Apple's Bid for Beats: There's a Method in the Madness

Apple Inc. (Nasdaq: AAPL) is not a rash and foolish company, and neither is its CEO, Tim Cook.

So the general condemnation in the media of the possible purchase of Santa Monica, Calif.-based Beats Electronics for $3.2 billion by the Cupertino, Calif.-based tech giant seems a bit premature.

While the deal is not official, the news first appeared in the Financial Times and was quickly backed up by stories in most other major financial news publications. If true, which appears very likely, an announcement could come as early as next week.

AAPL stock barely reacted and was down less than 1% in mid-day trading.

Beats, which sells a very popular line of headphones and recently launched a streaming music service, was founded by hip hop legend Dr. Dre and renowned music producer Jimmy Iovine in 2008.

The deal would be the biggest ever for AAPL (the record is the $400 million acquisition of NeXT in 1997, which brought Steve Jobs back to Apple - the bargain of the century). But for a company that rakes in about $40 billion a year in profits and has more than $150 billion in cash, $3.2 billion is trivial.

Still, the question on everyone's mind is why.

There are lots of reasons it would be crazy for Apple to buy Beats:

The main business of Beats is selling headphones; Apple hardly needs to drop a lot of coin for that. It already designs its own earbuds. The Beats music-streaming service is relatively new and small with about 200,000 subscribers. And Apple already has an iTunes streaming service (though it hasn't exactly caught fire). Beats has revenue of about $1.4 billion a year. AAPL has revenue of nearly $180 billion. The deal clearly doesn't work as a strategy to "buy growth." Beats is a very hot brand, particularly among young consumers. But Apple is already one of the best-known and liked brands on the planet. Apple is no stranger to acquisitions, but it has never made big, splashy acquisitions. And usually the smaller companies it buys have some sort of technology it plans to adapt. Beat doesn't seem to possess anything Apple doesn't already have.

Veteran AAPL analyst Gene Munster of Piper Jaffray had a typical reaction, sending out a note that said the acquisition "sounds like bad deal."

Munster said he'd rather see Apple spend its copious cash on something in the Internet services space such as Yelp Inc. (Nasdaq: YELP), Twitter Inc. (NYSE: TWTR), Square, or Yahoo! Inc. (Nasdaq: YHOO).

"We are struggling to see the rationale behind this move," Munster wrote.

What could Apple possibly be thinking?

Here's a closer look...

Why Apple Inc. (Nasdaq: AAPL) Could Be Buying Beats

We have to start from the premise that Apple has a good reason for buying Beats, even if that reason isn't obvious.

Hopefully Cook will explain himself if and when the deal becomes official. But we can make a few informed guesses in the meantime.

One possibility is that Apple feels that Beats could help with its music-streaming strategy.

Despite having the capability, AAPL purposely shunned a streaming model for years because Steve Jobs hated it. He was convinced people wanted to own their music.

And for a while, Jobs appeared to be right. Sales of iTunes downloads soared while streaming music companies struggled.

But in the past few years, that trend has reversed. Pandora Media Inc. (NYSE: P) has 75 million active users, and Spotify, which is planning an IPO this year, has 24 million active users. And those numbers are growing.

Apple's iTunes Radio, launched last year, has gained some users - about 20 million - but hasn't gained the kind of traction the company would like. And it's not available on devices that run Google Inc.'s (Nasdaq: GOOG, GOOGL) Android, which dominate the market.

This is where Beats could help.

AAPL could see Beats as a way to attract younger users to iTunes Radio - by adopting the Beats brand.

While Apple has a strong global brand, it's not as hip as used to be and certainly doesn't have the same "cool factor" that Beats now has. That's what happens when you become the largest company on the planet.

It would also be less awkward (and a little bit sneaky) for Apple to port a Beats-branded music streaming app to the Android platform.

The Beats headphones business would be a bonus for AAPL, which already sells the gear in its stores. While critics think the headphones are junk, young people are willing to pay a premium for them - anywhere from $170 all the way up to $450. And they carry a tidy 33% profit margin, which is just short of Apple's average.

For that matter, Beats would supply $450 million in cash flow, which makes it a much better addition than many of the profit-starved companies Apple's competitors have been spending billions on like WhatsApp.

Another big reason AAPL may be going after Beats is for the insights of Jimmy Iovine.

In an interview with The Wall Street Journal last year, Iovine criticized iTunes but offered a lot of ideas on how to fix it, particularly in the area of curation - the context in which you're listening to music (exercising, driving) and the order in which you hear the songs.

"iTunes was great, but it needs to step forward now," Iovine told the Journal. "Most technology companies are culturally inept. They're never going to get curation right."

So why do you think Apple is looking at buying Beats? Will it turn out to be a brilliant move or a colossal blunder? Speak out on Twitter @moneymorning or Facebook.

AAPL stock recently breached the $600 mark for the first time since November 2012. Beats deal aside, Apple has been making a lot of moves lately - and investors have been cheering most of them. Here's why AAPL should keep going higher in 2014...

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