Is Beats Becoming a Headache for Apple, Inc.?

With quality issues, shuttered products, and lawsuits, Beats seems unlike Apple's second-largest acquisition NeXT.

Jamal Carnette, CFA
Jamal Carnette, CFA
Jun 23, 2015 at 8:00PM
Technology and Telecom

Image Source: Flickr user Kārlis Dambrāns.

Apple's (NASDAQ:AAPL) never been the type of company to engage in high-priced splashy acquisitions. Cupertino does buy other companies, nearly 70 known as of last count, but the company typically buys semi-finished goods or technologies it can use in its devices to improve the user experience. Even its arguably most successful acquisition, the purchase of NeXT -- and more importantly, the acqui-re-hire of Steve Jobs -- only cost the company $400 million.

The NeXT acquisition is Apple's second largest by price tag. Topping the list is the 2014 purchase of Beats Electronics, as Apple paid $3 billion for the streaming music service and headphone maker. While it's too early to declare the acquisition a success or failure, the deal has presented Apple with a few headaches.

Possible product issues
On the hardware side, it appears Beats' products are of lower-quality than Apple users are accustomed to from the company. According to venture capital firm Bolt (hat tip to fellow Fool Evan Niu), a teardown of Apple's Beats Solo headphones that was posted on Medium found Beats uses snaps and glues as fasteners to save money rather than durable screws. Perhaps more shocking is that Beats uses tiny weights for the sole purpose of making the product feel like high-quality, durable headphones.

Recently, Variety reported Beats was deep in development of a new speaker product designed to compete with Sonos. Apple reportedly shelved the product after the acquisition due to numerous problems in the development process, including switching chipset vendors and postponing the launch date more than once. While most technology companies have products that don't make it to market -- even Apple shelved its TV set -- these two disclosures point toward process, manufacturing, and design issues with Beats' products.

Lawsuits and more lawsuits
Quickly after Apple announced the merger, Beats was sued by headphone competitor Bose for supposedly infringing on its noise-cancellation patents. The lawsuit was settled out of court, with terms undisclosed, but bad blood remained that culminated in Bose's products being briefly pulled from Apple Stores. Tensions were eventually diffused, and Bose products -- including its noise-canceling headphones -- are now available through the Apple Store.

However, another lawsuit could be even worse for Apple. Per Bloomberg, Noel Lee of high-end speaker-cable manufacturer Monster is moving forward with his lawsuit against Beats founders Andre Young (aka Dr. Dre) and Jimmy Iovine, accusing them of "stealing the design, manufacturing, and distribution rights" of the brand. While Apple is not a named defendant, Bloomberg reports Apple's lawyers are defending Young and Iovine.

Alleging wrongdoing in the sale
The lawsuit centers around a "change of control provision" that stipulated if Beats Electronics were sold the new owners would no longer be required to do business with Monster as the manufacturer. And that's exactly what happened: In August 2011, years before Apple bought the company outright, HTC bought 51% of Beats from Iovine and Young for $309 million, valuing the company at $606 million. In June 2012, Beats and Monster ended their manufacturing relationship.

The issue, from Lee's perspective, is less than a month after Apple parted ways with Monster, which only was possible due to the change of control provision, Iovine and Lee bought back half of the 51% interest they sold to HTC, with private equity firm Carlyle buying the other half of HTC's stake for $501 million -- good for a valuation of nearly $1.95 billion. Lee alleges the sale to HTC was essentially a sham designed to trigger the contractual clause and cut Monster out of its contracted manufacturing rights. Supposedly, a member of HTC's board told Monster executives that was indeed the case.

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Will this become a major issue for Apple? Probably not, although Apple did subsequently revoke Monster's MFi license to make official third-party accessories since it said the relationship was no longer "mutually beneficial." Overall, the dispute centers on the $150 million Lee would have made if he would have kept his initial 5% stake he willingly sold back to the company, as this was independent of the manufacturing deal. Even if Apple paid the full amount, it would amount to less than 1% of Apple's cash. However, it seems the Beats deal has brought considerably more headaches than Apple's second-largest acquisition, NeXT, which bought Steve Jobs back to the company.