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 []