Beats Electronics needed Apple. Actually, based on an analysis of legal documents and private financial statements by PrivCo, Beats desperately needed a financial savior. Apple became that savior.
Here's a short version: PrivCo claims last year Beats was "a distressed business by any standards." Margins fell as Beats switched from licensor to manufacturer and assumed the duties involved with handling its own inventory. The company's cash needs -- operations as well as a dividend paid to co-founders Jimmy Iovine and Dr. Dre -- left Beats on the brink of insolvency. Credit rating firms issued warnings on Beats' debt. After numerous potential lenders passed on extending financing, Beats took a one-year, collateralized loan in June of 2013. Just before that $225 million loan came due, Apple acquired Beats for $3 billion.
For the full version check out PrivCo's lengthy online post.
Part of this story lies in the messenger. PrivCo has earned a reputation for seeking publicity by releasing negative analysis. Sometimes it's spot-on. Last year, PrivCo correctly derided Facebook's $38 IPO share price and instead set a value at $25 per share, although Facebook has since posted solid earnings and its share price currently sits at $63.30. Not every analysis hits the mark. In 2012, PrivCo called Spotify's business model "unsustainable," not an uncommon assessment of digital music licensing deals but seemingly unaware that the company's bottom line will improve as it expands around the world and grows over time.
But even if PrivCo has painted a somewhat accurate picture, Apple didn't necessarily make a bad decision. Judging from PrivCo's analysis, Apple is exactly what Beats needed: a top-tier corporation with world-class management and supply chain operations that will help improve Beats' below-average operating margins and find untapped potential in the brand. Beats appears to be better at marketing, industry relations and product concepts than the basic-yet-vital blocking and tackling involved with running a large business.
PrivCo's analysis questions why Apple paid $3 billion for Beats. Using the prices/sales and enterprise value/EBITDA multiples of two Beats competitors, Skull Candy and Harman International Industries, PrivCo values Beats at just $1.1 billion. PrivCo posits "no traditional valuation measure" justifies Apple's purchase price for Beats.
So why did Apple pay $3 billion, if Beats may have merited a much lower valuation? I see three explanations. The first is the value of Beats Music, a subscription service with untapped potential that hadn't launched in the period -- 2013 -- covered by PrivCo's evaluations. Although Beats Music has only 250,000 subscribers, Apple paid a premium for a unique streaming service that it can take global.
The second is a desire by a wealthy company to close the deal. At the end of March, Apple had about $19 billion of cash and cash equivalents and another $41 billion in short-term investments. Although Beats was by far Apple's largest acquisition, Apple has the luxury of overpaying to secure a desired company.
The third and perhaps most important factor: the Beats leadership. Apple's acquisition of Beats is partly an acqui-hire that brings Jimmy Iovine and Dr. Dre to Apple. Iovine and Dre represent the intangible value not found in a traditional corporate valuation exercise. Don't think of the value of Iovine and Dre to a company that does a few hundred million dollars in annual business. Think of the pair's value to Apple, its content negotiations, Apple TV and its efforts to capture market share in the digital living room, and, as PrivCo points out, Apple's soon-to-be-launched wearable technology products like smart watches. Visionaries don't come cheap.
Give Beats credit for not taking a low price. Apple paid a premium even though Beats appeared to have little time to sort out its financial situation. Three billion dollars isn't a fire sale price for a distressed company. Beats may have been distressed, but it didn't negotiate like one.