Apple Buys Beats for $3B; Hits 52-Wk High - Analyst Blog

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Confirming earlier rumors, Apple Inc. AAPL recently announced that it is acquiring Beats Electronics for $3.0 billion ($2.6 billion in cash and $400.0 million in equity). To date, the deal is Apple's largest buyout. The acquisition is expected to close in the fourth quarter of fiscal 2014 and will be accretive to Apple's fiscal 2015 bottom line.

Shares of Apple reached a new 52-week high of $629.83 on May 28. Following the news, shares increased 58 cents to $624.59 in after-hours trading. Year-to-date, Apple shares are up 12.8% compared with 4.3% increase in the S&P 500.

Beats Electronics founded by rapper-producer Dr. Dre and music producer Jimmy Iovine is popular for its “Beats by Dr. Dre” headphones, priced within $170 to $450. Its $10 a month streaming service has gained significant popularity due to aggressive marketing, promotion by celebrities such as Ellen DeGeneres and partnerships with AT&T T and Target TGT.   

The Beats service has 250K paid user base, which is much smaller than rivals Spotify and Pandora P. However, Apple believes that the Beats streaming service will be able to attract 800 million iTunes users with its unique “Right Now” offering. Under this offering, users are allowed to create a playlist of their choice based on four variables: a place, an activity, a person and a genre of music.

As revenues from music-download continue to decline at a rapid pace, subscription-based services are expected to be the next life-line of the music industry. Beats service will not only complement Apple's ad-based music-streaming service iRadio amid growing competition, but also develop into a steady recurring revenue stream for the company in the long run.

Apple's strategy of allowing Beats to continue to use its own brand-name will attract quality-conscious users. Beats founders who have good connections in the music industry will also join Apple on a full-time basis. This will help in the continuous expansion of Beats music library (more than 20 million songs at the time of launch), which will be a key differentiator against competing offerings, going forward.

Nevertheless, the acquisition price seems too high for a company, which was valued only at $1.0 billion in its latest round of private funding by the Carlyle Group. In Sep 2013, Carlyle invested $500.0 million for almost 50.0% stake at Beats. The reported deal will hand over a net $1.0 billion profit to the group.   

Although Apple expects the deal to be profitable in 2015, we believe that intensifying competition will be a major headwind. Despite all the growth forecasts for subscription-based steaming market, service providers are finding it difficult to grow paid user base. Services like Pandora have yet to report profit, which is a major concern for investors.

Although Apple's loyal customer base is a big advantage in this regard, we believe that the company will take substantial time to gain a strong foothold in the market. Moreover, Beats Music pays a higher loyalty to labels compared to its peers, which can hurt Apple's profitability in the near term.

Currently, Apple has a Zacks Rank #3 (Hold).


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