How HTC can fight back

March 23, 2012: 8:32 AM ET

The Taiwanese phone maker came out of nowhere to dominate Android phones, only to be beat back by competitors that borrowed from its playbook. Now, it's banking on a strategy of bold acquisitions.

By Richard Nieva, reporter

mogFORTUNE -- Is audio equipment maker Beats Electronics -- popularized by big-name celebrities like Dr. Dre and Lady Gaga -- on the verge of acquiring music subscription service MOG? Neither company would confirm a tie-up, but rumors to that effect have been gathering steam online all week. Here's why such a deal would make sense -- most of all for Beats parent HTC.

All three have strong businesses with break-through brands, but each find itself in crowded markets with fierce competition. Bringing together could help them in the tussle.

The Taiwan-based phone maker HTC, founded in 1997, seemingly came out of nowhere in 2008, breaking out as a formidable presence in the cellular market thanks to its slick handsets based on Google's (GOOG) Android platform. At a time when Apple's (AAPL) iPhone dominated the smartphone spotlight, HTC managed to pump out phones with larger screens and other glitzy features. It was a surprise darling with consumers too, briefly becoming the largest smartphone maker in the U.S. market in the third quarter of 2011 as shoppers waited for a new iPhone model to debut. In a sign of its ambitions beyond phones, HTC bought a controlling stake in Beats for a reported $300 million in the summer of that year.

MORE: Rhapsody: Life in a Spotify world

But HTC has come back down to earth. Competitors like Samsung and Motorola caught onto its playbook, squeezing its business on quality and price. Apple, meanwhile, hurt HTC when it introduced the iPhone to Sprint, eating up much of HTC's market share with the carrier, according to the NPD group, a research firm.

MOG is a tough spot too. The online music market may have begun with the chaos of Napster in 2001, but it has developed a rigid caste system. Streaming services now allow users to access large music libraries from a computer server instead of owning the songs themselves. MOG is third-tier to Rhapsody and Spotify.

Founded in 2005 as a music blog network, MOG has a catalog of 14 million songs and charges $10 a month for mobile access, roughly equivalent to its competitors. Online music subscription revenues were about $201 million in 2010, the most recent year the data is available, according to the Recording Industry Association of America. Research firm ABI predicts 161 million subscribers worldwide will be accessing music through mobile phones by 2016.

MORE: Spotify will never turn a profit? Not quite

Of the three brands, Beats appears the strongest. Aside from its headphone operation, Beats, which was founded in 2008 by hip hop veteran Dr. Dre and record executive Jimmy Iovine, also sells its "music compression" technology to other businesses. This allows music to keep its crispness when it is digitized into sound files. Beats licenses this technology to companies like Hewlett-Packard (HPQ), which uses it in some of its high-end notebook lines.

Beats co-founder Iovine has also long championed the sale of higher-quality mp3s, appealing to record companies to provide first-rate sound files to online distributors like Apple's iTunes. MOG has the highest quality-streaming rate of the major subscription services. Ross Rubin, an analyst with NPD, says because of the constant improvement of streaming, MOG's lead "doesn't seem like a strong differentiating factor." Still, Iovine has ties to legendary record producer and Columbia Records co-president Rick Rubin, who sits on MOG's board of directors. When Iovine began his campaign for higher quality sound files, he asked Rubin to do the same at Sony (SNE), Columbia's parent.

If a deal for MOG materializes, how would HTC benefit? One possibility is bundling MOG with its Android offerings. Last year, Rhapsody created a partnership with mobile phone carrier Metro PCS (PCS). So far, results have been unspectacular. Another possibility is all three brands creating an "end to end" product combining music streaming, Beats audio technology, and HTC hardware, says Rubin, the NPD analyst. MOG could even be rebranded, taking the Beats moniker. CNET reported rumors of plans for a new commerce website that sells music, headphones and other items.

MORE: Sean Parker's 'new' role at Founders Fund

There are also some potential landmines. If HTC pushes MOG onto its handsets, it may upset deals that carriers have with other music subscription services. Plus, MOG's business is still small compared to Spotify. It is estimated to have under 100,000 paid subscribers compared to its larger rivals 3 million worldwide. Apple has made gains because it owns the entire experience, from hardware to software. Google bought Motorola (MMI) to achieve similar efficiencies. But HTC is much smaller.

Still, NPD's Rubin says the acquisition is an investment. "The idea is that, over time, new generations of consumers will care less about ownership and more about access," he says. Iovine seems to be on the same page. In 2010 he told Billboard, "We're in the music transmission business," he said. "I just want people to enjoy it more. Whether they buy it…or borrow it." With MOG, HTC and Beats may very well be able to lend it to them.

Join the Conversation
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.