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Apple buying Beats for $3.2 billion? Smart move

Music to Apple's ears?

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Not to malign members of my own demographic, but it seems a lot of 40-something white guys are simply incapable of fathoming why Apple (AAPL) might want to pay $3.2 billion for Dr. Dre and Jimmy Iovine’s Beats business.

I think they’re probably missing the big picture, or at least that’s what my two teenagers and the tween told me at breakfast. Adding a fast-growing, super-high-margin headphone business and a slick, Apple-like music streaming business for a cool 0.6% of Apple’s market cap seems pretty smart to me. But not to everyone.

Related: Will.i.am: Beats is the answer to a growing void in music industry

“I am not familiar with the demographics of Beats,” writes BTIG analyst Walter Piecyk. As Jon Stewart might say at this juncture: Go on…

“But citing youth can be code for lower credit classes,” Piecyk notes in a perhaps too quickly written analysis of the rumored deal. He goes on to sum up three popular objections: Apple is a cool brand that doesn't need Beats, Apple is already popular with young people and Beats customers aren’t very Apple-y.

Blogger John Gruber says the deal “doesn’t make any sense to me.” Wall Street Journal tech columnist Chris Mims tweeted, “This is not the Apple we knew” and “Youth culture brands are by their nature fleeting in popularity.” Piper Jaffray analyst Gene Munster, in his research note, is “struggling to see the rationale behind this move.”

Why the deal makes sense

First, let’s start with why the deal makes sense and then address some of the risks raised by critics, many of which are legitimate issues to consider.

Apple has been the leading music seller in the world for many years, thanks to Steve Jobs and his team’s foresight in adding iTunes and the iTunes Store to the iPod business early on. It’s notable both that the iTunes software came from outside the company (it was based on a program called SoundJam) and that the store’s business model of selling single music tracks for 99 cents completely upended the then-dominant retailing strategies.

[See related: Beats deal shows Apple has finally woken up to reality]

But lately, all is not well in iTunes land. The software has become bloated and unwieldy. Sales of music tracks have slipped as more music lovers have begun using streaming subscription services such as Spotify and Pandora (P), or watching for free on Google’s (GOOG) Youtube.

And Apple’s own efforts to bolster its music business, including the shuttered social network Ping, the modestly popular iTunes Match service and the new streaming app iTunes Radio, have thus far failed, at least from a financial perspective. Apple has also unsuccessfully offered high-end audio gear (raise your hand if you actually remember the Hi-Fi Stereo).

That led to some fascinating behind-the-scenes reporting this spring that Apple and its pals in the recording industry were contemplating a few semi-radical ideas. Maybe offer iTunes for Android phones. Maybe create a subscription service to take on Spotify directly. But Apple’s track record thus far wasn’t great, and putting its brand on Android could be risky if it was seen as an endorsement of that platform, or lessened the appeal of iPhones.

Buying Beats could provide a smarter and less risky way for Apple to address its music challenge.

The Beats brand is dominant with people spending a lot of money to satisfy their love of music, carrying a market share of 60% in the high-end headphone business, according to NPD. It’s also popular with celebrities and music stars. And it could remain a separate brand in the Android market, where the Beats Music app is the 7th-most-popular free music app (admittedly behind Pandora and Spotify but ahead of Google’s own music-service app, as well as Rdio, Amazon MP3 (AMZN) and many others).

The app itself is also pretty cool, or "wicked awesome," as we say in Boston. The design is different than most other services, with a unique feature that creates playlists based on your mood, location and activity. Yahoo Tech reviewer Alyssa Bereznak found it among the best of its kind, though she thought it needed a longer free trial period. Wall Street Journal reviewer Joanna Stern liked Beats best of all.

Meanwhile, iTunes Radio is part of Apple’s crowded Music app, breaks no new ground in design and hasn’t been substantially improved since it was introduced last year. From Apple’s point of view, the app has done little to improve download sales or stem the momentum of competitors’ streaming services.

The iTunes Radio app, dull as it is, has attracted millions of users in rapid fashion, thanks to its inclusion in Apple’s iOS software on every iPhone and iPad sold. So why not put that market power to work behind a streaming service that could bring in a lot more revenue?

The critics' arguments

Now, to the critics!

One objection is that Apple would be paying too much if it completes the deal at the rumored price of $3.2 billion. It would be Apple’s largest acquisition ever, seemingly dwarfing the $400 million paid for Next – the deal that brought Steve Jobs back to Apple in 1997. But at the time, the purchase price represented a much heftier 15% of Apple’s total market cap.

Further, Beats headphone business is rapidly growing and reportedly carries sky-high profit margins. Even at a 33% profit margin, Beats $1.4 billion of sales last year would represent more than $450 million of cash flow, or less than seven times what Apple is paying – nothing like Facebook’s (FB) $19 billion WhatsApp bazillion-times-revenue-and-no-profits purchase. And while Google paid $3.2 billion for thermostat maker Nest, that was rumored to be a price ten times the unprofitable company's sales.

A second objection is that Apple could tarnish its existing brand image by associating with Beats. Hopefully, that’s not a subliminally racist view. But it seems incredibly low risk to offer “Apple Beats” headphones prominently in Apple stores, where they are already a popular item with tons of shelf space. And the streaming service could get the same treatment on iOS, or be rebranded as SoundJam was all those years ago.

Apple devices are insanely popular with young people, but the iTunes brand? Not so much. The music-listening habits among my three kids revolve around Spotify, Pandora, Youtube and more-obscure alternatives, admitedly an anecdotal observation, but I believe they're pretty typical in 2014. Almost twice as many teens frequent Youtube as iTunes, according to eMarketer. Another survey found Pandora about three times more popular than iTunes Radio with young people, though iTunes was on par with Spotify.

And Beats is actually pretty Apple-like, from its high-margin, good looking headphones to its slick, intuitive streaming app. Iovine, who remains a senior recording industry exec, is rumored to be joining Apple as part of the deal. "The idea of Beats ... to be very frank, I got from Apple," Iovine told the Wall Street Journal recently, explaining he focused on the "uniqueness of their blending of technology with popular culture."

A third concern is that Apple doesn’t need to buy Beats because it could easily build its own streaming service. I can’t fathom how so many people believe that, considering iTunes and Ping and iTunes Match and iTunes Radio, or even the company’s initial Podcast app. But, even so, Apple acquires apps, services and engineering teams all the time to bolster its own efforts. Siri, Maps and the iPhone 5S fingerprint reader were all based on or heavily rely on outside acquisitions. Why not acquire Beats now, when its streaming service is polished and market-ready but still small, rather than try further in-house experimentation that has an uneven track record at best?

Finally, some see the acquisition as a possible management distraction. That’s certainly possible – most acquisitions in corporate America don’t pay off. But weighed against the obvious current distraction of Apple’s slipping music business and the ease of keeping Beats as a separate operating entity if desired, it feels like the bigger risk is not doing the deal.

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