Apple’s Recent Disclosure To Regulators Points To An Upcoming Crisis

Apple has made a disclosure to European regulators which shows that the company receives a fee from only 680,000 subscribers of Spotify (SPOT). Spotify has over 100 million paying customers. Hence a 15% fee is charged on 0.68% of Spotify’s total paying customers. This comes to close to $1 million monthly payment by Spotify to Apple. Although this is no pocket change, the bigger argument is that Apple is restricting Spotify in providing best possible features to its customers. The short term focus is on a trade agreement at G-20 summit but longer-term sentiment would depend on the challenges faced by App Store and other segments.

Apple does not allow Spotify to market any new offers to customers and does not allow direct upgrading from free to paying options. This issue will come up with other big apps which have moved their billing outside the App Store. Eventually, Apple would need to show a new way to monetize its App Store platform which can lead to a complete change from the current commission based system. Investors should follow this case as it points to the future revenue and margin direction of the Services segment.

A precarious position

Apple has not been receiving significant fees from Spotify for the past few years. In the recent statement, Apple mentions that it received a 15% fee from 680,000 paying customers of Spotify. All of these had started their subscription prior to 2016 when Spotify removed the billing from App Store. A back of the envelope calculation shows that Apple is getting: 680,000 * $10* 0.15 = $1.02 million per month from Spotify. A $12 million annual payment to its main competitor is not a small amount, but Spotify has been very successful in cutting out the revenue stream from the App Store.

Despite Apple Music’s good growth, Spotify has been able to show better growth in paying customers. Apple has close to 50 million paying customers since it launched this segment four years back. On the other hand, Spotify has added 70 million incremental paying users in the last three years.

Apple will still face a David Vs Goliath fight where it is not good to be the Goliath. Due to Apple’s control over the ecosystem and its resources, regulators will be likely to favor Spotify’s argument.

Spotify has complained that restrictions are placed on its app within iOS. This includes restricting any information given to customers regarding new prices, discounts or upgrading. Apple needs to put these restrictions because it wants to prevent other apps moving outside the App Store. However, these restrictions end up hurting customer choice which should be viewed negatively by almost all the regulators.

This puts Apple in a difficult position on how to monetize its iOS platform. Apple is facing similar issues in the U.S. where the Supreme Court has an allowedantitrust case against Apple.

Importance of App Store

App Store revenue is central to Services growth of Apple. As the iPhone unit shipments fall, the management is focusing on Services segment to drive future growth. In early January 2018, Apple announced that app developers earned $26.5 billion in the calendar year 2017. If we take a 30-70 split for Apple, the company’s App Store would have given revenue of $11 billion in 2017. A 20% growth in 2018 would put the App Store revenue at $13 billion. This is equal to 35% of the Services revenue in the last fiscal year.

The gross margin of App Store is also much higher compared to other businesses. Recently, Apple reported 64% gross margin for Services segment. A big chunk of this margin would be due to licensing fees from Google and the App Store. On the other hand, business like Apple Music has very low margins. Even Spotify has been reporting losses.

In a WSJ article, Ben Schachter of Macquarie Capital estimated that Apple Music had a gross margin of only 15% while Spotify had 24% gross margin. It is also important to note that after four years of operation and amassing over 50 million paid subscribers, Apple Music has not been able to show a pricing premium over Spotify’s plans. Hence, Apple’s ecosystem advantage in this business is very small.

Netflix (NFLX) has already moved its payments outside iOS. “Fortnite” has also left Google’s app store in 2018. It is likely that other big apps will also move their payments outside the App Store to avoid paying the heavy commissions. Apple’s management has many times mentioned the large base through which it gets App Store revenue. This shows that Apple is not very much dependent on a single app. However, in the recent scenario, most of the bigger and more popular apps would have the ability to move outside the App Store. Only the smaller apps would be stuck paying the heavy commissions.

Again, this would not be an ideal scenario for regulators in almost any jurisdiction. If bigger streaming players or games move outside the App Store, it gives them an undue advantage over smaller players who are stuck within the App Store. It is very likely that some major decisions could be taken against the commissions of the App Store and the restrictions which Apple puts on the outside apps.

Future margins

Wall Street analysts have been closely following the Services segment of Apple for the past few quarters. But most of the growth was due to licensing revenue and App Store growth. Both of them show the strength of Apple’s ecosystem. But they also show that the services are not provided by Apple itself. The App Store growth was because of the popularity of streaming players and gaming apps. If most of the players in these two industries move out of the App Store, it would create a major challenge for Apple.

The higher gross margin in Services segment also means that a fall in margins of App Store will have a major impact on the overall margins and EPS. Apple has already reported falling YoY operating margins in thirteen out of the past fourteen quarters. Hence, any big headwind for App Store can magnify itself and become a big challenge for future margins and EPS.

Apple’s operating margin has seen a rapid fall in the recent quarter. In the last quarter, OPM was 23.12% which was 288 basis point decline over the year-ago quarter. The EPS estimates for 2 fiscal years ahead have also been declining in recent months. This metric has declined from a high of $16.6 to $14.2, a decline of 15% in less than six months. We should see further downward revisions in forward EPS estimates if Apple continues to face more exits from the App Store leading to slower Services growth and lower margins.

Investors should closely watch the Spotify-Apple case to see the future initiatives taken by Apple to preserve and grow the revenues from App Store.

Investor Takeaway

Apple has recently mentioned that it receives fees from only 0.68% of the paying customers of Spotify. This data shows the challenge faced by Apple within its App Store. Future regulatory action against Apple could lead to fines or a push to reduce the restrictions on outside apps running on iOS. It is likely that we will see a different monetization formula compared to the commission rates charged by Apple. This can result in lower revenue and fall in margins of the Services segment.―Seeking Alpha