Apple (NASDAQ: AAPL) stock has taken a pounding this month, dropping 10.3 percent since May 1. Much of the financial media attention related to Apple’s weakness is focused on the trade war. Ramping trade tensions are certainly an overhang for Apple stock price in the near-term. Unfortunately, the biggest long-term risk for Apple this week came from the U.S. Supreme Court.
On Monday, the Supreme Court voted 5-4 to allow an iPhone user antitrust lawsuit to proceed. The heart of the issue is the 30% sales commission Apple charges third-party apps for sales in Apple’s App Store.
The lawsuit alleges that Apple’s dominant share of the smartphone market violates antitrust laws and gives them non-competitive pricing power. As a result, Apple gouges app developers, which are forced to raise prices for consumers.
Apple Stock and the Complaint
App developers and iPhone users have criticized Apple’s App Store practices for years. In March, Streaming music leader Spotify (NYSE: SPOT) filed a complaint with the European Commission alleging similar app store abuses.
Spotify and other developers say Apple deliberately promotes its own applications at the expense of third-party developers. Third-party developers like Spotify must agree to Apple’s terms to sell their apps in Apple’s App Store.
By taking a 30 percent cut of third-party developers’ sales, developers claim Apple is deliberately inflating its competitors’ prices. At the same time, Apple does not allow third-party apps to access Apple hardware.
Apple also does not allow developers to communicate directly with customers about deals or promotions. Spotify said it was ultimately forced to remove its premium subscription service from the App Store completely.
For years, the general bull thesis hinged directly on iPhone unit sales growth. Today, that narrative has shifted from selling more iPhones to better monetizing existing iPhone customers.
The core of that thesis is that it’s fine for iPhone sales to plateau as long as Apple can hold onto its existing iPhone customers. Apple can sell higher-priced iPhones to customers looking to renew their hardware, and it can grow revenue by selling more services.
The App Store is at the center of Apple’s high-growth Services segment. In the second quarter, Apple Services revenue hit a record $11.5 billion. It’s still a relatively modest number compared to iPhone sales. However, while iPhone sales were down 17%, Services revenue was up 16.6%.
Apple’s 390 million paid customer subscriptions is up 30% from a year ago. Management has said it wants to push that number to 500 million by 2020. It is also targeting $14 billion in Services segment revenue by 2020.
In a nutshell, the iPhone is approaching a global saturation point, and Services to pick up the slack if Apple stock is going to grow again. If regulators find Apple is guilty of non-competitive practices in its App Store, it could take a major bite out of Services revenue growth and margins. It could also result in some stiff legal penalties and potential fines.
The Bottom Line on Apple Stock
I see regulators as the biggest threat to Apple in the long-term, but China is also a problem. According to Sensor Tower, Apple App Store revenue is expected to more than double over the next five years and hit $96 billion by fiscal 2023. Not surprisingly, Sensor Tower said China will be the single largest growth source for App Store spending.
Bank of America estimates China accounted for about 28% of App Store revenue in fiscal 2019, even more than the U.S. at 27%.
Apple is more than just an American company that does business in China. It’s the most valuable American company and a symbol of American technology. Apple management said earlier this year that trade war uncertainty is already impacting its business. However, the biggest threat could come if China decides to single out Apple to make a point.
At the end of the day, I believe a trade deal is coming sooner rather than later given the trade war is hurting both the U.S. and China. However, if regulators crack down on Apple and force more lenient App Store terms, the impact on Apple’s bottom line could be significant and lasting.
As of this writing, Wayne Duggan did not hold a position in any of the aforementioned securities.
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