Beats Deal Could Give Apple More Control Over Various Parts of Its Business

The CE industry was abuzz Friday following reports in the Financial Times Thursday that Apple is planning to buy Beats Audio for $3.2 billion. According to NPD numbers, Beats already has 62 percent of the premium $100-and-above headphone market in the U.S., which topped $1 billion for the 12 months ended March 31. Beats’ Pill wireless speakers have 9 percent of annual revenue in that category, which is forecast to double this year, NPD analyst Ben Arnold said.

Under the rumored deal, Beats would be able to grow its brand beyond the 18-34-year-old demographic, Arnold said. As Apple’s in-house audio brand, Beats would be able to tap into the enormous base of iOS and Mac users spanning various demographics, he said, and Beats would benefit from Apple’s continued expansion into new categories and markets. Apple TV sales have grown 40 percent over the past 12 months, and Beats Audio could help extend Apple’s reach with CarPlay beyond Chrysler, Fiat and Dodge, he said. And, Arnold said, Beats’ crossover into fashion electronics “says their brand or design imprint will be felt” in the wearables market.

The acquisition would allow Apple more control over the user experience on iOS devices and iTunes, Arnold said. Apple’s influence over a user’s music listening experience has thus far ended once headphones or speakers are connected since a large number of users buy add-on headphones instead of the Apple earplugs that come in the box. Bringing Beats aboard “helps Apple promote its design and UX ethos to the emotional components of the product experience -- namely the quality of the sound and the look and feel of the listening device,” he said. “This is an area where Beats excels."

"It’s simply not clear” how the deal might affect other high-end headphone makers distributed through Apple stores, Doug Henderson, president, B&W Group, told us. B&W believes Apple “values their relationship with Bowers & Wilkins” and that B&W headphones are “sufficiently differentiated in the market from Beats to continue to co-exist in their mix.” A spokeswoman for Bose told us the company won’t be making any comments on the news.

Speculation in the mainstream press Friday focused on what was called a moribund digital download market that has been supplanted by streaming services such as Beats Music, which launched in January. Music downloads slipped 2 percent last year, according to International Federation of the Phonographic Industry data, while paid music streaming services jumped 51 percent to more than $1 billion.

Henderson said, “I don’t think we're at the end of the download era, but we may well be at the beginning of the end unless changes are made to the model.” B&W is hoping a healthy competition will emerge between streaming and download music providers and that “the differentiation between streaming and downloading becomes a qualitative one,” with download options moving to higher quality audio. He compared the scenario to listening to radio versus buying a CD. “Both can exist side by side, but I struggle with seeing that balance achieved if streaming actually offers better fidelity,” he said.

Petro Shimonishi, who headed up Denon’s headphone business before moving to Tempur Sealy International in January, said the report “puts all the other headphone companies on the defensive.” The deal could enable Apple to have more control over the headphone market, she said. Historically, headphone makers have been paying Apple royalties and embedding the Made for iPhone (MFI) or Made for iPad chips into remote controls included with headphones, Shimonishi said. Apple cracked down on that over the past year and a half, requiring not only brands, but ODM makers, to pay the MFI license because some ODMs were making headphones with the Apple MFI chip for unlicensed brands. “Because they made headphones for another brand, like Denon, they would buy the chips in bulk and then use the chips in other products as well,” she said. The licenses added “a pretty decent cost” to the bill of materials, she said.

As a result, some headphone makers have been moving away from the costly MFI chips, Shimonishi said. With Android proliferating, headphone makers are moving toward one-button headphone remotes that don’t use the MFI chip but still allow users to play and pause an iPhone, along with Android phones, she said. “The industry started getting smart and getting around it” as pricing pressure mounted in the category, she said. “I wonder how many headphone companies are going to continue making headphones that are fully iPhone/iPad-compatible because of this announcement with Beats,” she posited. She said Apple already lost some AirPlay licensing when Bluetooth became an alternative for music streaming to wireless headphones and speakers.

On the retail side, the deal could be “dreadful” for World Wide Stereo, said Bob Cole, president. The move would be good for Beats and a good move for Apple, extending their reach and distribution, Cole said. Beats product would become Apple product and be sold in specialty audio stores, along with big box stores, he said. The downside of that “is significant because Beats is driving the bus; they're the biggest player in the headphone industry right now,” he said. Profit margins “are tough enough” with Beats, but Apple “is notorious in the distribution of their product for being profitless,” he said. “We could roll over and have 40 percent of our business in that channel all of a sudden be without profit."

Margins in the headphone category range from “extremely good to extremely awful,” Cole said. Manufacturers are having trouble controlling the market amid counterfeiting and “bandits selling at very low margin,” but Beats’ so-so margins are offset by “clean distribution,” Cole said. “They come down really hard on people who break price,” while other manufacturers “have given up and the profit has gone out,” he said. Headphones are a “huge” part of World Wide Stereo’s business and Beats is 40 percent of that chunk, he said.

The deal could be a positive for specialty dealers if it makes Beats “more professional and more sensitive to the fact that specialty items need specialty people to drive the technology,” Cole said. When products become commodities in big-box stores, “it becomes very hard to drive new product and keep it profitable,” he said.

The report has not been verified by either company, and neither Apple nor Beats responded to queries Friday. It’s possible that the deal won’t come off at all, sources noted. “Wall Street definitely doesn’t like it,” Shimonishi noted, citing a nearly $5 drop in Apple’s share price at one point during the day. “When Tim Cook went to visit Tesla in February, there were similar reports of Apple buying Tesla Motors,” Shimonishi said. “This may not come to fruition at all.” Apple shares ended the day Friday down $2.45 to $585.54.