Why regulators are targeting a US$2-tril Apple

“Apple has followed an underappreciated playbook: build high-quality products that enrich lives, then do the hard part: reinvent yourself every decade,” says Gene Munster of Loup Ventures in Minneapolis. Apple remade itself from a company that sold user-friendly PCs to one that made iPod music players, to the maker of the iconic iPhone to making iPads, Apple Watches and AirPods, and to a firm that increasingly sells subscription bundles of hardware, software and services.

“Apple products have the highest satisfaction rate in consumer surveys because of its incredible focus on delivering exceptional customer experience,” says RBC’s Muller. Once you are locked into its ecosystem with an iPhone, you tend to buy an iPad rather than a Samsung tablet or a MacBook rather than a Dell laptop and try out other products such as the Apple Watch or AirPod. It is rare for Apple users to abandon its ecosystem for a rival.

More recently, Apple has focused on higher-margin services such as the Apple Music streaming service, Apple News, iCloud storage or AppleTV+ video streaming service as well as apps that customers use on iPhones, iPads and Apple Watches or its warranty programme for hardware. “A loyal customer base, with recurrent cash flow from repeat purchases, equals a strong balance sheet” with nearly US$90 billion net cash, says Muller.

The recent pandemic-induced lockdown played right into Apple’s hands. While many of its stores remained closed, well-heeled users found themselves beholden to their smartphones, tablets and wearables. “Affluent consumers lost more opportunities to spend and that created a strong pull for Apple products,” says Pierre Ferragu of New Street Research in New York. “Money not spent on restaurants, travel and holidays got spent on consumer electronics.” That boosted online sales, resulting in blockbuster April-to-June quarter earnings. iPhone revenues were up 11%, or US$59.7 billion, in the quarter. Ferragu, a long-time bear on Apple stock, concedes that he was “shocked” by its spectacular earnings. “Wall Street is lazy on Apple,” he shrugs. Ferragu now expects the company to cross the US$100 billion revenue mark in the October-to-December first quarter of its new financial year when new 5G phones are introduced.

Elongated product cycle

Apple has 950 million iPhones and 700 million other devices in use globally. Detractors say iPhone users increasingly tend to hold on to their ageing devices longer. Yet, even if 20% of iPhone users upgrade every year, Apple would sell 200 million of them, as it is expected to over the next 12 months. Its user base has become so big, ecosystem so sticky and customer loyalty so strong that an elongated iPhone replacement cycle is no longer an issue for investors.

Over the years, Apple’s detractors have compared it to fallen consumer electronics firms such as Nokia or the defunct radio manufacturer RCA, suggesting that its fortunes might take a similar trajectory. Consumer electronics firms’ sales burgeon only for margins to eventually decline as costs rise. Moreover, new technology can quickly make products obsolete. Yet, Apple has consistently entered new areas even as it innovates on existing products.

Apple also vertically integrates its products. More of iPhones components are designed in-house rather than purchased from other chip makers. Last year, Apple bought Intel’s 5G chips design unit. Although it is buying 5G chips from Qualcomm this year, analysts expect that it will use its own 5G chips within two years. Macs and MacBooks have for years used Intel’s microprocessors. Apple will soon begin installing its own silicon to power its computers. Making its own components not only helps bring down costs, thereby improving margins, but also allows Apple to design unique products — a key differentiating factor.

One criticism hurled at Apple, which has returned more than US$360 billion to shareholders over the past eight years through stock buybacks, is that the company deliberately shunned big transformational acquisitions that could have catapulted it to even greater heights. Its biggest acquisition ever was that of headphone maker Beats Electronics and music streaming service Beats Music for US$3 billion in 2014. Wall Street speculation about Apple buying Netflix began when the video streaming giant’s stock was under US$50. It was US$547 on Aug 26, or up a whopping 11 times. Even if Apple had paid a 30% premium for Netflix, enough to woo shareholders who did not want to sell cheaply, the deal would still be seen as the bargain of the century, given how well Netflix has done.

Another oft-heard comment about Apple is that under CEO Tim Cook’s helmsmanship, the firm has not been as innovative as it was when late founder Jobs, who had a habit of introducing transformational products every few years such as the iPod, iPhone and iPad, was running it. “To say Apple is no longer innovative misses the point,” veteran Silicon Valley guru Roger McNamee noted in a recent TV interview. Quite aside from wearables such as Apple Watches and AirPods, McNamee notes that Cook has actually “innovated” Apple’s entire business model by transforming it from a hardware maker to one driven by services and subscriptions and turning it into the world’s biggest money machine.

Battle royale for apps

But the more money Apple makes and the higher its market value, the more scrutiny it faces. Last month, Cook was grilled by US Congress alongside CEOs of Facebook, Alphabet’s Google and Amazon.com on whether their firms had become too powerful and were abusing their power. In recent months, there have been regulatory concerns about Apple, particularly through the tightly controlled and curated App Store. Epic Games, creator of Fortnite and Battle Royale, and music streaming firm Spotify, have alleged that Apple uses its position unfairly. App developers selling services through the App Store pay a 30% fee to Apple. “Sellers always think they are paying too much and owners of the platform on which the transaction takes place believe they are getting too small a cut,” says RBC’s Muller, who cites the fact that Google also charges 30% and Amazon often even more on its marketplace.

The App Store makes up 10% of Apple’s total profits, and a total shutdown, while highly unlikely, would take some wind out of Apple’s sails. But think of the App Store as a department store or supermarket. If you are a major brand, you need shelf or rack space, so you pay a premium just for the space. On top of that, you pay the store owner a cut of your total sales. Google, Apple and Amazon are modern-day supermarkets and department stores. So, what they are doing is no different from how retail goods have been sold for decades.

What might regulators do if they conclude that the App Store is anti-competitive? Clearly, they cannot tell Apple that it is not allowed to collect 30% for apps or instruct it to collect only 10% or 15% in fees because it is not like a regulated electric utility. In a free market, Apple can charge whatever users are willing to pay. “What regulators can do is say Apple must allow customers to access apps through a store other than its own App Store,” says Bernstein & Co analyst Toni Sacconaghi.

Yet, new app stores on the iPhone are unlikely to have much traction. “The App Store has more than two million apps, which are all vetted by Apple. There are no bugs associated with them. All the apps adhere to certain technical and moral standards,” he notes. Apple also absorbs credit card charges. And that is just the way users like it. Apps on App Store work promptly and seamlessly with any upgrades to Apple’s iOS operating system. “Most App Store users, not unlike those who use Amazon’s Marketplace, take a great deal of comfort in the Apple-operated app store. They believe it is safe and secure. Most app developers value the store as a marketplace for apps that Apple creates for them and on which they can generate a ton of business,” Sacconaghi argues.

Sure, Epic, Spotify and others can start their own store on Apple’s iPhone. While many Fortnite or Spotify fans might flock to their store to take advantage of 10% or 20% discounts, most will probably continue to buy apps from the official App Store. Over the long run, it will not be in the interest of most app developers to abandon the App Store and try and make extra money on an unofficial one that users feel is less secure. Gadget users are creatures of habit. Apple fans are also affluent and loyal and, even if they could find Fortnite 10% cheaper in an untrusted store elsewhere, they would not all abandon the App Store.

Still, regulators are hovering, and bigger companies such as Apple are easy targets like sitting ducks. Jobs positioned Apple as a David battling tech Goliaths, but the roles have since reversed. Cook deftly navigated the choppy waters around trade policies in Washington and Beijing, when most investors thought Apple would be the main collateral damage in the US-China trade war. As he tries to take Apple to new heights, Cook must focus not just on maximising profits, but doing what a responsible company of Apple’s size must do. If that means sacrificing a billion dollars of App Store revenues, so be it.

For corporate giants, optics can be as important as anything else. Apple needs to be seen as a more caring company, not a penny-pinching one. If it can navigate the regulatory turmoil, it is destined for bigger milestones. “Apple’s best days are still ahead,” Munster tells The Edge in a recent phone interview. Three years ago, it was hard to imagine that Apple would reach the US$1 trillion mark, he says. Two years ago, it was difficult to imagine a US$2 trillion market capitalisation. The path to the US$3 trillion milestone starts with the fact that the world has changed, he notes. “Apple’s future golden geese — health and wellness, augmented reality and autonomous systems — are becoming more central to our lives in this new world,” the veteran Apple-watcher says.

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