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Why Apple Is Buying Beats

That’s a bit of a presumptuous headline:

  1. The sale is not yet confirmed UPDATE: The deal was confirmed on May 28
  2. It’s likely no one outside of 1 Infinite Loop will ever likely know the true reasons

Indeed, as Benedict Evans wrote in his weekly newsletter:

The deal [is] something of a Rorschach Blot – people who think Apple has lost its way see this as proof, while people who don’t assume there must be some other piece to the puzzle (TV? wearables?) that we can’t see to make this deal makes sense.

I’ve consistently placed myself somewhere in the middle on Apple: I believe their high end position is secure, but that the high end market is increasingly saturated, making consistent growth a challenge. I think that reality is as good a place as any to start when thinking about this deal.

Apple’s Need for Growth

In an ideal world, Apple could simply focus on making the best possible Macs, iPhones, and iPads, and sell what the market would bear. Unfortunately, life as a publicly traded company isn’t so simple, particularly one with the scrutiny of Apple. Stock price has little if anything to do with past performance (this is why pointing to record quarters as evidence the stock is underpriced misses the point). Rather, a stock’s price is about future earnings. If those earnings are expected to grow, then the stock will be higher relative to today’s earning; if the earnings are expected to be flat, it will be significantly lower; if the earnings are expected to decline, it will be lower still.

This matters for Tim Cook and the Apple executive team not only because of activist shareholders, but also because of the role an appreciating stock plays in employee retention. While a sense of mission is the primary driver for those willing to endure a very difficult workplace, knowing you’re getting rich certainly helps.1

So the need is evident; it’s the means that are much trickier.

Apple Has No Clear Means of Growth

Apple’s growth, or lack thereof, is dominated by the iPhone. Last quarter it accounted for 57 percent of Apple’s revenues after fully realizing the upside from the China Mobile deal (the iPad was 17 percent, the Mac 12 percent, and iTunes nine percent); unfortunately, that was the last of the low-hanging fruit when it came to obvious levers for iPhone growth. I don’t think Apple will ever truly go downmarket; beyond the risk of cannibalization, it’s absolutely the case that the iPhone’s premium status is one of the leading reasons-to-own in China in particular. That said, I don’t think the iPhone is at risk for disruption either. Instead it will grow by single digits, befitting its ~20% share of the still-growing smartphone market.

Meanwhile, the iPad has plateaued, the Mac is growing in a shrinking market, and iTunes app revenue is growing as music revenues decline. None are likely to dramatically offset the iPhone.

There is no next iPhone

The standard response of Apple’s defenders is confidence that the “next iPhone” will solve the growth conundrum. After all, Apple created the Mac, iTunes, the iPod, the iPhone, the iPad, surely something else is just around the corner. But while I agree that Apple is a black swan, uniquely able to create revolutionary new products, this confidence sells the iPhone’s massive success and place in history short.

If you look back over the history of technology, there have been four epochs: the mainframe, the PC, the Internet, and mobile. Each of the first three lasted for about 15 years; we’re in year seven of mobile, and there are no challengers in sight. Based on history, I think it’s fair to assume that iOS and Android will be the primary platforms until 2020, give or take a few years.

In other words, I believe the iPhone will be Apple’s chief revenue driver for at least the next five years. Something like the iWatch may be interesting, but it’s unrealistic to expect it or any other product category to drive Apple’s growth in a meaningful way, at least in the short term. So Apple needs lots of small revenue drivers in place of one big one. And that means accessories.

Apple Accessories and the Case for Beats

Apple has long had two types of products: personal computers (the Mac, iPhone, and iPad), and accessories for those personal computers (the LaserWriter, iPod, and AppleTV). These accessories have been the manifestation of how Apple sees its personal computers being used: the LaserWriter enabled the Mac to be used for desktop publishing; the iPod made the Mac your digital hub; and the AppleTV emphasizes the iPad as the center of your entertainment.2 Notably absent is a leading accessory for the iPhone.

This, then, is the first justification for buying Beats. As I noted immediately after the iPhone 5S launch, Apple has clearly decided to position the iPhone as an aspirational device, embracing its upmarket status and emphasizing its “coolness”. And, given that positioning, it’s difficult to think of a better accessory than Beats.

I’ve been alternately amused and annoyed at geek kvetching over Beats “quality.” For the majority of the population, sound accuracy ranks very low on the list of what makes a pair of headphones great (and, for those that prefer an unnatural bass-heavy sound, accurate sound is a detriment). What Beats realized is that a pair of headphones is one of the most visible items you own; most people don’t choose their apparel based primarily on technical appropriateness, but rather on fashion and comfort, yet most headphone makers emphasize the former. Thus, when it comes to fashion and comfort Beats is so far ahead of the competition that it’s laughable.3 Meanwhile, you can’t find a picture of a musician or athlete without Beats headphones, leading to massive mindshare among young people especially.

The Beats business model is also very Apple-esque: sell a commodity hardware product with a significant markup based on the experience of owning them. And, like Apple, it’s a lucrative one: Beats was reportedly on track to earn $1.4 billion in revenue in 2013, with a commanding 60%+ share of the over-$100 headphone market. Apple’s worldwide distribution could drive that figure significantly higher over the next few years, providing a small but noticeable impact on, you guessed it, growth, both top and bottom line.

Moreover, the Beats music service fills a big hole for Apple; iTunes downloads are declining rapidly, which is problematic not just for revenue but also as an indicator that iTunes is increasingly not a differentiator for Apple hardware. Beats Music could potentially plug both holes.4

Ultimately, Beats solves a lot of problems for Apple: it provides a meaningful revenue stream, it fixes their streaming music hole, and it’s an aspirational music brand that is increasingly rivaling Apple itself with the next generation.

Why, then, the angst among Apple fans in particular?

What is Apple

I think the overriding sentiment among Apple fans is that this move feels so un-Apple-like. Sure, $3.2 billion isn’t much for a company that made $9.5 billion in profit last quarter, but Apple’s previous largest purchase was Next for a mere $400 million. Moreover, Beats’ best attribute is its brand; would Apple really allow that to live on? And if you’re going to make a streaming music service, why not build it on the most popular digital music service in the world? And while Beats may provide an experience, where is the software differentiation that makes Apple’s hardware unique?

Furthermore, as impressive as Jimmy Iovine and team might be, there doesn’t seem to be a great fit with Apple’s tight-lipped culture. And, in general, acquisitions are hard, require a lot of executive attention, and rarely turn out well in the consumer space in particular.

As I’ve contemplated this acquisition, I’ve returned often to my time at Apple University. A central tenet the team emphasized again and again was that Apple was an interlocking organism that relied on multiple characteristics to make it go. One of these was that Apple was functionally organized; there were no product divisions, and the only P&L was the one reported every quarter by the CEO. As I wrote after Microsoft’s reorganization (here and here), this sort of organization is great for developing a few very high quality products, but it does not scale to multiple product lines. Everything connects at the executive level, and there simply isn’t enough time in the day to provide the appropriate level of focus and coordination to make an acquisition like this work.

However, Joel Podolny, the head of Apple University, repeatedly noted that Apple was so big now that change was inevitable; managing and understanding that change would be paramount.

This, then, is what brings this meandering article full circle. Apple Computer the name may have been retired in 2007, but Apple the personal computer company is 38 years old, and very well may have grown as big as it can grow. Is it doomed to simply slowly fade, delivering massive profits and interesting side projects along with a stagnant stock, much like Microsoft in the 2000s? It wouldn’t be a failure of Tim Cook, but more the natural order of such things.

Or are we witnessing a reinvention, into the sort of company that seeks to transcend computing, demoting technology to an essential ingredient of an aspirational brand that identifies its users as the truly with it? Is Apple becoming a fashion house? Think about it: you have Jony Ive as all-up head of design, the equivalent of a Tom Ford or Donatella Versace. There is the hire of Angela Ahrendts – why would she leave the CEO position of Burberry for a Senior VP role? You have an iPhone framed as an experience, not a product. And now you acquire an accessory maker differentiated almost completely by its brand, not its inherent technical quality.

Consider the financial allure: LVMH’s P/E ratio of 21 is low for a fashion brand, yet is 50% higher than Apple’s 14. Tiffany & Co is 62! Moreover, it is high-end fashion that is dominant in the fastest-growing region in the world, Asia, and especially in the fastest-growing country, China. Even with a recent slowdown prompted by an anti-corruption crackdown, China accounted for 29 percent of the worldwide luxury market, although Southeast Asia has recently eclipsed China in growth.

Still, I can imagine the very thought of Apple positioning itself as a fashionable luxury brand is somewhat nauseating for many of my readers. It’s an understandable reaction, and one I somewhat share. I worry that Apple is losing what makes Apple, Apple, especially that desire to make the power of computing accessible for normal people. But I also know that stasis means stagnation, and over the long-run, death.

In the end, I don’t know for sure where Apple is heading, just like I don’t know for sure why they did this deal, but it just might be worth something that they’re headed somewhere.

  1. Microsoft suffered through this problem over the last 15 years
  2. Admittedly, this last one is a bit of a stretch
  3. I am a geek; I own a pair of Sennheiser HD 380 Pros; I am also very aware of how ridiculous they look, and how much cooler every Beats model is
  4. Although there is an inherent tradeoff; it will be fascinating to see if Apple keeps the Android and Windows Phone apps. I suspect not. Apple is a vertical company, which means their services exist to differentiate their hardware, not to be primary money makers

66 thoughts on “Why Apple Is Buying Beats

  1. Gotta say, that I got a little worried about where Apple (read: the values I see in Apple) is headed.

    However, I begin to realise that Apple perhaps needs to transcend into something else/bigger in order to continue to strive.

    I believe that they have a shot of doing this thing right. (In Copenhagen however, where I’m from, Beats are seen as a taudry and cheap, not the price, brand in comparison to B&O and AIAIAI).

  2. While I agree with the general thrust of your article I find the statement that Apple is becoming a luxury fashion brand too simplistic. I think that Apple remains a technology company first and foremost, one that will retain its emphasis on “it just works” relative ease of use. Fashion and Hip coolness have been part of the Apple brand since the days of the white earbud iPod commercials. Steve Jobs compared the iPhone 4 to a Leica camera, ever a controversial product with its German engineering perfection, Swiss International style rationality and eye watering price tags.

    As has often been noted Apple is one of the few brands willing to disrupt itself in order to revitalise itself. I don’t see Apple becoming a luxury fashion brand per se. That implies a focus on fashion first. I see Apple saying that along with all the other things which make relatively expensive Apple devices appealing to a mass market, a keen fashion awareness will help them differentiate their products in an increasingly competitive me-too market for devices. Samsung and no name Chinese OEMs can churn out me-too looking tech products but Apple is positioning itself as the trend setter. As you and others have noted, when it comes to certain heavy use personal items people will pay higher prices for the sense of well being associated with the frequent use of quality fashionable items be they handbags, jewellery, cars, sneakers (trainers), jeans, watches, cars or smartphones. That doesn’t make them a luxury fashion company, it makes them a savvy high-end tech company. Maybe the distinction is a subtle one but I think the choice of wording is important.

  3. “Meanwhile, you can’t find a picture of a musician or athlete without Beats headphones”, surely this is what the Beats marketing effort has achieved. What Google has completely failed to do with Glass is get anything like mainstream social acceptance for wearing the tech. This is much more important for wearables than the tech itself. Beats have shown they know how. Apple’s hires and various leaks and public comments hint strongly at future wearables.

    Mobile phones have always been fashion items. Fashion is about status and identity much more than clothing. Nokia recognised this early on and it was a huge part of their success. Apple has always been (in part) a fashion brand, it’s just that it was a niche tech geek fashion brand and now it has gone mainstream.

    It’s possible to retain the focus on a small number of products that Apple’s organisation is suited for and produce a lot more different looking variants. The key is keeping the hardware and software the same and varying the outer shell. I see experiments here with the 5C and the gold 5S. While at Nokia (back in 2006) I couldn’t understand why they insisted on trying to differentiate almost every product in software as well as hardware when almost no-one used 90% of the features anyway and we could all predict relative success of devices approximately as soon as we saw the industrial designs.

    It’s good that Apple is embracing the fashion side of the business and replacing some of the marketing talent they lost with Steve Jobs.

    Also, purely anecdotal but my brother is a music lover (not an audiophile) who listens to 10s of hours a week as a focussed activity, not just background. He has a pair of Beats and thinks they’re the best he’s had. He’s previously been through about 3 different pairs a year, including Sennheiser.

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  6. I have no issue with Apple buying a cool company with great people who love music, who can help develop a great new music franchise — because music is in Apple’s DNA. Music epitomizes Apple’s present success. But I do hate the idea of Apple buying Beats for some scheme to sell shitty iPhones and iPads. Fuck growth. Not at that cost. I don’t think that’s the reason anyway, because Apple could easily build a buncha shit to drive incremental growth.

    For over a year I’ve heard Tim Cook talk about “incredible plans that we’ve been working on for awhile” and “that we think customers are going to love”. Buybacks and a stock split which he said “shows we’re investing in Apple, we’re confident in what we’re going to do”. Let new products and services be the drivers for real growth. Tim Cook himself said he feels no pressure to “buy” revenue for revenue’s sake, so I have no concern that this is really what it’s about.

    That said, Beats could be a cool addition to the product experience. Why should a best-in-class product have shitty headphones? They should have the best possible standard headphones on the planet. I’m ok with this deal as long as Apple retains its focus on overall strategy and vision, and not some separate tentacle that exists outside of the Apple vision.

  7. The general assumption seems to be that Beats will be folded into the Apple corporate entity (as previous Apple acquisitions have been) but if we acknowledge there are a lot of things different about this deal (profile, price, personalities), does precedent act as much of a guide? Why not run Beats as a separate company?

    Doing so would enable two major things:

    avoid the problems of an internal culture clash; and
    maintain the Beats brand as independent of Apple.

    (It would additionally allow for an effective separate P&L for the Beats unit without requiring Apple proper to change its practices and avoid having to relocate Beats from Santa Monica to Cupertino with the attendant issues that would bring.)

    If it works with Beats, this model could be extended to other brands Apple feels are complementary to its business. Ben refers to LVHM in the article. It’s worth noting that LVHM owns many more brands than the two that are in its name, all of which are organised through subsidiaries with LVHM sitting atop the corporate conglomerate. This type of model is not unique: see also Kering(formerly PPR), Richemont and Gap.

    The conglomerisation of Apple could be means for Apple to achieve growth without requiring major sacrifices to its corporate culture or unusual organisational operations. Given how common this is in the fashion world, it further supports the notion that Arendhts was hired to be more than a senior VP.

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  9. Smart analysis.

    Beats and Apple seems weird on the surface, but when you consider the value of the brand and the potential for a real accessory ecosystem with the iPhone on the one hand and the streaming service on the other, it makes more sense.

    When you take into account the income that it generates in its existing state against the massive piles of cash that Apple has on top of that, it seems very low risk with a high potential for value in the medium to long term.

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  14. Since music is a core part of Apple’s DNA, this rumored acquisition isn’t as odd as it looks upon first glance. This is how I see the Beats Music part of the equation playing out over the next 6-18 months.

    Apple will integrate Beats seamlessly into iOS. Leveraging Iovine’s contacts in the entertainment industry to negotiate with the respective labels, Apple will debut free, ad-supported streaming within iOS. Said streaming will also be tightly integrated with iTunes, so that you can purchase any song or album that you may be listening to with only one click (and biometric verification). Apple will work quickly in expanding this globally to reach 100s of millions of potential customers. If like me, you find commercials interrupting your carefully curated playlists to be extremely annoying, you can pay $10/10 Euros for an ad-free experience.

    Being able to stream 25-30 millions tracks on demand with any iDevice you purchase, would be yet another compelling reason to purchase from Apple.

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  16. I wonder if Apple would consider giving labels a cut of Beats headphone sales, instead of pushing the subscription cost to customers. The financial opportunity in streaming looks absolutely dismal, yet it would be a killer feature for iOS customers if it were free and full featured. I don’t like Apple’s dilly dallying with ads.

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