Dre and legendary music producer Jimmy Iovine were willing to sell a nearly 50 percent stake in Beats to a private equity firm for roughly $500 million nine months ago. That implies a valuation closer to $1 billion. So why is Apple reportedly paying more than three times as much?
In reality, selling almost half of the company for one amount isn't the same as selling all of it for twice as much. I might sell you half of my PBJ for a nickel, but that doesn't mean I'd sell the entire sandwich to you for a dime. What would I have for lunch?
However, even if Beats was worth just $1 billion last September when Carlyle Group (CG) snapped up that nearly 50 percent stake, it still doesn't mean that Apple will be overpaying now. Beats is worth a lot more to Apple than it would be to nearly anybody else.
Drumming Up New Sales
Apple investors are doing pretty well these days. The stock recently hit a new 52-week high, briefly topping $600 for the first time since late 2012. However, Apple still faces challenges. It recently reported a surprising decline in iPad sales. We've seen iPod sales decline for a couple years. And while Macs are holding their own, desktops and laptops in general have been a stagnant market.
In short, Apple has become all about the iPhone. It has grown to account for 57 percent of the company's overall revenue, and that doesn't even begin to include the iTunes and App Store sales that result from iPhone ownership.
Apple is promising new products in the coming quarters, but it doesn't hurt to diversify. It also only helps that Beats is a play on the faster-growing marketplace for Android gadgetry. Apple's been losing global market share to cheaper Android smartphones and tablets for some time. Having Beats in its arsenal isn't just about improving the quality of its own iOS accessories. Beats doesn't discriminate: Its premium headphones, earphones, and Bluetooth speakers work with devices regardless of their OS. Sales to users of non-iOS devices won't go away if Apple buys Beats. Apple will just be able to drum up more sales for Beats by featuring its products prominently at its stores.
Beats isn't just about hardware anymore. Back in January, Beats rolled out Beats Music. The on-demand music streaming service is similar to Spotify -- a platform where music buffs pay $10 a month to enjoy any of the millions of available tracks. It hasn't been as successful so far as Dre and Iovine were probably hoping when it was introduced, backed by a celebrity-studded Super Bowl commercial. Beats claims that millions of people have checked out the service, but record label sources tell Billboard that they estimate the number of paying subscribers to be in the low six figures.
Labels have been reportedly reluctant to give Apple more power in digital music by dealing these rights, but acquiring Beats Music would make those negotiations moot. Apple would have the on-demand service it needs to remain relevant at a time when iTunes Music Store sales are waning.
Of course, it's not just about the hardware and the digital music service. Dre and Iovine are music icons who have succeeded as entrepreneurs. You don't see that very often, and if the rumors are true -- that both will be offered executive leadership positions at Apple -- you begin to see another reason Beats is so valuable to Apple. CEO Tim Cook has fared reasonably well since the passing of Steve Jobs, but he could use some charismatic visionaries to help dig Apple out of its rut when it comes to innovation.
Given all of that, and considering the tech behemoth's enormous cash stash, this would be $3.2 billion well spent.
Motley Fool contributor Rick Munarriz has no position in any stocks mentioned. The Motley Fool recommends Apple and Pandora Media. The Motley Fool owns shares of Apple and Pandora Media. Try any of our newsletter services free for 30 days.