Apple: Mr. Cook, Tear Down This Walled Garden! (NASDAQ:AAPL)

The European Union’s Digital Markets Act will radically change how large U.S. technology companies such as Apple (NASDAQ:AAPL) are regulated. The regulation goes beyond trying to ensure competition and attempts to supervise the businesses of so-called “gatekeeper” digital platforms such as the App Store. If the Act is successfully enforced, Apple’s carefully constructed “walled garden” of iOS will be demolished. Apple should act before the EU does.

The European Union tilts the playing field against Big (American) Tech

It’s difficult to convey just how radical and unprecedented the Digital Markets Act (DMA) is. It was passed by the European Parliament, the legislative body of the European Union (EU) on July 5. A few days ago it was given final approval by the European Council, made up of the heads of states of the EU member countries.

The reaction in the Apple tech media has been quite muted. For instance, Malcolm Owen of Apple Insider described the DMA this way:

The DMA goes after “gatekeepers” of large online platforms, such as Apple’s management of the App Store and Messages. The rules aim to make the business environment as fair for all parties, by forcing gatekeepers into various concessions, such as making Apple’s Messages platform work with third-party services.

For the App Store, the rules can force Apple to provide more marketing or advertising performance data to developers, allow third-party payment platforms to be used, and to prevent Apple from ranking its own apps above others in relevant App Store searches.

Well, it’s going to do a lot more than that. I’ve read the full 81 pages of the DMA and I went through it in some detail in a recent article for Rethink Technology subscribers. In this article, I’ll provide a top-level summary.

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.

Normally, competition regulators only interfere with a company’s business after a violation has been legally established in court. Not in the EU, as this quote from the EU announcement of the DMA attests:

“The purpose of the digital single market is that Europe gets the best companies and not just the biggest. This is why we need to focus on the legislation’s implementation. We need proper supervision to make sure that the regulatory dialogue works.” – Andreas Schwab (EPP, Germany), Leading MEP on the Digital Markets Act.

It’s clear that the intent of the DMA is to foster European competition with the large U.S. technology companies such as Apple, Google (GOOG), and Amazon (AMZN). In the name of “leveling the playing field” it does exactly the opposite. The smaller (European) companies will be completely free of the regulation and supervision imposed on the larger (American) companies.

Under the EU Digital Markets Act, Apple will be “obligated” to allow side-loading of apps in iOS, iPadOS and watchOS

The DMA focuses on “supervising” so-called “digital gatekeepers”. These are companies that control online digital platforms that offer a wide array of products and services, such as the three companies mentioned above. Another radical departure of the DMA is that it asserts the power to regulate these online stores in much the same way that broader commerce is regulated within the EU.

In this context, the gatekeeper company is considered a “monopolist” of its own store, and inherently abusive and anti-competitive. Thus, it must be closely supervised. To see how strange a concept this is, imagine a department store owner being regulated in this way by Federal competition regulators.

The regulators barge into the store, tell the store owner what products to offer, what prices to charge, and may even require the store owner to allow competitors to set up stores-within-a-store to sell goods in competition with the store owner. All in the name of “fairness” and “contestability”.

The DMA sets forth various technical criteria for determining a “gatekeeper”, but suffice it to say that Apple will be designated a “gatekeeper” for its iOS (and iPadOS and watchOS) App Stores.

Unlike macOS, Apple goes out of its way to make the downloading and installing of apps outside of the App Store very difficult. It’s not impossible, and courts have ruled that it’s not illegal, but it is very difficult. Apple’s “walled garden” has numerous benefits, including greater security, better quality assurance, and ease of app installation, yet many people find it objectionable.

The walled garden seems particularly to have aroused the ire of EU regulators, and the App Store is clearly in the cross-hairs of the DMA. The text of the DMA is very technical, but it contains a number of introductory paragraphs that explain its provisions. Here’s the paragraph that applies to the App Store:

The rules that the gatekeepers set for the distribution of software applications may in certain circumstances restrict the ability of end users to install and effectively use third party software applications or software application stores on operating systems or hardware of the relevant gatekeeper and restrict the ability of end users to access these software applications or software application stores outside the core platform services of that gatekeeper. Such restrictions may limit the ability of developers of software applications to use alternative distribution channels and the ability of end users to choose between different software applications from different distribution channels and should be prohibited as unfair and liable to weaken the contestability of core platform services. [Bold face mine.]

From my reading of the DMA, I believe that the macOS model would be considered the desirable alternative to the current iOS App Store. MacOS has an App Store, and Apple controls it in much the same way that it controls the iOS App Store. But at the same time, macOS users are free to download and install third-party content independent of the macOS App Store. MacOS XCode APIs provide for the creation of app installation packages that are readily downloaded and installed by the user.

Any arguments that Apple might make that the current restrictions of the iOS App Store are essential for iOS security are undermined by the existence of macOS. The fact that macOS provides Mac devices with reasonable, if not optimal, security, provides an existence proof that App Stores and sideloading can coexist.

In some of the articles I’ve read about the DMA, there seems to be some doubt about whether it really would mandate sideloading in some form. And the reader may suspect that my interpretation of the above paragraph from the DMA is overly negative. But keep in mind what the intent is.

The intent of the DMA is to weaken the dominant position of the gatekeeper platforms. EU regulators will certainly see mandating side loading as the best way to weaken the App Store.

What’s at stake for Apple: Estimating App Store revenue

Imposing the Mac model on iPhone and iPad would almost certainly be devastating for their respective App Stores. Large software developers such as Microsoft (MSFT) and Adobe (ADBE) would almost certainly abandon the App Store altogether. Large game developers would as well, preferring to join or set up their own game app stores. Mostly the developers who would be left on the platform would be those making less than $1 million a year in revenue, for which Apple’s commission has already been lowered to 15%.

But what exactly is the App Store’s contribution to Services revenue? Apple doesn’t say, and one sees various numbers bandied about. For instance, CNBC published an article claiming that the App Store “grossed more than $64 billion in 2020”. However, that’s gross receipts of the store of which Apple would at most receive about 30%, its maximum commission, or about $19.2 billion.

To arrive at a more current estimate, I start with Sensor Tower’s estimate that the App Store had gross receipts of $41.4 billion in the first half of calendar 2021 (fiscal 2021 Q2 and Q3). Assuming the 30% maximum commission puts the Apple App Store revenue for those quarters at $12.42 billion.

Total services revenue for fiscal Q2 and Q3 was $34.387 billion, making the App Store 36% of Services revenue. Taking the 36% as a good general figure, then App Store revenue in fiscal 2021 was $24.63 billion. As a percent of total revenue, it was about 6.7% in fiscal 2021.

Assuming the same proportion of European revenue, then the App Store in Europe generated about $6.01 billion in fiscal 2021. If Apple could somehow limit its “obligations” to the European market, then the most that Apple would have to lose is some large fraction of the $6.01 billion.

But creating two different versions of iOS and iPadOS for Europe and the rest of the world would be problematic both technically and legally. The European versions would have to be based on the Mac model, since I doubt that anything less would be acceptable to the European Commission.

But even if sales of the European version were restricted to Europe, Euro-spec units would undoubtedly leak out to users desiring the features of the Euro versions. It would be difficult for Apple to confine the Euro versions to Europe.

Also, there’s the question of how Apple would comply with EU regulations for U.S. spec devices carried into the EU by travelers. Would such devices be required to comply with EU regulations while in the EU?

The difficulties of maintaining EU and non-EU device versions might be such that it would not make sense to maintain a non-EU version with the traditional App Store restrictions.

Thus, if Apple acceded to EU “obligations” for the iPhone and iPad, it might be impossible for Apple not to provide such devices to all users globally. It’s not just the European App Store that’s at stake, it’s the global App Store.

Investor takeaways

Apple will certainly fight the legislation, but it will almost certainly lose. The Treaty on the Functioning of the European Union (TFEU) which serves as a sort of constitution for the EU, allows very broad latitude concerning the regulation of commerce within the EU.

Basically, anything goes as long as the EU members can agree on it, and they already have agreed on the DMA. The DMA expresses a certain hostility within the EU towards big U.S. technology companies and towards American big business in general.

There’s not much that Apple can do about that. The penalties authorized by the DMA are far greater than what the App Store is worth, on a global basis, so Apple can’t afford to just ignore the regulations and pay the fines. It may take a few years, but the end of the walled garden is coming.

And I can’t really feel that bad about it, even as an Apple investor, even with the loss of App Store revenue. If I ask myself honestly, which would I rather have for my iPhone, the current App Store restrictions or the more open macOS model, I would rather have the macOS option.

And I think most users would rather have the freedom offered by the macOS model, if the choice were offered to them. So, iPhones and iPads configured on the macOS model might be more appealing to consumers and win over more users of alternative operating systems such as Windows and Android.

The EU’s imposition of this “obligation” on Apple, as annoying as it is, may have a silver lining. With the global smartphone market growing very slowly, Apple’s growth increasingly depends on attracting switchers from the more open platforms. A good way to do that would be for Apple to go back to its roots and embrace the openness of the macOS model.

So I say, Mr. Cook, tear down this walled garden, before the EU does it for you. I remain long Apple and rate it a Hold.