The Apple Ecosystem Giveth, And The Apple Ecosystem Taketh Away

My one and only time working with Apple came around 2000, before the iPhone or even the iPod. Back then, the company endured questions about its relevance not unlike those that dog Microsoft and its smartphone platform. With just a sliver of the PC market, many developers just didn’t see a return on investment sufficient enough to justify building software for Macs. The same circumstances suppress the mobile app count available for Windows Phone.

It was in this context that I met with Apple to discuss porting some popular video game titles from Windows to iMac. Expecting Apple to react enthusiastically to our idea because of the company’s software deficit, I was shocked to find their indifference.

Maybe my experience was an outlier, but did you know that Steve Jobs initially resisted allowing third party apps onto the iPhone? Jobs created a culture that deeply mistrusted anything not built in Cupertino. It also explains his refusal to license the Mac OS. It’s why Apple controls the entirety of the user experience, from hardware to software.

How ironic, then, that third party apps vaulted the iPhone to the world’s most dominant computing device. Software plays a different role in the company’s business model, relative to hardware. Apple built its App Store with the same mindset that spawned iTunes: as a cost center that funnels about 70 percent of the revenue it generates back to publishers. All those songs and apps help Apple extract an industry leading gross margin – about 40 percent – from its devices. In return, Apple has created a thriving marketplace that enables it to off-shore billions of dollars of investment in innovation to third parties.

Put another way, imagine if Apple had to develop all the apps itself. If each app costs, on average, $30,000 to make – a conservative estimate given the high cost of games – with about 1.5 million apps, it would cost $45 billion for Apple to develop the App Store’s contents on its own. Instead, Apple has paid $30 billion to developers to stock the store through its 70/30 revenue split. Seventy percent of $30 billion puts the Store’s total revenue at nearly $43 billion, meaning Apple has made nearly $13 billion from its 30 percent cut.

Examined through the lens of Apple’s 2007-2008 reality, running the App Store to harvest third party innovation makes sense. Even if one could imagine Apple building 1.5 million apps on its own, better to pay a net $17 billion ($13 billion in app revenue minus $30 billion in cash payments to developers) than to commit/risk $45 billion.

In 2015, though, Apple must reconsider its approach. Now, the company has $178 million in cash on hand. With 2014 revenues in excess of $182 billion, it would take more than $9 billion in additional sales to grow just five percent. That’s about what Microsoft paid for Nokia’s phone business and the total 2014 sales of food giant Hormel, maker of Spam.

With that much cash to spend, with pressures to find new sources of significant revenue, and its preference for Made by Apple, it’s no surprise to see the company announce plans to start competing with two of the bigger third party app developers: streaming music provider Spotify, and news aggregator Flipboard. Both news and music commonly operate with subscription-based business models. In fact, Spotify has 20 million subscribers each paying $10 a month. If Apple could match that performance, it could reap $2.4 billion in additional revenue from music alone.

Apple also made headlines last week with Tim Cook’s criticism of data-driven advertising companies. Presumably a shot at Google, this suggests that Apple will, over time, make it relatively harder for advertisers to acquire meaningful information about iPhone customers. That would put more pressure on app developers to rely on in-app and pay-per-download monetization models, both of which would benefit Apple’s bottom line (except for its iAd business, Apple doesn’t take a cut of in-app advertising revenue).

Add a couple of subscription revenue streams and nudge more third party app developers to forego advertising in favor of payments from which Apple can take a bite, and voila: Apple easily could find at least five percent growth.

Apple’s relentless pursuit of additional sales means that it can no longer treat the third party app community as allies in its effort to sustain device margins. It means those same developers may soon become Apple competitors.

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