Apple: How the Beats Acquisition Fits In to the Big Picture

We're now a few weeks removed from the initial media crush of Apple's (NASDAQ: AAPL  ) Beats acquisition.

The speculation continues about exactly what Apple is going to do with its prize, but at this point, we can step back and think bigger picture. 

Apple Innovates Different
Ideally, when you look at each of a company's many actions, some semblance of a thoughtful, long-term grand plan emerges.

That's what we see with Apple's overall innovation process.

Apple's focus on just a few core products means it takes a good amount of risk with each big launch. To mitigate that risk, it has to be conservative where it counts -- like in maintaining that massive cash hoard that will allow Apple to survive to try again no matter how disastrous the next major product launch may be.

Meanwhile, Apple's innovation process reduces the chances that cash hoard will need to be tapped.

The process is a far cry from the Silicon Valley cliche of hoodie-wearing unstructured chaos -- and it gives me faith that Apple can continue to innovate post Steve Jobs.

Apple uses the standard technique of hiving off new product teams into their own "start-ups" to reduce bureaucracy, but there's a rigor here that's lacking at many other tech companies.

Apple's new product process is kept on track via a program that acts as an intricate checklist. Per the recent book by Leander Kahney, this checklist "detailed exactly what everyone was to do at every stage for every product, with instructions for every department ranging from hardware to software, and on to operations, finance, marketing, even the support teams that troubleshoot and repair the product after it goes to market."

The checklist has the effect of grafting the organizational skills of an accountant onto the creation skills of a techie. Add in weekly executive team product reviews, a seemingly infinite loop of iterations that won't be rushed no matter how much the press and investors clamor for the next big Apple gadget (the iWatch or a full-fledged Apple TV, anyone?), and an obsession with the product above all, and you've got a formidable, repeatable process.

Despite being famous for refusing to cut corners, Apple's process combined with its limited product line allows it to achieve massive wins at very low costs.

How low?

Apple's research and development costs make up less than 3% of sales. If you go back in time and look at the entire time the iPod, the iPhone, and the iPad were being developed, Apple's research and development, or R&D, costs never hit 10% of sales. Yet that R&D fueled a 30-fold lift in sales from when that first iPod launched in 2001.

Apple's $5.1 billion in R&D spend over the trailing 12 months is a tiny 2.9% of sales. Samsung spends twice as much; Facebook spends six times as much! Check it out:

What also needs to be factored in is the alternative to R&D -- M&A, or mergers and acquisitions. By merging with or acquiring companies, a company like Apple is either buying (1) new revenue streams or (2) instant R&D.

Apple has been firmly in the latter camp. It's not trying to make up for lackluster growth by bolting on a huge, game-changing acquisition like a Netflix or a Best Buy. It's basically trying to outsource the innovation process for capabilities outside its wheelhouse. For example, the 2012 AuthenTec acquisition got Apple useful fingerprint scanning technology it uses for the Touch ID in the lastest iPhones.

In the past year alone, Apple has made 17 of these acquisitions. But the beauty of Apple is that these are tiny, tiny buys.

Apple's $3 billion Beats acquisition is seven times as large as any other move it's made in its history (No. 2 is the $400 million purchase of NeXT in 1997 to effectively bring Steve Jobs back into the fold), yet Apple could literally buy Beats 50 times over with its $150 billion cash hoard. Even if the Beats acquisition does nothing, Apple won't be meaningfully negatively affected on the money side.

Put another way, if we added the costs of all 17 of the past year's acquisitions to its R&D costs, Apple's still nowhere near spending 10% of its sales on innovation.

How Beats fits in
With the Beats acquisition, Apple has access to three assets:

  • The Beats paid online music streaming service.
  • Jimmy Iovine (and Dr. Dre).
  • The Beats headphone business.

What's especially interesting is that in the Internet speculation mill, each of the three is being touted as the "real reason" Apple bought Beats. Here's my paraphrase of what folks are saying:

  • The paid steaming service -- which competes with the likes of Pandora and Spotify -- can allow Apple to plug a hole in its music offerings between the free iTunes Radio streaming service and the iTunes music store. Apple's traditionally dragged its feet on streaming because of its success with selling music downloads on iTunes, and its free iTunes Radio experience hasn't been a world-beater. Apple CEO Tim Cook said Beats will give Apple a "head start" versus developing its own paid streaming space organically, arguing that Beats is the "first subscription service that really got it right" through its use of "human curation" in addition to its technology.

Left to right: Jimmy Iovine, Tim Cook, Dr. Dre, and Apple exec Eddy Cue. (via Cook's Twitter feed).

  • Although already in the Apple fold, furthering the relationship with Jimmy Iovine could allow smoother entertainment industry negotiations in areas such as the Apple TV product (the rumored category-killer one, not the disappointing current iteration). Here's what The Wall Street Journal wrote regarding Iovine helping Apple with Apple TV: "[I]t has struggled to strike the deals with media companies and cable providers to make it a reality. The hope, according to one person familiar with the matter, is that Mr. Iovine can help in this process."

  • Beats by Dre sells popular premium headphones (you could spend as little as $170 and as much as $600 on a pair). Think of the upsells to iPhone, iPad, and Mac users.

A mid-tier pair of Beats headphones.

You can easily argue that each of the three acquisition elements fits nicely into Apple's plans -- not just because they fit into Apple's current businesses, but also because each puts a priority on premium user experience and each has the potential to boost Apple's "cool factor" with younger demographics. ("My mom has an iPhone, but she would never wear Beats by Dre!")

Similarly to how Apple figured out long ago that the average person just wants computers, smartphones, and tablets that work intuitively, Beats operates on the notion that the average person just wants a music experience that "works."

Which leads us to ...

The upside potential
It doesn't take much to make this deal a success from a short-term monetary standpoint.

Beats already generates somewhere around $1 billion in sales from its cash-cow headphones (plus a few odd million dollars from the $9.99 monthly fees of the nascent streaming service), so if Apple bought it as a standalone business, that's less than three times sales. That's pricey, but not unheard of.

However, that's not what's happening here. Normal M&A math doesn't apply because of Apple's tremendous ecosystem.

A lot of bad business moves have been made because of arguments of scale and synergies, but Apple's ecosystem is the real deal. For instance, there are a lot of advantages in sharing apps between your iPhone and your iPad. And if you have both of those, it's not a far leap to pick up a Mac.

In the most obvious example of how this deal could work, consider that 80% to 90% of Apple's $170 billion-plus in sales comes from devices you can plug headphones into. It's not hard to see that billion dollars in Beats headphone sales exploding via bundles or upsells at Apple stores and online.

On the other hand, I don't want to put a lot of faith in Iovine as the magic bullet that gets Hollywood to give in to Apple's desire for content deals. He's certainly a celebrity who crosses industries, but his skill and reputation lie as a music guy. And it's not as if he's new to Apple.

He's been in the Apple fold since he met Steve Jobs back in 2002 and helped grease those industry-changing iTunes deals with record companies. But now the relationship is more formal. Any good he does benefits from Apple's scale, even if it's just adding some Jobs-esque flash to complement the more muted Cook.

That said, where he can really add value is on the music side. Besides co-founding Beats, his 10-second biography includes producing albums for a wide-ranging set of artists, including John Lennon, Lady Gaga, U2, Dr. Dre, and Bruce Springsteen and co-founding the rap-heavy label Interscope Records. Like Jobs in tech, Iovine is seen as a visionary in music. As a fellow record mogul said in a New York Times piece, "He can see around corners."

That kind of leadership of Apple's music strategy can be very valuable.

For example, scaling up the Beats subscription service from a quarter-million subscribers to the 10 million paid subscribers Spotify currently has would make it a billion-dollar business. More importantly, a smartly run music strategy can enhance the Apple ecosystem -- rather than just being an upsell once you have the hardware, the Beats streaming service can be a reason you'd want the hardware in the first place. That's certainly worked in the past with iTunes.

Of course, since music was so integral in Steve Jobs' life, it has long held meaning for Apple beyond its role as a hardware sidekick. Music has shown Apple's taste leadership (remember those iconic iPod ads that made Apple the world's de facto top DJ?) and acted to highlight its desire to create an uncompromising, visceral consumer experience.

Blowing Spotify and Pandora out of the water would have esprit de corps benefits beyond the money. Picture every Apple employee as Harrison Ford demanding that you get off their plane.

Beyond Beats: Apple moving forward
Call it a halo effect, an ecosystem, or momentum, but Apple still has it on its side. Other companies can talk about it, but even Google's and Amazon's ecosystems can't compare with Apple's. Consumers aren't salivating on a daily basis at the possibilities of their next new big things the way they are at the completely unconfirmed rumors of Apple's potential forays into the living room or onto the wrist. That's not to mention the upcoming iPhone 6. And no one integrates its high-margin products into an integrated, must-have portfolio like Apple does.

We can grouse about Apple's current revenue growth problems, but most important for Apple's long-term viability is keeping its products loved (and charging a premium for those products).

Looking at metrics like loyalty rates on the iPhone, e-commerce buying rates on the iPad, and market-share gains on Macs, Apple's still way above the competition in delighting its customers.

Considering all this, when we look at an Apple acquisition, we have to ask three questions:

  • Could it be Apple's next big thing?
  • Will it enhance the key products meaningfully?
  • Is it a big risk or a distraction?

In the case of Beats, let's be clear -- it's not Apple's next big thing. That said, the streaming service and Jimmy Iovine's leadership could each meaningfully improve the Apple ecosystem with a better music experience.

Since Apple is decidedly a hardware provider, it's ironic that the hardware part of the Beats acquisition is the part I worry about as a potential distraction. If handled badly, the headphones could not only distract management but also dilute the Apple ecosystem. Still, I don't see a big risk here.

Fitting it all back into the big picture, I'm bullish on the Beats acquisition. It's another good small bet that could have outsize rewards that enhance Apple's organic product development.

But let's not forget -- it's Apple's next few Cupertino-produced products (whatever they are) that will determine whether Apple can remain the largest growth company in history.

As investors, we must keep our focus there. Hopefully Apple will do the same. 

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  • Report this Comment On June 21, 2014, at 7:46 AM, Drichter wrote:

    "Put another way, if we added the costs of all 17 of the past year's acquisitions to its R&D costs, Apple's still nowhere near spending 10% of its sales on innovation."

    Put another way, it turns out that it's not all that expensive to 'research' existing technologies for use in your own products, nor is it very difficult to 'innovate' the iPhone into a bigger screen size (iPad) followed by a smaller screen size (mini).

    It's especially easy when you then take those relatively cheap products and charge a huge markup on them, relying upon the 'luxury brand' halo, carrier subsidies, a locked-down ecosystem and the 'grass is greener' phenomenon to essentially trap customers and limit their options as much as possible.

    Apple is good at what they do, but you are confusing innovation with branding and marketing.

  • Report this Comment On June 24, 2014, at 2:55 PM, TMFBWItime wrote:

    This has me doing a 180' on my initial skepticism around the acquisition. Another wonderful article. Thanks!

  • Report this Comment On June 25, 2014, at 3:13 AM, Tom10Saga wrote:

    Apple Stock News: Understanding Apple’s Acquisition of Beats: http://apple-stock-news.com/2014/06/apple-stock-news-underst...

  • Report this Comment On June 25, 2014, at 7:39 AM, macmonkeytn wrote:

    Don't forget about Trent Reznor keeping his post on board as CCO. He deserves note alongside Dr. Dre and Jimmy Lovine.

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