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Why Apple Is Betting Big on Beats: Hardware for Now, Streaming for Later

Beats sells lots of headphones, but so far it hasn't sold many music subscriptions. Apple thinks it can change that.

Peter Kafka covers media and technology, and their intersection, at Vox. Many of his stories can be found in his Kafka on Media newsletter, and he also hosts the Recode Media podcast.

Apple is set to make the biggest purchase in its history: A $3 billion-plus deal for Beats, the company that sells high-end headphones and recently launched a streaming music service.

The deal, first reported by the Financial Times, isn’t closed yet, according to people familiar with the transaction. But let’s assume it is going to go through, generating a big payday for co-founders Jimmy Iovine and Dr Dre, as well as investors who include the Carlyle private equity firm, Len Blavatnik’s Access and Universal Music Group.

Next question: Why is Apple doing it?

Apple has more than $150 billion in cash on its books, so it’s easy enough for the company to pull the trigger. But Apple has traditionally kept its M&A activity to smallish pickups of technology companies, not spending billions on established brands.

What has changed now?

The best way to think about Beats, for now, is as two separate deals. In one, Apple gets an electronics maker that has trained lots of people to spend money on headphones with high price tags, even though some audiophiles don’t think highly of them. Industry sources peg Beats’ electronics sales at more than $1 billion a year.

Marrying that business with Apple’s established design and product operation, overseen by Jonathan Ive, could give Apple a new series of product lines and/or new channels to push out new products like the rumored iWatch.

It’s likely that Apple is more interested, long-term, in the potential of Beats Music, the subscription streaming service.

Apple helped reorder the music business when it launched its iTunes music store in 2003 and began selling digital songs for a dollar apiece. Over the years, Apple’s lock on the digital music market helped propel its sales of hardware like iPods and iPhones, since it was easier for people who had built music collections with Apple to keep using its products instead of rivals. And former Apple CEO Steve Jobs was famously resistant to the subscription model.

But download sales have been flattening for years and are now declining, due in part to the rise of streaming services like Pandora and Spotify, which offer ad-supported free music, served via the cloud, as well as paid options.

The decline in iTunes music revenue isn’t material for Apple, which now makes much more from the sales of apps than it does from music and other media. But apparently Tim Cook thinks the company needs its own streaming service instead of one run by outsiders.

Beats Music, which launched in January, hasn’t been a roaring success: Industry estimates put the company’s subscriber count at around 200,000 users, driven overwhelmingly by a marketing deal with AT&T, which is giving its customers a free trial.

Beats chief Jimmy Iovine had publicly announced that his first goal was to hit 500,000 subscribers, which would still leave it far behind Spotify, which is thought to be closing in on 10 million paid subscribers. Last month, Beats indicated that it felt pressure to grow beyond its AT&T base by agreeing to sell subscriptions via iTunes, which takes a 30 percent cut of any revenue Beats generates from sales inside its store.

If Apple wanted to, it could certainly have built a streaming subscription service itself; the company had been floating the notion of one with label executives in recent months. But it’s possible that Apple’s most recent attempts to extend its music business beyond the iTunes store helped convince Cook that he was better off getting outside help.

Both iTunes Match — Apple’s service that let users store their own music on its servers — and iTunes Radio — its attempt at a Pandora-like service — have been disappointments to the music industry, and even Apple loyalists won’t argue that they’ve been successful. So rather than trying to build another service in-house, why not speed things up by buying a turn-key operation?*

That’s the kind of thinking Apple’s rivals at Facebook and Google have been comfortable with for years, as they’ve splashed billions on acquisitions like Motorola and WhatsApp. If the Beats deal means Apple has changed its perspective, Silicon Valley deal-making may get much more interesting.

* This assumes that the music labels that have licensed Beats want to create new deals with Apple, since the rights won’t transfer after the sale. I’ve heard split opinions on this.

Additional reporting by Ina Fried, John Paczkowski and Dawn Chmielewski.

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