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

Not much is known about Beats' financial condition, but it turns out it might have been in pretty bad shape. Why is Apple taking this risk?

Jun 8, 2014 at 11:00AM

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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.

Leaked: Apple's next smart device (warning -- it may shock you)
Apple recently recruited a secret-development "dream team" to guarantee that its newest smart device was kept hidden from the public for as long as possible. But the secret is out, and some early viewers are even claiming that its everyday impact could trump the iPod, iPhone, and the iPad. In fact, ABI Research predicts that 485 million of these devices will be sold per year. But one small company makes this gadget possible. And its stock price has nearly unlimited room to run for early in-the-know investors. To be one of them, and to see Apple's newest smart gizmo, just click here!

Evan Niu, CFA, owns shares of and has options on Apple. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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