Did Apple Inc. Merely Put Beats Out of Its Misery?

Apple's (NASDAQ: AAPL  ) $3 billion acquisition of Beats is the company's largest purchase ever. This we know. Since most of Apple's acquisitions tend to be of small private companies (with AuthenTec being an exception as the most recent publicly traded acquisition), investors typically don't get a lot of insight into the financials of Apple's acquisition targets.

The Wall Street Journal pegs Beats' 2013 revenue at $1.3 billion, and its sources say the total price tag was allocated as $2.5 billion for the headphone business, with the remaining $500 million for Beats Music. That might not seem too shabby, but those are only top-line figures that don't speak to Beats' underlying profitability beyond a vague statement that Beats "was profitable."

Peeking under the hood
PrivCo, which specializes in gathering financial data on private companies, has released a detailed analysis of Beats' financials -- and it's ugly. In fact, Beats may have been in absolutely terrible financial condition, flirting with bankruptcy in 2013.

Before 2012, Beats was merely a brand licensor and marketing machine. Monster Cable, the maker of high-end cables, designed, manufactured, and distributed the Beats headphones. According to PrivCo, 60% of Monster's revenue was coming from Beats products by the end of 2011. Licensing businesses tend to be very high-margin enterprises, and Beats originally was no different.

Things changed in 2012, though, when Beats decided to transition its business model to actually producing its hardware. The challenge there is that operating a licensing business and running a physical consumer-electronics company are very, very different. The latter requires significant working capital to manage inventory, pay suppliers, and handle retail distribution, among other things, and margins are much slimmer.

All the while, Dr. Dre and Jimmy Iovine were extracting cash in the form of hefty dividend payouts. Much of the revenue growth that Beats touted at this time was just a consequence of its business model transition, since now it would recognize revenue on the products themselves instead of just royalty income.

For these reasons, Beats levered up with hundreds of millions of dollars in debt -- debt that Beats continuously had to refinance at increasingly unfavorable terms, as many lenders walked away after seeing Beats' financials. Beats' inventory turnover and operating margin were below industry standards, and well below those that Apple enjoys.

Less than a year ago, Beats was able to secure a $500 million loan, which helped fund a $530 million dividend payout to equity holders. That included $215 million to Dr. Dre and Jimmy Iovine each.

Apple to the risky rescue
As if Apple investors weren't already confused about the Beats deal, these new financial details, if accurate, make the Mac maker's largest acquisition even more mind-boggling. Throughout the due-diligence process, Apple must have seen all of Beats' digits, and still decided to move forward with the deal.

Once the deal closes in the fiscal fourth quarter, Apple may have to disclose various aspects of how the acquisition's value was broken down given its size. Investors should keep an eye out for the subsequent 10-K to see how much of the purchase price is allocated to intangibles. That will quantify the impairment risk that Apple faces should Beats backfire.

Apple can afford to start taking more risks with acquisitions, but that doesn't mean it should throw caution to the wind.

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Read/Post Comments (7) | Recommend This Article (5)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 08, 2014, at 11:08 AM, TMFAeassa wrote:

    Superb analysis, Evan. Thanks for writing!

  • Report this Comment On June 08, 2014, at 12:53 PM, lutherwilliam wrote:

    The more that's disclosed about Beats the is the potential damage done to Apple's once respected name. Monster commanded premium prices for cables that were obscenely overpriced but known for quality. When the company turned to small bluetooth speakers and FM transmitters for cars, they produced unworthy junk--sporadic operation, distortion, overpriced at any price. Why would Apple bother to give away 3.3 billion to a categorical loser?

  • Report this Comment On June 08, 2014, at 5:06 PM, WineHouse wrote:

    How did PrivCo get their hands on this financial data in the first place? (I'm assuming Evan Niu purchased a report from PrivCo).

    Just wondering.

  • Report this Comment On June 08, 2014, at 5:31 PM, WineHouse wrote:

    Here's an excerpt from an article posted Feb 14 - 15, 2013 on the New York Business Journal website, by Gary M. Stern, entitled "PrivCo gets private companies to talk, which makes Sam Hamadeh a go-to source -- if you can catch him"

    -- (these are direct quotes from the article):

    "Asked how PrivCo unearths the finances of many private companies that often prefer to keep that data confidential, Hamadeh, at first, parries the question. “We can’t give away too many trade secrets,” he retorts, but then he says the firm “gets insiders to talk.” PrivCo’s staff offers myriad skills including forensic accounting, reviewing investment journals, and knowing where private companies must report financial documents.

    Moreover, Hamadeh invested some of the millions earned from selling Vault.com into building a technology platform that uncovers insider data."

    The article also notes that PrivCo has 30 employees.

    I find the idea of a "technology platform that uncovers insider data" rather mysterious -- in fact, I cannot figure out what it means, with respect to privately-held companies.

    The subscription costs and/or individual-reports costs are quite high. This is how the company makes its money.

    I remain somewhat skeptical -- there's really no way to determine whether or not the information in the reports are valid.

  • Report this Comment On June 08, 2014, at 8:54 PM, Breaker18 wrote:

    C'mon. There is no way this Company with 50% profit margin s was on the verge of bankruptcy.

  • Report this Comment On June 09, 2014, at 9:28 AM, turbo wrote:

    If the private owners were really "milking it" as described (borrowing $500 million to pay a $500 million dividend) then a profitable company could eventually go bankrupt.

    More likely they had already made plans to sell, and just wanted to get back as much as they could up front.

  • Report this Comment On June 10, 2014, at 3:06 AM, 1audio wrote:

    Most of the Beats products (and consumer electronics as a whole) are sold through "big box" retailers. Those retailers command a substantial margin on the products in the accessory class like headphones. Often the margin is more than 50% of retail leaving very little for a manufacturer. The numbers in the report seem realistic for the kind of operation Beats is operating.

    Apple usually forces the retailers to take a much smaller margin. With the competitors in the headphone segment that may not work.

    Usually very little of the original company survives a takeover like this. I would expect the existing margin structure and sales channels to change a lot if there is any merger of the two entities. Otherwise what was the point?

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