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An epic dent in Apple’s App Store business model

Assif Shameen
Assif Shameen9/16/2021 08:08 PM GMT+08  • 9 min read
An epic dent in Apple’s App Store business model
The outcome of the Apple-Epic Games case could lead to an overhaul in the way app stores operate
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With the launch of the new iPhone 13 this past week, consumer electronics giant Apple may have updated its formidable line-up of 5G smartphones with faster processors and state-of-the-art cameras with low-light functionality, but the biggest update yet to its products is likely to be in its iOS App Store.

Just days before the unveiling of the iPhone maker’s latest gadgets, the long-drawn courtroom showdown between Apple and video game Fortnite reached an epic ending on Sept 10. Though the knockout winner was Apple, which won on nine of the 10 counts, Fortnite’s creator, Epic Games, won the last one on points. The case is being appealed, and unless the two sides reach an out-of-court settlement, more courtroom drama is expected as subsequent appeals could take years.

In her 185-page ruling, Federal Judge Yvonne Gonzalez Rogers declared that Apple was not a monopoly either as a distributor of smartphone apps or within its in-app payment (IAP) solutions. She ruled that smartphone users have viable alternatives to games consumed through Apple’s iOS apps, switching costs are low, barriers to entry are not high, iPhone maker’s IAP requirements are legal, and nearly all of its App Store policies are valid. Apple’s requirement for developers to use the App Store to distribute iOS games and apps makes the iOS more competitive against Android and gives consumers choices in the marketplace, the judge noted.

But she also issued a permanent injunction telling Apple that it could no longer prohibit developers from including links that direct customers to external purchasing mechanisms, in addition to in-app purchasing, within an iOS app. She ruled that Apple’s long-standing anti-steering policy — which prevents developers from steering customers away from in-app purchases to their own website to avoid Apple’s high commission rates — was “anticompetitive” since it hurt consumers by limiting information about pricing.

App tax

What’s all this app fuss about? Apple is probably one of the most important e-commerce platforms on earth. Its App Store chalked up profits of US$20 billion ($26.8 billion) on revenues of US$72 billion last year — way more than the profits Amazon makes from its entire e-commerce business. (The bulk of Amazon’s profits are from its web service, AWS, not from e-commerce.)

The iPhone made up just over 21% of new global smartphone sales last year, with phones on Google’s Android OS controlling most of the rest. Where Apple, with a more affluent user base, does far better than Android is the money it makes from smartphone apps as well as in-app purchases. About two-thirds of global app revenues are through Apple’s App Store, with a third going through Google Play Store.

Developers call it the app tax. Every time a consumer downloads and pays for an app on the App Store, Apple collects a percentage of the sales. Apple takes 15% commission from all payments of apps that generate less than US$1 million and 30% for apps that generate more than US$1 million. Google Play Store users pay similar commissions. Indeed, when you download games from any online store selling digital goods, you are probably paying up to 30% to the store operator.

No wonder, then, that the iOS App Store is huge. At US$72 billion, Apple’s App Store revenues over the last four quarters exceeded the revenues of Walt Disney, Boeing, Goldman Sachs, Pfizer and Cisco for the same period. If the App Store was a standalone company, it would be the 15th most profitable firm in America and probably the 20th most profitable company on Earth.

Epic Games, one of America’s biggest game developers, tried to set up a payment system that was a clever workaround to Apple’s strict in-app payment system. Apple quickly shut it down. Epic Games, which is founded by billionaire Tim Sweeney, then sued Apple. For its part, Apple said Epic Games had agreed to adhere to App Store’s rules and was in clear breach of contract by steering users away to alternative payment platforms.

In her ruling, Judge Rogers said Epic Games was in breach of its contract with Apple when it implemented the alternative payment system in the Fortnite app. As a result, she ordered Epic Games to pay Apple 30% of all revenue collected through the new system since it was implemented. The judge reasoned that Apple’s hefty 30% revenue share stemmed from its burgeoning market power.

Her judgement suggests that she is bothered by the arbitrariness of the 30% take rate, although Google, Microsoft and others are collecting similar commissions. Yet she ruled that Apple does not have to reduce its fees but must allow firms like Epic Games to steer users away from their own apps to alternative payment methods like their websites.

Opening up the App Store

Apple was going in that direction anyway. Over the past several months, the iPhone maker has made incremental changes to open up its App Store. On Sept 1, Apple agreed to allow external sign-up links for “reader” apps like TV streaming service Netflix and music streamer Spotify, following a regulatory investigation in Japan. Last month, Apple agreed to a US$100 million settlement after being served a class action suit by some US app developers. Under the settlement, developers can now email app users about different payment options that bypass Apple’s 30% cut.

Allowing users the ability to pay somewhere else doesn’t mean they will actually do so. When it comes to the crunch, most app users will use Apple’s in-app payment system. People are essentially lazy. They want the convenience of Apple’s one-click app downloads on their iPhones, iPads or Macs. If it takes 15 steps and up to 10 minutes to make the same payment by first quitting the app, then opening a browser, filling a form as well as credit card details, most of them will stay within the iOS app even if that costs them a few dollars more. Sure, 25% to 30% of app users might prefer the cheaper option even if it takes them a lot of time, but an overwhelming number of Apple’s affluent users just can’t be bothered.

Apple’s App Store revenues grew 22% in the first half of this year and until recently, analysts were projecting 20% to 25% revenue growth for the App Store next year. Much of the growth is coming from switchers — Android users crossing over to Apple’s ecosystem. Apple is projected to sell 240 million iPhones in its current fiscal year that ends this month. Over the next 12 months, it is projected to sell 260 million iPhones. If 10% of new users are switchers from Android, Apple is adding over 25 million new users each year who need to load up their phones with new apps. Add in new users of iPads and Apple Watches, and you get over 30 million new users downloading an array of apps.

If Apple cuts its 30% app commission to just 15%, and only a third of the users flee to alternate payment platforms, Apple’s App Store revenues might dip slightly for two or three quarters and then recover, longtime Apple analyst Gene Munster of Loup Ventures told me recently. He believes most people will stick to Apple’s in-app payment as a default. In the worst-case scenario, he believes Apple could take a hit of between 1% and 4% to its revenues and profits in the first year after it slashes app commission.

Clearly, users would prefer their money to go to app creators rather than the middlemen like Apple. But even Judge Rogers acknowledged that Apple built the infrastructure on which the app train runs. Epic Games, Spotify and Netflix are happy for Apple to charge a small commission for the first-time download of an app but insist it should not keep charging for subsequent in-app purchases or subscriptions. Should the company that builds a toll road or railway tracks be paid only the first time you drive on the road or ride the train, or should it collect a fee for each journey?

Detractors argue that while Apple built the infrastructure, it doesn’t cost much to maintain and upgrade and therefore they should have free access. Apple’s contention is that in free market capitalism, its success should not be penalised.

In the mid-1990s, just before the late Steve Jobs returned to helm the PC firm he had founded, Apple was merely weeks away from bankruptcy. Banks were unwilling to give it more money. So, the company pivoted to making the iPod music player, reimagined the mobile phone as the iPhone smartphone, created iPad tablets and Apple Watches, which helped catapult it to become the world’s largest listed firm with a market capitalisation of US$2.5 trillion. Why shouldn’t it be allowed to reap the fruits of its hard work and infrastructure that it has painstakingly built?

As for its dominant position, being a monopoly is not illegal, though abusing monopoly power is clearly illegal. Search giant Google, social media powerhouse Facebook and e-commerce behemoth Amazon.com are all monopolies in some ways, just like Microsoft was when it was sued for violating antitrust laws back in 2000. Yet when the Seattle-based software giant crossed swords with antitrust lawyers from the US Department of Justice two decades ago, the court found that Microsoft was not abusing its monopoly powers.

Why, then, is everyone going after the App Store right now? Digital goods and services business around the world is about to explode over the next five years. It is no longer just digital video entertainment from Netflix, digital music from Spotify, cloud-based digital games from Google and Microsoft, or digital books from Amazon, but also non-fungible tokens or NFTs as well as an array of other digital assets that aren’t even being sold yet. The trouble is, Apple owns the toll roads and rail tracks. Regulators and Apple’s competitors are focused on slashing its total take rate on the App Store down to the barest minimum so that digital goods creators get a bigger slice of the cake.

As long as the global digital economy continues to grow, Apple will happily take just 15% of a bigger pie rather than insisting on 30% of the current smaller pie. Even Epic Games, which has vowed to sue Apple until it can succeed in slashing the take rate on the App Store, has conceded that 12.5% might be a fair rate for a toll collector like Apple. In a burgeoning digital economy, even at that reduced take rate, the iOS App Store would likely be among the most profitable enterprises on earth.

Assif Shameen is a technology and business writer based in North America

Photo: Shutterstock

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