Apple hears the music on subscriptions with Beats. Now what?

After years turning up its nose at subscription music, Apple changes its tune with the Beats acquisition. What does it mean? Jimmy Iovine, for one.

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Dr. Dre and Jimmy Iovine Getty Images

Read into it what you will: Apple is staying coy about its math behind the $3 billion acquisition of Beats, but Beats Music -- the headphones company's fledgling subscription-streaming music service -- got the first shout-out in the computer maker's release about the deal.

A potential focus on Beats Music hints at how Apple plans to stay relevant as consumers' preferences for music change by finally embracing a subscription model it has long shunned. But why Beats? And what will the acceptance mean for the future of Apple? From early signs, Apple seems willing to tap its enormous stockpile of cash to buy what is hard for anyone to build: the cool factor that comes with Dr. Dre and Jimmy Iovine. And early signs elsewhere point to a future where all-you-can-eat music helps downloads rather than hurts them.

Apple has consistently been dismissive of subscription music services like Beats Music, which launched in January with the model that $9.99 gets you all the music you want to hear for a month. Subscription services have been around since Rhapsody launched in 2001, but Apple co-founder Steve Jobs referred to the model as "bankrupt" and insisted "people want to own their music." He was right, for a long time -- download sales in the US grew every year for a decade.

Until last year, that is, when they shrank for the first time ever. Meanwhile, subscription streaming services like current market leader Spotify -- though still small compared to music downloading -- posted the best growth rate of all digital categories, according to data from the Recording Industry Association of America.

Jimmy Iovine, Apple executive

Less tangible is the benefit of bringing Iovine, a significant figure in the music industry, to Apple. Iovine, Apple noted in its release, "has been at the forefront of innovation in the music industry for decades, and he has been an instrumental partner for Apple and iTunes for more than a decade."

Iovine worked as a recording engineer with legends like John Lennon and Bruce Springsteen and as a producer for big acts like Tom Petty & The Heartbreakers, Patti Smith, and U2. He founded Interscope Records in 1990, which eventually became part of Vivendi's Universal Music Group, one of the remaining big three music labels. His label hosted such stars as Dr. Dre (shockingly), Eminem, the Black Eyed Peas, and Lady Gaga.

He also pitched a subscription service to Jobs in 2003. The Apple founder, clearly, was not persuaded.

But Iovine eventually followed that path on his own. He founded Beats with rapper and producer Dr. Dre in 2006, first as a licensor of its brand to headphone maker Monster and then as the maker of Beats headphones itself in 2012. That same year, Beats bought MOG, an on-demand subscription service that won solid reviews but failed to gain much traction. Iovine said that he plans to combine that MOG technology with the Beats brand to create what eventually launched as Beats Music in January.

So what makes him valuable to Apple? Beats headphones success -- the company leads the high-end headphones market -- proves his track record in cultivating coolness and bulldozing savvy marketing to sell high-margin, high price-tag electronics.

"We can see the strategic value in having talent" like Dr. Dre and Iovine join the Apple team, ISI analyst Brian Marshall said in a note, adding that Beats' nascent subscription business can bolster iTunes Radio.

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Jimmy Iovine with Tim Cook, Dr. Dre and Apple executive Eddy CueTim Cook

The 'star-struck' premium

Like those who pay top dollar for a set of cans with the ubiquitous lower case "b" on the sides, Apple is paying a premium, too.

PrivCo, a provider of financial data on private companies, estimates Beats Electronics made about $1.02 billion in revenue last year for a profit of $40 million, which was weighed down by debt payments linked to private equity firm Carlyle Group's leveraged investment last year and big dividend payouts to Dr. Dre, Iovine, and Vivendi, a corporate backer through its Universal Media Group.

"Apple is paying a star-struck valuation for Beats Electronics, based on PrivCo's analysis of Beat's private financials and comparable consumer electronics companies," the data provider said. "No rational analysis can justify Beat's valuation of $3 billion without some unknown strategy only Apple is privy to, such as expanding into headphones used as wearable tech."

The acceleration of subscription music services may have contributed to the premium Apple paid, too. Although Apple could craft its own subscription service, and likely will need to negotiate new licensing deals with major music labels after Beats acquisition anyway, it will gain the human curatorial cachet that Beats Music has marketed as its identity. And though Beats Music's subscriber numbers are limited by its lifespan of just four months, a major partnership with AT&T gave it a jump start into a huge base of potential customers, and it will soon have iTunes' 800 million global registered users to work with.

Music downloads in jeopardy?

But what of the fear that subscriptions will cannibalize downloads? It's a paramount worry for Apple, with its iTunes store still considered the king of the format. Downloads are the biggest source of music sales in the US, and while physical sales still beat digital ones globally, the inflection point is coming based on data trends from the International Federation of the Phonographic Industry, an organization that represents the recorded music industry worldwide.

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The deal wasn't turning any investors' heads Wednesday, with Apple shares up just 28 cents, or less than a percentage point, at $624.29, in after-hours trading.

Apple hasn't shunned the streaming business entirely. In September, it launched iTunes Radio, a Pandora-like streaming radio service that generates revenue from advertising -- but the product was largely a support system for the iTunes store, with red and green "BUY SONG" links included on every screen as tracks play.

Of all the major online music services, only Google's Play Music has offered both a music download store and a subscription streaming service alongside one another. Executives there told CNET the two services are additive to one another, rather than eating the other's lunch.

Put that way, the Beats buy may be an expensive way for Apple to jump into the subscription race and, with the massive scope of iTunes to fuel it, leave all the others in the dust.

 

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