Was Apple's Beats Buyout Worth More Than Money?

Source: Apple.

As the largest publicly traded company ever, technology giant Apple (AAPL -1.88%) is no stranger to breaking its own records. And like most great companies, Apple has its own corporate traditions and norms that have loomed that help explain its disproportionate success.

Although plenty of other examples exist, for the purposes of this article recall that Apple long maintained a strong aversion to highly public and expensive acquisitions, but it deviated from it when it agreed to purchase premium audio maker Beats Electronics for $3 billion last May. And between rumors of a possible Apple buyout of the similarly large GoPro and the recent launch of Apple Music, revisiting whether Apple's unprecedented break with history worked out as intended seems appropriate for current and future shareholders.

A clear financial triumph
Let's just get this out of the way right away, Apple buying Beats was likely a home-run success from a financial perspective. Because while the $3 billion price tag certainly broke Apple's long-standing bias against sizable acquisitions, Beats is also likely a profit powerhouse very much in the same vein as Apple.

Apple acquired Beats as a private company, so it never regularly produced financial reports to give us a definitive sense of its financial performance. However, a steady stream of reported internal leaks suggest the company generated massive profits on each unit of hardware it sold. A report last year from The New York Times claimed that a single set of Beats headphones carried a cost of goods sold of as little as $14, implying its high-end headphones that regularly retail for between $199 and $399 enjoyed incredible gross margins. So, for illustrative purposes, let's look at some grossly oversimplified numbers to get a sense of the likely financial merit of the Beats deal.

Source: Author's calculations.

There are a few things to note here. The first is that this isn't meant to reflect or project Beats' actual financials. But viewing the business in these kinds of stripped-down terms can still prove helpful in framing one's thinking about the deal. Assuming the $14 COGS figure is even directionally accurate, using the 50% profit margin figure here should provide ample margin for error to cover input costs and below the line operational costs (SG&A, R&D, taxes, etc). The key point this chart is really meant to focus Apple investors toward is that Beats wouldn't need to sell that many sets of headphones, speakers, and the like in order to fully recoup Apple's investment.

For reference, a mid-2013 report claimed that Beats had sold 15 million to 20 million headphones since its 2008 founding. And assuming a higher proportion of those units sales were weighted toward the later years as it scaled its operations, we can pretty easily imagine Beats currently enjoys an annual units sales run rate of well over 10 million devices.

It's also worth briefly mentioning that Beats also likely benefited from its allegiance with Apple in a host a ways (distribution breadth, inventory procurement, etc.), so this thinking could quite conceivably understate Beats' ROI profile for Apple. Bottom line: This deal was likely a grand-slam financial investment for Apple, which makes the strategic initiatives that I believe drove the deal almost a free option for Apple. From a purely investment perspective, this deal was likely a home run for Apple.

Strategic merit still emerging
If Apple bought Beats with the sole intent of making money, it likely achieved its objective. However, as one of the most profitable companies in the world, Apple's aims in buying Beats almost assuredly lay beyond merely purchasing a fresh profit stream.

In sizing up Apple's strategic objectives with Beats, Apple likely coveted Beats for two central purposes. First, as often happen in tech buyouts, Apple likely used Beats Music's code to help accelerate the development of its Apple Music that launched in June, rather than developing the product from scratch. And especially given Spotify's ongoing business momentum, finding the quickest path to market for Apple's on-demand music service was essential in keeping Apple relevant in the rapidly shifting digital music market. And if Beats Music even shaved months off Apple Music's development time, the deal also likely made sense, even if Apple was still late to the party.

Another possible strategic rationale for Apple's Beats buyout was its executive team and the possibility that its seasoned leadership could help break negotiation stalemates for long-rumored services like Apple's elusive over-the-top TV product. With Apple's rumored TV service still not even necessarily confirmed by the company, assessing this angle's success lacks any real veracity. However, reports that former Beats executive and music industry legend Jimmy Iovine was instrumental in helping Apple secure its exclusive debut of HBO Now indicate Iovine is active in a dealmaking or negotiating capacity for Apple.  

So, in assessing its value at present, Apple's Beats buyout likely created ample value for Apple shareholders. Although it might not prove the silver bullet some had hoped, it's also likely that Beats has helped strengthen Apple's hand in its pursuit of the above two critical projects. Apple's failures in on-demand music and frustrations in bringing TV to market are more its own fault, if we're assigning blame, rather than Beats'. Don't blame the son for the sins of the father, if you will. So, as the dust continues to settle on Apple's largest-ever acquisition, Apple shareholders should note that its purchase of Beats has probably proven a resounding, if not more nuanced than some realized, success for the world's largest company.