Apple: Mr. Cook Begins To Tear Down The Walled Garden

Summary:

• Apple decides not to fight the EU Digital Markets Act.
• Why Apple chose not to fight the EU.
• Investor takeaways: a more open iOS will increase market share.

In July I wrote an article titled “Apple: Mr. Cook, Tear Down This Walled Garden!” regarding the impact of the EU Digital Markets Act on Apple’s (NASDAQ:AAPL) iOS App Store. From the article comments, I got the impression that many thought I was kidding, but I was deadly serious. If Apple didn’t deconstruct the App Store, the EU would do it for them, in a very invasive and unpleasant way. That sound you hear is just the beginning of the collapse of the Walled Garden.

Apple decides not to fight the EU Digital Markets Act

On Monday, December 13, Mark Gurman of Bloomberg broke the news that Apple intended to comply (mostly) with the Digital Markets Act (or DMA):

Apple Inc. is preparing to allow alternative app stores on its iPhones and iPads, part of a sweeping overhaul aimed at complying with strict European Union requirements coming in 2024.

Software engineering and services employees are engaged in a major push to open up key elements of Apple’s platforms, according to people familiar with the efforts. As part of the changes, customers could ultimately download third-party software to their iPhones and iPads without using the company’s App Store, sidestepping Apple’s restrictions and the up-to-30% commission it imposes on payments.

The moves — a reversal of long-held policies — are a response to EU laws aimed at leveling the playing field for third-party developers and improving the digital lives of consumers. For years, regulators and software makers have complained that Apple and Google, which run the two biggest mobile app stores, wield too much power as gatekeepers.

In fact, I argued in my July article that the DMA was not about “leveling the playing field” but rather tilting it against American technology companies like Apple:

One of the radical departures of the DMA from traditional competition regulation is that it’s not enough for a company to have competition. The authors of the regulation more or less acknowledge that companies such as Apple have competition. Under the DMA, a company’s market position must also be “contestable”. What does this mean? It’s never really formally defined, but apparently it means that a smaller company should be able to compete effectively against a much larger company, despite lacking the resources, technology, or market clout to do so.

How does one arrange this? By putting the large technology companies under very close, proactive supervision by EU competition regulators. By setting forth a set of “obligations” that the companies must comply with in advance. And by exacting very onerous penalties for “bad behavior”.

The DMA confers enormous power on the European Commission Department of Competition, headed by Margrethe Vestager. The Competition Department authored the legislation.

My view of the impacts of the DMA is that it’s intended to provide advantages to European companies competing with the US tech giants. The smaller European companies will be completely free of the regulation and supervision imposed on the larger US companies.

The justification for this is that the large US companies are “digital gatekeepers” that control large online platforms offering a wide array of goods and services. The DMA considers these platforms to be markets unto themselves, and therefore in need of regulation.

In this view, the gatekeeper is regarded as the “monopolist” of its own online store. So Apple would be regarded as the monopolist of the App Store and therefore in need of supervision, as well as policy changes such that Apple’s App Store is no longer “monopolistic”.

The online stores are just virtual versions of the bricks and mortar department store. Imagine regulators barging into a department store, telling the owner what products and services the store owner could offer, and forcing the owner to allow competitors to set up competing mini-stores in the midst of the department store. In effect, that’s what the DMA allows regulators to do with online stores or platforms such as iOS.

I regard this as an unprecedented encroachment on free market capitalism which should receive push-back from the US government. However, there has been none. The current head of the FTC, Lina Khan, fully embraces the concept of “digital gatekeepers” and has advocated policies and legislation similar to the DMA.

When the DMA was passed back in July, it provoked little concern among Apple analysts, who seemed not to comprehend its full impact. Gurman’s article gets to the heart of the changes it would require in Apple’s business model:

The act requires technology companies to allow the installation of third-party apps and let users more easily change default settings. The rules demand that messaging services work together and that outside developers get equal access to core features within apps and services.

Gurman’s sources describe Apple’s compliance efforts:

Apple is applying a significant amount of resources to the companywide endeavor. It hasn’t been a popular initiative within Apple, considering that the company has spent years decrying the need for “sideloading” — the process of installing software without using the official App Store. In lobbying against the new European laws, Apple has argued that sideloading could put unsafe apps on consumers’ devices and undermine privacy.

According to Gurman, Apple’s approach is rather piecemeal, with Apple still deciding whether to comply with some provisions of the DMA. For instance, Apple hasn’t made a decision about whether to allow developers to install third-party payment systems within their apps. Apple also hasn’t decided whether to open up iMessage to work with other messaging services.

Most significantly, Apple’s changes are planned only for the EU. As I discussed in my article, I’m skeptical whether this will be practical. Delicate software surgery will be required to create and maintain separate EU and US versions of iOS.

How will Apple prevent Euro-spec versions from leaking to the US? And will the iPhones of US travelers in Europe be expected to comply with the DMA? Apple may be building a single version of iOS with a set of internal switches governing things like sideloading that will change state depending on the geolocation of the device. However Apple goes about complying with the DMA, not inconsiderable expense will be involved.

Why Apple chose not to fight the EU

In the past, Apple has often fought protracted legal battles in the name of what it believed was “right”. But as any good attorney will tell you, the law is not about what’s right or wrong, but about what is legal or not legal.

In defending what it believes is right, Apple has sometimes come up short. Apple believed it was right to enter into pricing agreements with book publishers for eBooks on the iPad in order to counter what it regarded as Amazon’s (AMZN) eBook monopoly. Unfortunately, the legal judgement was that Apple and the publishers had violated the Sherman Antitrust Act.

In August of 2016, the EU ordered Ireland to collect $14.5 billion in taxes from Apple because the EU Competition Department regarded Ireland’s corporate tax laws to be illegal state aid. Apple is still fighting this case after winning its appeal before the EU General Court in July 2020.

The EU Competition Department is now appealing that decision to the Court of Justice of the European Union, which has the final say in the matter. According to an article in the Financial Times, the Competition Department is expected to lose its appeal.

In January of 2017, Apple sued QUALCOMM (QCOM) claiming unfair and monopolistic licensing practices for Qualcomm’s chips. The Federal Trade Commission sided with Apple and filed its own antitrust suit against Qualcomm. The FTC ultimately lost on appeal, and Apple eventually settled with Qualcomm, more or less on Qualcomm’s terms.

Despite Apple’s mixed track record in regulatory matters, I fully expected Apple to fight tooth and claw to defend the walled garden. The walled garden was a very Apple institution, closely associated with a certain insularity in Apple’s corporate culture. Although I don’t know whether anyone at Apple read my July article, the arguments I made in favor of complying with the DMA are likely the arguments that prevailed among Apple’s decision makers.

First and foremost, there is effectively nothing that Apple can do to legally challenge the DMA. Although the European Union behaves like a European government, it is formally a treaty organization governed by the Treaty on the Functioning of the European Union (TFEU).

Unlike the U.S. government, there are no constitutional or legal constraints on how the EU can regulate business as long as fundamental human rights and the rights of member nations are not violated. Virtually any form of regulation is permissible as long as all member states agree, and all the members have agreed to the DMA.

The DMA allows the Competition Department to impose “obligations” on gatekeeper companies without any finding that competition has actually been harmed. An example of an obligation would be allowing sideloading of apps in iOS.

To enforce its obligations, the EU may conduct interviews, investigations, and onsite inspections. This will all be part of an ongoing “dialog” between the Competition Department and the gatekeeper about how to make the gatekeeper’s business practices “fair and contestable”.

If the Commission is dissatisfied with the dialog and believes that the gatekeeper is deliberately defying the Commission and failing to meet its obligations, the Commission may impose fines equal to 10% of global annual revenue to start. More fines can be imposed for continued non-compliance, up to 20%. In Apple’s recently completed fiscal 2022, Apple’s total revenue was $394 billion.

Clearly, the Commission chose the magnitude of the fines in order to make outright defiance of the DMA untenable. $39 billion is more than the App Store is worth. In my July article, I estimated App Store revenue at about 6.7% of Apple’s total revenue. This is based on Apple’s percentage of the App Store gross receipts. This number is in rough agreement with Gurman’s estimate of 6%.

I also estimated that the European contribution to the App Store was about 1.6% of total revenue, while Gurman estimated it at 2%. So our numbers roughly agree, which is about the best we can hope for, since Apple doesn’t provide a breakdown of the contributions to its Services reporting segment.

The relatively small European contribution to App Store revenue was probably another factor weighing in favor of compliance. If Apple could find a way to comply with the DMA in Europe while maintaining the walled garden elsewhere, then at most, the revenue damage would be some large portion of the 2% European contribution.

And this brings us to the final factor in favor of compliance, which I did not account for. At some point, Apple must have decided that it was technically feasible to create a version of iOS tailored to the requirements of the DMA while the rest of the world would get a different version.

Or something like that. It’s not clear how they’re going about it, but presumably, the cost of this is less than the revenue hit if Apple made the EU version universal for the world. The walled garden will not be entirely torn down, merely reduced in size, for now.

Investor takeaways: a more open iOS will increase market share

One argument on behalf of compliance with the DMA that I doubt was given much credence within Apple is that an open iOS will increase market share. I suggested it back in July, but I believe it more strongly now.

Openness, variety, and low initial cost are the main advantages of Google’s (GOOG) Android. While Apple can’t compete on variety and cost, an open iOS platform would take away at least one important Android advantage. Apple will probably find ways to mitigate the malware risk in doing so, which will also be an advantage.

As users discover that Apple offers the best of both worlds, openness with security, more Android users will be motivated to switch. As Apple gains market share in Europe, it will have to rethink its policy of containment of the DMA version.

Undoubtedly, Apple naysayers will depict the end of the walled garden as a fundamental threat to iOS and Apple’s dominance of smartphone profitability. Far from being a threat, I expect the end of the walled garden to open up new avenues of market expansion for iPhone. I remain long Apple and rate it a buy.

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Disclosure: I/we have a beneficial long position in the shares of AAPL either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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