Apple Beats

Apple Inc. (NASDAQ:AAPL)’s rumored acquisition of Beats Electronics for $3.2 billion seems to have set the tech blogosphere on fire. Some industry observers have struggled to understand the rationale and have delved into Beats’ assets, from the fledgling music streaming service to the industry clout held by Jimmy Iovine, in order to demystify the proposed deal. Interestingly, the secret to understanding this may lie in Apple’s business model itself.

Apple – Beats acquisition: The nice to have

First, let’s attempt to separate “nice to haves” from the actual rationale for the proposed deal.

First, and most obvious, this is unlikely to be a $3.2 billion acqui-hire of Jimmy Iovine and Dr. Dre. As a point of reference, Apple Inc. (NASDAQ:AAPL)’s acqui-re-hire of Steve Jobs (and NeXT) was worth roughly $400 million in 1996. Granted that Apple is far more cash rich today than it was during those dark days, but this doesn’t quite pass the smell test.

Second, this acquisition is unlikely to be about Beats’ streaming service (Beats Music). Licensing rights from music labels are likely to be non-transferable and I doubt they have any technology that could interest Apple Inc. (NASDAQ:AAPL). Most importantly, Beats Music’s subscriber count is just at 200,000 and even that was mainly because of a free trial to AT&T customers. How many subscribers did Beats have before the free trial? 28,000. Worth a couple of million perhaps, but $3.2 billion? No.

Third, this acquisition is unlikely to be purely about the Beats brand. While Beats is certainly part of American pop culture, the value of the brand beyond the US is questionable. It’s certainly not valuable enough to launch new products or product categories under the Beats brand. And re-branding iTunes to Beats is unlikely to increase music downloads when users are migrating to streaming services.

This isn’t to say that Apple Inc. (NASDAQ:AAPL) did not value any of the factors mentioned above. These could certainly have had an incremental impact on the valuation. But the actual rationale is far simpler if we understand Apple’s business model.

Revenue potential of Apple’s iTunes

Analysts who track the revenue potential of iTunes miss the larger point — iTunes is not and was never meant to be a standalone business. iTunes (and other software/services) generate less than 10% of Apple Inc. (NASDAQ:AAPL)’s revenue and a miniscule portion of their profits (profiting from both “devices & services” is difficult). Instead, Apple uses their services, content and application ecosystem to make their premium, high-margin devices more attractive to potential buyers. This premium hardware monetization strategy has seen sharply slowing revenue growth over the past 12-18 months.

So what is Apple Inc. (NASDAQ:AAPL)’s rationale for this deal? As anti-climactic as it sounds, they seem to be buying a premium, high-margin, hardware accessories business — one that seems to be a good fit with their current business model. Beats supposedly generated more than $1 billion in revenue last year, so the valuation (3X revenue) doesn’t seem particularly high. Selling Beats headphones through Apple stores could boost revenue growth, especially given the potential overlap in their customer base. In other words, the rationale seems far simpler than what many industry observers have proposed.

The staying power of Apple’s premium, hardware-based business model could be debated. But if we take that as a given, Beats is a good fit.

This article first appeared on Tech-Thoughts.