Three things we learned about Apple in the Epic trial

When Fortnite developer Epic Games filed a lawsuit against Apple (US: AAPL) last year, it did so with all the chutzpah of a young tech company carving out its own fortunes in the digital world. But going up against a titan like Apple is no mean feat, with its seemingly endless capital (nearly $70bn in cash and marketable securities) and legal firepower. Still, as the trial concluded this week, it looked like Epic had a shot at winning its case.

This could spell trouble for Apple shareholders - a concern we flagged when we suggested investors sell their shares last year. But one positive has surfaced from the trial: detail about how the iPhone maker operates.

Apple has long had a reputation for keeping its cards close to its chest. Take “Project Titan” - the codename for its electric car. Last year when Hyundai (KRX:005380) let slip that it was in talks about collaborating with the Silicon Valley giant, Apple almost immediately cut off discussions. An obvious misstep by Hyundai, given Apple’s reputation for secrecy. And a reminder that despite the fact that Apple is one of the most popular companies in the world, most people have no idea what is going on behind its ivory walls. 

The Epic trial has given us a peek into how Apple works. Here are the three key things that the market learned about Apple during the trial:

1) App Store margins

Apple has always shrouded the App Store in secrecy. This is where the company hosts third-party apps which are charged the so-called ‘Apple Tax’ - a 30 per cent fee on in-app purchases. Analysts have suspected that margins and cash generation for the App Store are sky-high, given that it requires little ongoing capital expenditure. 

In court, Epic claimed that the App Store operates with a 78 per cent profit margin. Apple denied the figure, although did not respond with the correct version. In fact, it said that it could not calculate a margin for the App Store because it does not break out the costs and revenues for that part of the business. But it seems unlikely that when chief executive Tim Cook asks his finance team, “hey, where is all this cash coming from?,” he is met with silence. 

2) The Mac is not that safe 

When Cook testified, he warned that the iPhone could become unsafe if Apple lost control of how apps are downloaded. “We review thousands of apps a week; you can imagine if you turned app review off how long it would take for the App Store to become a toxic kind of mess”, he said.

Epic is pushing for Apple to allow alternative app stores on its devices, and argued that iPhones should work more like MacBooks and iMacs, its laptop and desktop computers. Macs allow users to download apps outside of what is displayed on the Mac Store.

Apple’s response was, simply, that Macs are not as safe as iPhones. Craig Federighi, head of software, said: “We have a level of malware on the Mac that we don’t find acceptable and is much worse than iOS”, Apple’s smartphone operating system.

3) Google pays Apple billions a year 

Apple’s secretive relationship with Google parent Alphabet (US:GOOGL) has long been the elephant in the room - or rather, the Valley. Reports have circulated that Google pays Apple billions annually to reserve its position as the default search engine on iPhones, and late last year a congressional report estimated that the figure was somewhere around $12bn. 

Tim Cook did not deny the existence of the arrangement. But he did claim that he could not remember how much Google pays, and could not explain why the search engine provider would pay for the privilege. Essentially, the deal appears to be worth so much because most Americans have an iPhone, and Google wants as many eyeballs as it can get for its advertisers.   

Investors should be minded, however, that Apple’s relationship with Google might not be for the long-haul. The Financial Times reported last year that the iPhone maker was developing a search engine of its own; notwithstanding the fact that growing into search might not be the best way to avoid regulatory attention. 

What’s the verdict?

Judge Yvonne Gonzalez Rogers is not expected to rule on the case for several weeks yet. It is unclear whether she will recommend major changes to Apple’s business model, although she did speak against the Apple tax. “The 30 per cent number has been there since the inception,” she said “and if there was real competition, that number would move, and it hasn’t.” 

The point stands. A decade ago, Phil Schiller, the Apple executive in charge of the App Store, sent an internal email that discussed cutting the 30 per cent rate to 25 or even 20 per cent. “Do we think our 70/30 split will last forever?” he wrote. “I think someday we will see enough challenge from another platform or web based solutions to want to adjust our model.” 

Changes to the App Store model look feasible. It seems unlikely to be enough to dethrone the $2trn company, but a blow to the services division could harm its strategic pivot towards its higher-margin, subscription-based software products, like streaming and gaming. A ruling in favour of Epic could mark a serious bump in the road for Cook’s long-term vision for Apple.