Here's What Apple was Really After at Beats Electronics

U.S. stocks are roughly unchanged in early trading Thursday, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) up 0.11% and 0.01%, respectively, at 10:30 a.m. EDT. In company-specific news, Apple (NASDAQ: AAPL  ) has confirmed it is acquiring high-end headphones maker Beats Electronics for $3 billion. What exactly is it  getting for that price?

The New York Post scooped the top financial news organizations yesterday when it reported that Apple would finally announce its acquisition of Beats Electronics at a price of $3 billion (approximately $2.6 billion up front in cash, plus roughly $400 million in Apple shares). That is marginally less than the $3.2 billion figure that was initially cited when the Financial Times broke the story earlier this month. As I have written before, this looks like an expensive purchase from an outsider's perspective, so it's worth trying to understand Apple's rationale for the deal.

Source: Wikipedia.

Although Beats Electronics derives the vast majority of its revenue from premium-priced headphones and speakers, Apple appears to be emphasizing the company's new streaming music service, Beats Music, in "selling" the deal. Witness Apple CEO Tim Cook's statement in the press release on the deal [my emphasis]:

That's why we have kept investing in music and are bringing together these extraordinary teams so we can continue to create the most innovative music products and services in the world.

I suppose one could (at a stretch) describe headphones as a "music product," but Apple's senior vice president of Internet software and services, Eddy Cue, was more specific in describing Beats' attraction for Apple [my emphasis]:

Music is such an important part of Apple's DNA and always will be. The addition of Beats will make our music lineup even better, from free streaming with iTunes Radio to a world-class subscription service in Beats, and of course buying music from the iTunes Store as customers have loved to do for years.

None of Apple's hardware executives were invited to comment on the transaction in the press release.

Beats Electronics co-founder Jimmy Iovine said at the inaugural Code Conference yesterday that Beats Music has signed up 250,000 paying subscribers since its launch on Jan. 20 (up from 110,000 in March), a 5% conversion rate relative to the 5 million people who have taken advantage of its seven-day free trial. That's impressive momentum and stickiness for an upstart service, but it still has some ways to go before it threatens Spotify, which boasts 40 million active users, of which 10 million are paying subscribers. Pandora Media (NYSE: P  ) has 70 million users and 3.3 million paying subscribers.

Beats Music is currently only available in the U.S., but joining Apple's ecosystem provides it with a global growth platform. To coincide with the announcement of the acquisition, Beats updated its Beats Music iPhone application, lowered its annual price to $99.99 from $119.98, and extended its trial period for 14 days.

The download model for music is being replaced by a rental model. I wrote that Apple is overpaying for Beats, but if Beats Music fulfills the promise that its suitor envisions, it is possible the deal will turn out to have been a bargain, vindicating Tim Cook's decision to oversee Apple's largest corporate acquisition to date.

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