Editors' note: Apple on May 28 confirmed that it's buying Beats for $3 billion.
For once, the intrigue surrounding Apple doesn't involve the next iPhone or iPad. Instead, it's centered on why the Silicon Valley consumer-electronics titan wants high-end-headphones maker Beats Electronics.
Apple is reportedly in talks to buy Los Angeles-based Beats for $3.2 billion, according to reports released Thursday. Established in 2008 by rapper Dr. Dre and longtime music industry executive Jimmy Iovine, Beats is best known for a top-selling line of high-end headphones. Beyond its bass-boosting ear pieces, Beats also plays in the competitive market for subscription-based, streaming music, with a mobile service that, unlike Apple's iTunes and iTunes Radio, offers ad-free, on-demand music listening for about $10 per month.
There's a lot of speculation about why Apple is considering making Beats the biggest acquisition in its 38-year-history (and turning Dr. Dre into the first billionaire rapper), and analysts are puzzled by the choice. Yes, Beats sells a lot of headphones, but Apple, which already sells its own branded in-ear headphones as part of a line of accessories for the iPhone and iPad, could make similar headphones of its own.
Ben Arnold, an industry analyst with the NPD Group, says US sales of premium headphones -- those priced north of $100 -- have surpassed $1 billion, with Beats owning more than 60 percent of that segment. He expects the category to grow by 10 percent to 14 percent this year. Beats headphones are among those prominently featured in Apple Stores.
As for a curated streaming music service such as the one offered by Beats, that's also something Apple could probably create on its own. In terms of the brand, Beats is popular with consumers and dominates the headphone market. But Apple already has one of the strongest brands in the world, with Interbrand ranking it the top global brand in 2013. Beats didn't even rank in the top 100.
And while it's believed Iovine will join Apple to help run iTunes and set Apple's music strategy, alongside current iTunes chief Eddy Cue, $3.2 billion seems like a lot for an aqui-hire."I've got to tell you, I'm scratching my head on this one," said longtime Apple watcher Tim Bajarin, an analyst with tech researcher Creative Strategies.
He's not the only one puzzled. Investors are also mulling over the potential acquisition. Apple shares slipped half a percentage point to $585.54 on Friday, and fell another 0.5 percent in after-hours trading. Apple didn't respond to requests for comment.
Apple has followed a predictable script for the past four decades, shunning big, well-known companies and instead buying small players with talent or core technology -- such as the Siri voice recognition technology -- to supplement Apple's current products or help it offer something new.
Most of those acquisitions have been so small Apple wasn't even required to disclose them. Before Beats, Apple's largest public acquisition on record was the $429 million it paid in 1996 for Steve Jobs' software maker NeXT. In the past 18 months, Apple CEO Tim Cook and his team have bought 24 companies.
One possible explanation for wanting Beats is that Apple might be working on a clandestine project that would benefit from the addition of a music-centric company. Some analysts have also speculated that Beats could help Apple's wearable-tech ambitions, by giving it access to designers and engineers who could create products that are different from Apple's norm.
"Apple has to have something great up its sleeve," said James McQuivey, an analyst with Forrester Research. "Short of something like that, it would cause you to evaluate whether Apple is still Apple."
What Apple gets
On the surface, Beats brings three definable assets to the table: a headphones hardware company; a subscription-based, streaming music service; and a high-profile brand customers are willing to pay for.
The problem is, none of these assets seems like a missing piece of the puzzle for Apple.
Beats' splashy branding and big-name partnerships have resonated with mainstream consumers willing to buy its pricey products. Earbuds start at about $99, while professional-grade, over-the-ear headphones retail for $450.
Since Apple already has the intellectual property and design chops to make its own high-end headphone line, what Cook and his team might get from Beats is access to hardware designers with deep backgrounds in the accessories market. Apple doesn't have a complete headphone line and it hasn't yet offered anything in the wearables market (though its long-rumored smartwatch is expected sometime this year).
Beats would bring "what we believe is an amazing creative team for the design and creation of hardware, primarily accessories that we believe could be very valuable in the context of the wearables market," says Peter Misek, an analyst with Jefferies. "Such a team could help the development of a future iWatch and other wearable products from Apple."
Meanwhile, Beats Music, launched in January, offers a service that, like rival Spotify, offers on-demand, all-you-can-eat streaming music to people who pay a monthly subscription fee. It's a model Apple lacks -- largely because Apple itself has resisted it.
Subscription model surging
Apple founder Jobs was defiant about subscription music for years. He called the subscription model "bankrupt" in Rolling Stone in 2003 and told Reuters "people want to own their music" in 2007. Jobs' death in 2011 didn't precede the introduction of subscription music services -- Spotify launched in Europe a full five years earlier -- but it did precede the turning of the mainstream tide toward them.
In 2011, digital downloads climbed 17 percent to $2.6 billion, with album download sales rising 25 percent, according to the Recording Industry Association of America. Last year, though, permanent digital downloads fell 1 percent to $2.8 billion, while streaming music grew 39 percent to $1.4 billion, the RIAA says.
Paid subscription streaming services like Beats Music grew faster than any other streaming category last year, rising 57 percent to $628 million. Streaming now represents 21 percent of total industry revenue, versus just 3 percent in 2007 when Jobs said "customers don't seem to be interested in it."
People are clearly interested now.
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 -- and from sales promoted by a big red and green "BUY SONG" link included on the screen while a tune plays.
Buying Beats would bring Apple its first-ever music subscription model. But, again, Apple could just as well deliver a service like that, or maybe even a better one, on its own with possibly less hassle.
For one, subscription license deals with the major music labels -- the agreements that give companies like Beats Music and Spotify access to the music they stream -- typically have change-of-control clauses in them. Should Apple buy Beats, it would need to hammer out new terms with the labels. Apple doesn't need to buy Beats to get negotiating leverage: With its iTunes still an essential cog in the music revenue machine, Apple has more clout at the negotiating table than upstart Beats does.
Second, Beats Music --still in its infancy -- hasn't had enough time to build up a subscriber base that would be attractive for Apple to acquire in its own right. The company hasn't disclosed user numbers, but rival Spotify took more than four years to reach 6 million paying subscribers as of March 2013, the last time it updated that statistic. Beats launched publicly less than four months ago. And to put the $3.2 billion Beats price tag in perspective, Spotify's last funding infusion valued the company at about $4 billion.
Third, Beats Music isn't bringing Apple unparalleled technology. Beats bought digital music service MOG in 2012 for $14 million, and MOG's technology formed the skeleton that Beats Music is built on. Since taking MOG under its umbrella, Beats Music has expanded its engineering team and its consumer messaging has largely been to stress the human curatorial bent to its digital service, rather than any particular innovation in its tech underpinnings. Pandora and Spotify both use human oversight, but they put more stock in their algorithms and treasuries of data to serve as recommendation and discovery engines, rather than Beats' angle of touting its tastemakers' lists as being a "service" and not a "server."
One thing Beats does really well is branding.
Touted by Dre, Beats is viewed as a hip brand that attracts buyers across income brackets. What its customers have in common is a willingness to spend big on trendy headphones that have been criticized by audiophiles as lacking the quality they crave.
Still, Apple's brand is strong enough on its own that it's unclear how much it would benefit from the Beats name. But Apple is concerned about its brand. Internal Apple documents presented as evidence in the recent Apple v. Samsung trial revealed that some of executives felt its branding needed an overhaul after Samsung launched its "Next Big Thing" campaign targeting Apple users in 2012. Apple even considered firing its ad agency in early 2013. "We are not getting what we need from them and haven't been for a while," Apple marketing chief Phil Schiller said in an email to CEO Cook.
An executive from the advertising agency told Schiller, via email, he believed Apple's brand was losing some cachet. While Schiller adamantly disagreed, in 2013, Apple unveiled a new marketing campaign around the "Designed by Apple in California" theme.
Of the all the analysts who have weighed in on Apple's possible takeover of Beats, most aren't happy with a possible deal. Instead, they argue that Apple, which has about $150 billion in cash, should expand its capabilities in areas such as digital health and cloud computing. Said Wells Fargo analyst Maynard Um, "Given the changing landscape and our view that Apple will have to reinvent its business model...we believe Apple should be acquiring other assets to better position itself, particularly for $3.2 billion."