brand, Beats has risen from very little relatively quickly when one considers how long the competition has been around. Beats many not make the best headphones, but it makes some of the most highly coveted headphones thanks to hip designs and highly visible spokespeople. Co-founder Jimmy Iovine is no slouch, either. Iovine has long had a hand in the music business producing records and, more recently, appearing on FOX's American Idol (with Beats branding clearly visible on his person, of course).

Beats doesn't have a good track record in striking deals, though. HTC famously bought half of Beats for about $350 million several years ago. HTC added Beats' sound processing technology to its handsets, and sold some smartphones with Beats headphones in the box. That story didn't end well, however. HTC was eventually forced to sell back its share of the company to Iovine. Given HTC's long slide towards oblivion, it's fairly obvious that adding Beats' brand to its own didn't help HTC sell any phones. Let's also not forget Beats' tie-up with HP, back in the day.

So what does Apple want with Beats?

The plain white earbuds included with most iPods and iPhones may be symbolic to Apple's brand, but they've always been junk to anyone with ears. Apple could stick Beats' lower-end headphones in iPod/iPhone boxes, but it's hard to see such a move generating a significant boost in sales. Beats Audio products already have a huge presence in Apple retail stores. Weighing Beats' margins is another angle to take. Beats often sells headphones that are marked up by as much as 1,000%. Who doesn't want margins like that? Purchasing Beats would allow Apple to add those fluffy margins to its own already-high margins.

[How will Google respond? Read Google Sends Shopping Alerts To Android Devices.]

The real target here is likely Beats' streaming music service, called Beats Music. Apple is already the world's largest seller of digital music through iTunes, but its efforts at launching successful streaming music services have been anything but successful. iTunes Match, launched in fall of 2012, is used by people more as a music library backup service than to actually stream music to their devices. Further, iTunes Radio, which launched in the fall of 2013, has seen limited uptake when compared to existing streaming services, such as Spotify, Pandora, and others.

Spotify claims to have about 6 million paying customers and 24 million total customers. Spotify isn't profitable, but it is popular. Pandora has three times as many active listeners, with about 75 million customers. There are well more than 100 million iPhones and iPods out in the market right now. That's a huge built-in market for Apple to target with Beats Music streaming service. There's just one hang-up: Apple would have to renegotiate all the contracts it has with the music labels. It's nearly impossible to assess how those negotiations might turn out, though Apple already has strong sway with music labels thanks to its huge iTunes numbers.

Apple hasn't commented on the deal with Beats, but multiple media outlets have seemingly confirmed the original Financial Times story with their own sources. Perhaps Apple will have something to say about the deal during its Worldwide Developers Conference, which kicks off June 2 in San Francisco.

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