Apple & Beats

In what must be an enormously frustrating development for Apple PR, rumors of Apple acquiring Beats for around $3.2 billion broke last night on the Financial Times website. I say frustrating, because if there’s one company that likes to control the message on a new announcement, it’s Apple. And it’s so hard to evaluate this deal without all the details – to my mind, we’re missing three crucial bits of information (besides official confirmation that a deal has been done): the actual price, and the currency (i.e. cash, stock etc), Beats’ financials (helping to know whether the valuation is reasonable) and the strategic rationale. The rumor is that the price is $3.2 billion, but there are no details on the currency. There have been rumors about Beats’ financials, but nothing official from the company itself. And it’s the last point – the strategic rationale – that has everyone scratching their heads.

I don’t have any inside information on any of these three questions, but I thought I’d share a few data points by way of illustrating possible reasons for the deal.

Digital content sales are declining

Firstly, what’s been happening to Apple’s digital content business over the last couple of years. I’ve excerpted the relevant sentence(s) from the company’s SEC filings, and there’s a clear trend emerging:

Apple digital content remarks from SEC filings

Note that a year ago, the company was talking about higher digital content sales, by October it was being vaguer, in January it was talking about flat sales, and in April 2014 it was talking about declines in digital music specifically.

We don’t know exactly what Apple’s revenue breakdown is between iTunes digital content and Apps, but we can get to a reasonably good estimate based on factors discussed in previous posts on Apple. As a result, we have this chart:

iTunes revenue split Apps vs Content

The apps revenue stream is growing at an accelerating rate, while content has started to fall in recent quarters. Digital music is likely the major driver of the decline in content revenues, as downloading is displaced by streaming from services such as Spotify, Rdio, Pandora and others. Though Apple now has an offering in the Pandora radio category, it still lacks an offering in the much more popular unlimited streaming category, and that’s been hurting its revenues. I’ve always assumed that the company could relatively easily launch such a service itself, since it has all the existing relationships necessary to do so, firstly through its long-standing download business, and more recently because of iTunes Radio. At any rate, if it has struggled to sign the appropriate deals, it’s not clear why acquiring Beats would help, since Beats’ existing deal would all be subject to renegotiation anyway with a change of ownership. But I do believe it’s imperative for Apple to launch a streaming service soon, with or without Beats. Perhaps it had decided that the urgency is so great that it can’t wait to develop the technology and sign the deals itself.

Accessories are stagnating

The other possibility is that the strategic rationale is motivated by wanting to boost Apple’s accessories business. Its growth in recent quarters looks like this:

Apple accessories revenues

I’ve included a line that shows 4-quarter trailing accessories revenues as a % of 4-quarter hardware (iPhone, iPad, iPod and Mac) revenues to put it in context. Since accessories are by definition bought to go with hardware, it’s a good proxy for thinking about the “attach rate” of accessories to the core hardware products. As you can see, both trends have flattened lately – both actual accessories revenues, and accessories revenues as a percentage of hardware. Beats could theoretically get both growing again, since it appears to be growing relatively rapidly. Some Beats-related revenue is undoubtedly already in Apple’s accessories line since it sells certain Beats products, but it’s likely a small fraction of total Beats hardware revenues. Beats would likely add about 25-30% to the accessories segment and would get it back to faster growth both in real terms and relative to hardware revenue.

It’s probably about both, and more

Almost everyone commenting on the deal seems to think it’s either about the hardware or about the music service (or about one now, and the other later), and is dismissive of the other. But in some ways what makes Beats such an attractive acquisition for Apple is that it provides help with two major parts of Apple’s business, each around 4% of its overall revenues. If it could get both of those stagnating businesses growing again, that would be a major boon, and $3.2 billion is equivalent to about a quarter of the combined iTunes content and accessories businesses. Given that core hardware growth is slowing too, creating greater leverage around the hardware revenue base (by increasing sales of related items such as content and accessories) is a smart way to keep revenue growth going, at least until a new hardware category emerges.

In addition to that, there’s the branding element, which is so much harder to quantify. Beats has a brand appeal with a certain (large) segment of the population, and it’s likely one with some but not complete crossover with Apple’s brand. That could be a good thing or a bad thing – good in that it has potential to extend Apple’s brand further into that segment, and bad in that the crossover might actually damage both brands among users that have positive associations with one but negative associations with the other.

At any rate, I’m not ready to call this deal inherently good or bad for Apple until we get those three pieces of additional information (and obviously the confirmation). But I do see a strategic rationale across Accessories and iTunes that makes at least some sense.

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