Apple and Google's app store businesses are coming under pressure - and the companies could end up losing billions of dollars

• Apple and Google earn big money through the commissions they charge of sales made through their smartphone app stores.
• Right now, they take a 30% cut of most sales made through their stores.
• But that rate could soon plunge, Macquarie analyst Ben Schachter said in a research note..
• The companies face regulatory and legal challenges over the rates they charge, as well as growing pushback from developers, Schachter noted.
• If Apple and Google were forced to cut their rates, the move could cost them billions of dollars in revenue and operating profits, he estimated.

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For years now, Apple and Google, in addition to their main businesses, have had a growing and profitable side gig going charging developers hefty commissions when the developers sell apps, subscriptions, and other items through their app stores.

But maybe not for much longer.

Apple and Google face regulatory threats and pushback from developers that could hamper their app store businesses and force them to reduce the cut they take from each sale, Ben Schachter, a financial analyst with Macquarie Research, said in a research note Monday. Even though the companies' app stores are just sideshows to both companies' main businesses, they could both take a significant hit to their financial results if they are forced to reduce rates, he said.

Apple, for example, could take a $16 billion hit to its adjusted earnings if its forced to take a major cut to its App Store commission rates, he said in the note.

"We believe that the traditional ... commission rates for app distribution may come under pressure," Schachter said in the note. He continued: "Changes in the commission rates would meaningfully impact profits."

Apple started taking a 30% cut when it launched the App Store

Both Apple and Google charge a 30% commission on purchases made through their app stores, including on buying apps, subscription sign-ups, and in-app purchases of digital goods. Both companies also now charge 15% on subscription charges after the first year; a reduction to entice developers to focus on subscription-based business models.

Although the basic 30% commission has been the norm since Apple launched the iPhone App Store 10 years ago, it's starting to come under increasing scrutiny. Earlier this month, Epic Games announced that it would distribute the Android version of its megapopular game "Fortnite" through its website rather than through the Google Play app store. It opted out of Google Play specifically because it didn't want to pay the search giant a commission on in-app purchases, which is the main way it makes money off "Fortnite."

Epic's move drew widespread publicity, because it was so unusual for a developer to opt out of one of the two major global smartphone app stores. But it may soon be followed by others, Schachter said.

"We've had behind closed door discussions with game developers who claim that [Apple] and [Google's] commission structure is unfair, and that they may take a more public role in pushing back against the business model," he said.

Developers are starting to push back against those commissions

And it's not just game makers who are getting fed up. Spotify, in a recent regulatory filing with the Security and Exchange Commission called out Apple and Google for charging it commissions that aren't applied to their rival subscription music services. The statement was only the latest move by Spotify to bring the issue to the attention of consumers and regulators, noted Schachter.

Like Epic Games, Spotify has essentially opted out of that model. Although iPhone users can download Spotify from the App Store, they can't sign up for its premium subscription service through it. Instead, they have to do that through its website.

Apple and Google could also see pushback from other developers, particular from streaming video providers such as Netflix, Schachter said. As that market starts to mature, and the players become less focused on signing up new users, they may start to become more concerned about the commissions they're paying to Google and Apple, he said. Those concerns might be heightened as the two giants rev up their respective video services, he said.

Already, Netflix is testing directing smartphone users to sign up for a subscription to its service via their web browsers, rather than through its app, Engadget reported Tuesday.

"As [Google] and [Apple] continue to add more services and directly compete with app developers, we suspect some of these voices from the music, video, game business, and others may become louder," he said.

Apple and Google also face increased regulatory and legal pressure

But the app store commissions are likely to come under pressure from other places besides developers, most notably from the legal and regulatory arena, Schachter said.

In the next year, the US Supreme Court is scheduled to hear an appeal of an antitrust lawsuit by consumers filed against Apple that targets its commission fees directly. The consumers charge that Apple's monopoly over the distribution of apps on the iPhone means that developers have no choice but to pay its commissions, which the developers then pass on to their customers in the form of inflated prices. Should the court allow the case to continue, it could eventually upset the whole business model of the App Store.

Meanwhile, Google's business practices have been under scrutiny for years now by European competition regulators. Last month, they hit the company with a $5 billion euro fine for forcing smartphone makers to install its apps.

Such regulatory scrutiny may only increase, Schachter said. Developers such as Spotify are complaining directly to regulators, he noted. With the market big and growing rapidly - global app sales hit $86 billion last year - and with Apple and Google offering increasing numbers of services that compete with those of leading app makers - their commissions and app stores will also be increasingly likely to draw regulators' attention, he said, referring to the companies by their ticker symbols.

"We are concerned that given AAPL and GOOG's dominance of mobile [operating systems] combined with their growing efforts to add value and services to customers using those OSs, it will draw regulatory and legal attention," Schachter said. He continued: "We are particularly concerned that as AAPL and GOOG add more features and offerings such as voice assistants, Apple Music, YouTube Red, a potential video service from AAPL, and more, that competing developers will claim that AAPL and GOOG's position as owners of the platforms may give them 'unfair competitive advantages."

Apple and Google could take a big hit to sales and profits

Should all this pressure on the app store commissions lead to decreased prices, the two giants could take a big hit, Schachter said. Over the last year, 14% of Apple's total revenue came from its services business, much of which is derived from commissions on App Store sales.

If nothing changes with commission rates, Apple should see an average commission rate of about 27% on such sales in its 2020 fiscal year, he estimated, taking into account the 15% rate it charges on ongoing subscriptions. The company's App Store revenue would be about $20.1 billion that year, while its total company earnings before interest and taxes (EBIT) would be about $78.6 billion, he said.

But if Apple is forced to slash its average commission rate to 15%, its App Store sales would fall to $11.2 billion in fiscal 2020, and its total company EBIT for the year would drop to $69.7 billion. If it has to cut commissions way down to 5% on average, its App Store revenue would be just $3.7 billion, and its company-wide EBIT - essentially its operating profit - would be $62.2 billion.

Those estimates "highlight just how levered operating profit is to the high-margin dollars of the App Store," Schachter said.

Google could see a similar hit if it is forced to slash Google Play commissions, he said. Assuming everything stays the same as it is now and the company continues to get an estimated average commission of 27% on app store sales, Google will pull in $10 billion in such revenue in 2020 and its company-wide EBIT will be about $40.2 billion.

But if its rates are cut to 15%, Google's app store revenue would be just $5.6 billion that year and its EBIT for the year would be $35.8 billion, he said. If rates plunge to just 5%, its app store revenue would be about $1.9 billion, and its total EBIT would be $32 billion.

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