Was Apple’s Inc. Beats Deal A Bad Investment?

Examining whether Apple’s Beats buyout might have actually been a Beats bailout instead.

Jun 12, 2014 at 12:01PM

Like it or not, tech giant Apple (NASDAQ:AAPL) and Beats are now one and the same.

Beats Music Logo

Source: Beats

With the ink officially dried on Apple's larger than ever acquisition, its $3 billion dollar purchase of Beats that was agreed on late last month, Apple investors have been busy trying to get a sense of exactly what they received in Beats. 

Sure, we all know Beats iconic headphones as well at its Beats Music subscription service. There's also the parallel storyline that Apple largely acquired Beats in order to "acqu-hire" its two top executives, music industry visionaries Jimmy Iovine and Dr. Dre.

But even as Apple's management team shelled out some $3 billion of its admittedly massive cash hoard, there still hasn't been much revealed about the financial state of affairs at Beats, until now.

Inside Apple's $3 billion toy
One of the challenges in gauging the overall desirability of Beats from a financial standpoint is the fact that Beats was a private company. Thankfully, well-respected private valuation company PrivCo ran its own analysis of the Apple-Beats merger, and its findings revealed a number of alarming insights about the financial state of affairs at Beats.

Although vague details leaked to the press stated that Beats revenue was in the billions and "was profitable," PrivCo's analysis portrays Beats as a company with below-average financials that served in no small degree as a mechanism to enrich its famous founders. Interestingly enough, Beats bulldozed its business model in 2012, shifting from being a higher margin brand licensor to in-sourcing the actual manufacture of its iconic headphones, to disastrous effects on its financials. By PrivCo's math, Beats generated a mere $67 million in operating revenue on sales of just over $1 billion in 2012, while also encountering all kinds of working capital management issues.

Moreover, Beats also carried a massive debt burden as it required additional working capital to finance its 2012 business model shift and further its international expansion. And after escaping a bankruptcy scare in mid-2013 by barely being able to refinance some of Beats' then-current debt, Beats still layered on $530 million in fresh debt to its balance sheet last October to finance a dividend for its founders. All told, Jimmy Iovine and Dr. Dre each received $215 million in cash payouts financed by that fresh debt from private equity giant Carlyle Group.

PrivCo's analysis certainly paints an ugly picture of the on-going state of affairs at Beats. All told PrivCo concludes Beats should have commanded a fair value of $1.1 billion.

Doesn't change much for Apple
Coming from Privco's perspective, this news is enough to incense any Apple shareholder. However, it's important for Apple investors to look at this from a higher-level perspective before rushing too quickly to judgement.

By now it seems the conventional wisdom about Apple's thinking in buying Beats is that it was simply a talent grab to land Dr. Dre and, probably more importantly, Jimmy Iovine to help break the stalemate that Apple's reportedly encountered in its pursuit of content deals for its long-rumored advanced Apple TV product.

And if that's indeed the case, then this deal still makes sense at the probably elevated $3 billion valuation Apple will pay Beats. Although the line-item has grown to include more than just iTunes, Apple's digital offerings generated $16 billion, or roughly 10%, for Apple's sales in fiscal year 2013, while also acting in many ways as the foundational glue for Apple's uber-sticky ecosystem as well.

The specifics of what will go into Apple's long-awaited television offering remain anyone's guess. But if Apple can come even close to replicating the home run success that it achieved with iTunes, the $3 billion it spent on Beats will be worth every penny for Apple shareholders, sky-high valuation or not.

Leaked: Apple's next smart device (warning, it may shock you)
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Andrew Tonner owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.

4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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