Some updates on Apple related to their Worldwide Developer Conference (WWDC) which started yesterday and on recent antitrust news. Yesterday, at their annual Worldwide Developer Conference (WWDC) Apple confirmed the transition of Macs to in-house designed chips w/ ARM based architecture from Intel x86 chips. This was not a surprise – it had been rumored as I indicated in my email attached below. The first Macs based on Apple’s custom silicon should be shipping later this year. The transition will cut costs (~$2.5B), but more importantly, enhances their competitive advantage as they continue their efforts to own and control the primary technologies behind the products that they make. Part of what differentiates Apple is they design their own silicon for the processor chips that are the brains of their iPhones and iPads (…and now for their Macs), which gives them better control over performance and feature integration in their devices (discussed further in previous email below). They also announced a slew of additional product updates that the WSJ nicely summarizes in a video linked below if anyone is interested.
On the antitrust front, Apple has had several recent developments. The risk around antitrust action is rising, but I expect the outcome to be manageable. This was not part of WWDC, though it is very relevant for the developer community (which are the key attendees of WWDC) as the issues primarily relate to fees charged in the App store. The App store relies on 3rd party developers to write software (Apps) which is a key ingredient to Apple’s thriving ecosystem. Recent antitrust related developments include an incident relating to an email App called “Hey” that’s owned by Basecamp, and was rejected from the App store b/c it was set up to charge for its fees outside of the App store, thus circumventing Apple’s cut. This issue is ongoing and getting lots of attention from developers. Then the EU announced an investigation of Apple’s App store – this could take some time to play out. Finally, the Justice Department’s yearlong investigation into the competitive practices of digital platforms (GOOG, FB, AMZN, AAPL) is set to wrap up in July w/ the CEO’s testifying in front of Congress. Last week the Chair of the House Antitrust Committee, David Cicilline, gave a rather foreboding interview which suggests the outcome of the investigation will include a recommendation for changes to Apple’s App store.
As a backdrop, Apple charges a 15-30% (mostly 30%) cut of transactions made through the App store. The App store facilitates a lot of commerce – $519B to be exact – and for most of this Apple gets no cut. For example, they earn a cut on selling an App like “Goodnote” but don’t earn a fee on each Uber ride. Apple has said that 84% of Apps do not share revenue. Apple commissioned a study from the Analysis Group which they released last week which broke down the $519B:
· $413 billion from physical goods and services, including $268 billion through retail apps, $57 billion through travel apps, $40 billion through ride-hailing apps, and $31 billion through food delivery apps.
· $61 billion from digital goods and services.
· $41 billion from in-app advertising.
To put this in perspective, Apple reported in 2019 that it paid ~$35B to developers. Grossing that up for Apple’s ~30% fee suggests ~$50B in sales through the App store where Apple earns a share – so Apple made ~$15B. Comparatively small relative to the $519B from Apple’s commissioned report – so, presumably, a key part of Apple’s argument will rely on the small percentage (<3%) they get of the full amount of commerce conducted through their App store. I do think the potential for antitrust action against Apple is mounting, but my view at this point is that I don’t think the outcome will be severely damaging to Apple. While it is unclear how this will play out, most importantly, Apple needs the developers and the developers need Apple. The level of fees seem to be the crux of the issue…30% is too high… the result might be some combination of lower fees and less stringent rules.
In terms of potential economic impact to Apple, their total Services revenue in 2019 was $46B (~18% of revenue) and is dominated by these App store fees and traffic acquisition costs (TAC) paid to them from Google (Google pays to be the default search engine). Given the above calculation, fees from the App store were close to 33% of that $46B (or less than 6% of total revenue) and TAC was another 26% (~4.5% of total revenue). The rest of Services revenue is from Apple Pay, Apple Music, Apple Care, iCloud etc. If Apple had a business model of “giving away” their hardware to make money on Services, this would be a problem. Services margins are in fact much higher, about double their hardware margins (64% vs 32%), but they do make most of their profit on their hardware. So the App store contributes somewhere between ~10-12% of total gross profit and Products/hardware still contribute 70% (other services contribute the rest). While growth of their high margin Services business is a key part of the story, App store purchases are only one piece of that and that growth is also driven by a growing installed base and increasing relevancy of their devices driven by new applications. The installed base grows w/ greater iPhone penetration (lower priced and used phones help with this) and new types of devices like wearables. And the utility of new applications evolve w/ new technologies like 5G, AI, augmented reality, virtual reality etc. While lower fees would obviously be a hit to them, I think it would be manageable…and the counter argument is that it could spur more innovation and better Apps as the economics to the developers improve.
From: Sarah Kanwal
Sent: Thursday, April 23, 2020 6:59 PM
To: CrestwoodAdvisors <crestwoodadvisors@crestwoodadvisors.com>
Cc: ‘postinvestdigest@gmail.com’ <postinvestdigest@gmail.com>
Subject: Update on Apple…
Sending an update on Apple regarding headlines today that they are planning to start selling Mac computers with Apple’s own main processors by next year. The chips likely would be in one laptop model, then extend beyond that. This would mean transitioning away from their current supplier Intel (Apple is ~9% of Intel’s sales). Taiwan Semiconductor (TSMC), Apple’s partner for iPhone and iPad processors, would build the new Mac chips. The potential for Apple to do this has been rumored/expected for a while. This isn’t about saving money (though it would), it’s about differentiating themselves and enhancing their competitive advantage…and is very much aligned with what Tim Cook said over a decade ago when he was COO, “we believe that we need to own and control the primary technologies behind the products that we make.” Part of what differentiates Apple is they design their own silicon for the processor chips that are the brains of their iPhones and iPads (…and now potentially for their Macs), which gives them better control over performance and feature integration in their devices. The cutting edge for them right now is their A13 bionic which TSMC (one of the few major semiconductor foundries) makes for them and is custom built on top of licensed ARM architecture (which underpins most mobile devices). Notably, this would further push ARM (owned by Softbank) architectures beyond mobile (where it dominates), to laptop/desktop (where Intel’s x86 architecture dominates) and some suggest could ultimately pose a threat to Intel’s data center business (e.g. chips in servers). For Apple, the advantage in doing this is that their silicon is unique to them and tailored for their operating system, iOS. This has proven to give them an advantage with the way they design their phones and an advantage with developers. Android and iOS basically have a duopoly in mobile operating systems…generally any smartphone that’s not an iPhone is running an Android operating system, which Alphabet gives away. That gives Apple about 15% operating system market share and Android about 85%, however that is split up across devices/brands. The fact that Alphabet’s mobile operating system is so fragmented (and that users are often not using the same/latest version) makes app development more complex, costly and time consuming. Moreover, Apple, which dominates the high-end smartphone market, has a wealthier installed base for developers to target. The app store is fueled by third-party app developers. Easier to develop apps and a target rich audience leads to a greater number of higher quality iOS apps created by these developers for iPhone owners to download, with a better user experience. This is great for Apple b/c they make a % of revenue from Apps sold through their App store. This latest potential development should build on this advantage. They would have Macs, iPhones and iPads running the same underlying technology which should make it easier for Apple to unify its apps ecosystem, including allowing iPhone and iPad apps to run on Macs. This advantage gets more and more important as computing power in phones increases, 5G delivers better connectivity and, as a result, we have the ability to use mobile phones in enhanced ways….like apps that take advantage of augmented reality and IoT related technologies. 4G enabled advances like Uber. 5G is a step function change from this. Along this same theme, last year Apple acquired Intel’s cellular modem business for ~$1B. These are the chips that connect smartphones to the internet. They had been using QCOM for these chips, then they shifted to Intel as AAPL/QCOM were embroiled in a lawsuit. That has been settled and now Apple is again using Qualcomm’s chips. But the long-term goal here is for Apple to make these chips themselves, furthering their goal of controlling the primary technologies behind their products…and moving away from suppliers like Intel and Qualcomm. All of this is aimed at cementing Apple’s technology and ecosystem advantage which is Apple’s moat and drives their massive installed base. This can be seen by the fact that despite only having about 15% of the global smartphone market, Apple earns almost all of the industry profits b/c they have a differentiated, proprietary product/ecosystem, while Android based OEMs don’t own the silicon and software.
Sarah Kanwal
Equity Analyst, Director
Direct: 617.226.0022
Fax: 617.523.8118
Crestwood Advisors
One Liberty Square, Suite 500
Boston, MA 02109
$AAPL.US
[tag AAPL]
[category equity research]