Beats buy is Apple’s play for new cool

In agreeing to pay $3 billion to acquire Beats, Apple Inc. is betting that two music industry insiders can help restore some of its fading cool among young consumers while also helping it reinvent a troubled digital music business.

The largest deal in Apple’s corporate history will include Beats Electronics, which sells headphones and speakers, and Beats Music, which just launched its music streaming service earlier this year. Although the Beats purchase represents a dramatic departure from Apple’s conservative approach to acquisitions, it’s still relatively small by Silicon Valley standards, using only a tiny fraction of Apple’s cash hoard of $151 billion.

Perhaps just as important as the products, Beats co-founders Jimmy Iovine and rapper Dr. Dre will join Apple in unspecified roles. The purchase price will result in a windfall for the two men who managed to create extraordinary buzz around the company’s headphones despite often poor reviews of their sound quality and a music streaming service that so far has fallen well short of expectations.

From the moment word of the deal first leaked several weeks ago, Apple analysts were puzzled about why Apple suddenly wanted to branch into the accessories business or why it couldn’t just build its own streaming service. The limited details revealed when the deal was announced Wednesday didn’t seem to change many minds.

“We struggle with why Apple has to acquire this business versus competing with it directly with a subscription streaming option on iTunes Radio,” wrote Bernstein Research analyst Toni Sacconaghi in a note to investors. “Apple would seemingly have significant advantages versus Beats Music including vastly deeper pockets.”

Apple’s bid for Culver City-based Beats departs from the company’s typical playbook.

For years, the company prided itself on designing and inventing its own products, an approach championed by Steve Jobs and led by its famous design guru Jonathan Ive. Beats headphones and its music app will become the two most significant products offered by Apple that were created elsewhere.

Also, those products will continue to work on mobile gadgets that run on rival Google’s Android platform. While Android has become the world’s largest mobile platform, Apple has refused to make iTunes available on it, although it did so for Microsoft Windows on PCs.

In addition, Apple maintains an insular corporate style, typically allowing only the chief executive and a couple of other top executives to appear and be quoted publicly. With Dre and Iovine, the company is adding two personalities accustomed to speaking their minds when and where they like.

Indeed, Dre caused a stir recently when he bragged in a video that appeared online about becoming the first rap billionaire, in apparent reference to the Apple deal.

Apple did not make executives available for comment. However, in an interview with the Associated Press, Apple Chief Executive Tim Cook said Dre and Iovine will blend perfectly with Apple’s style.

“We have known these guys forever,” Cook said. “We’ve dated, we’ve gone steady and now we are getting married. This relationship started a decade ago, so we know there is an incredible cultural fit. These two guys have a very rare set of skills. It’s like finding a particular grain of sand on the beach. It’s that rare.”

Iovine and Dre were also unavailable for comment.

In a prepared statement, Iovine said: “I’ve always known in my heart that Beats belonged with Apple. The idea when we started the company was inspired by Apple’s unmatched ability to marry culture and technology. Apple’s deep commitment to music fans, artists, songwriters and the music industry is something special.”

Indeed, Apple pioneered digital music early last decade with the launch of the iPod and the iTunes online store, and remains the largest music retailer in the world. But overall, the business of digital downloads is in decline as consumers shift to music streaming and subscription services such as Pandora and Spotify.

According to Recording Industry Assn. of America statistics, digital downloads represented 40% of music industry revenue in 2013, while streaming and subscriptions services had grown to 28% of revenue. According to Nielsen SoundScan, 2014 sales of digital tracks as of May 25 are down 12% from a year earlier.

Apple launched iTunes Radio last year, a service similar to Pandora, but so far it has had little impact with consumers. Meanwhile, more troubling for Apple is that while it boasts of having 800 million iTunes customers, the average amount each iTunes account spends fell 24% to $3.29 in the most recent quarter, according to a report from Morgan Stanley analyst Katy Huberty.

Rather than building its own streaming subscription service, Apple appears to be betting that Beats Music can help it make the rocky transition to streaming.

Launched in January, Beats Music charges $10 a month for access to its song library online. The company also partnered with AT&T to offer a $15-a-month family plan and now has 250,000 subscribers.

That’s well short of established competitor Spotify’s 10 million paying subscribers. However, analysts have noted that Beats could get a huge boost if it were featured in Apple’s App Store, or if it were pre-installed on iPhones and iPads.

“Music is such an important part of Apple’s DNA and always will be,” Eddy Cue, Apple’s senior vice president of Internet software and services, said in a prepared statement. “The addition of Beats will make our music lineup even better.”

Apple gains additional revenue from Beats’ audio business. Beats has 62% of the $1-billion U.S. market for headphones priced above $100, according to NPD Group. And it is endorsed by a number of high-profile celebrities.

But for the most part, the focus Wednesday seemed to be on what the injection of Iovine and Dre into the Apple bloodstream would mean.

“It’s very exciting for content and the relationship between talent and technology,” said Lucian Grainge, chairman and chief executive of Universal Music Group. “It ticks every single box strategically. It’s about a long-term future and the power of music and the power of content.”

The $3-billion purchase is below the $3.2 billion reported previously. That includes $2.6 billion in cash and $400 million in Apple stock expected to vest over an unspecified period of time. Apple said it expects to close before the end of September, the close of its 2014 fiscal year.

The biggest winner in the deal will be private equity firm Carlyle Group, which invested $500 million in Beats last fall for 50% of the company.

Universal Music Group stands to take in more than $400 million in cash, according to a source, a figure that could pass $500 million down the road thanks to dividends and other considerations.

Iovine and Dre also reportedly still hold big personal stakes in the company. One source close to Iovine said that as part of the music mogul’s 2009 divorce, he split all of his assets with his ex-wife 50-50, except for Beats.

“He kept it to himself on the side because it was new,” the source said. “He’s seen this coming the whole way. … The whole thing has been set up around him trying to find a strong, viable buyer. All along.”

Iovine’s move to Apple shifts leadership of Interscope Geffen A&M to new chairman and CEO John Janick, whom Iovine brought into the label in 2012.

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