How Much Profit Is Apple Making from the App Store?

Apr.20.09 | About: Apple Inc. (AAPL)

Apple (NASDAQ:AAPL) has two important events taking place during the week of April 19th. On Wednesday, April 22nd, at 5pm EDT, they report fiscal Q2 earnings covering January through March 2009. The second event, with exact timing dependent upon the customer demand rate, will see the one-billionth download from the App Store, which serves iPhone and iPod Touch customers with all manner of programs for its handheld telephone and gaming devices.

The subject of this article is how the second event - App Store downloads – will affect earnings, for Q2’09 and quarters to follow. In telling this story, I will try to highlight the financial mechanics of the App Store, which have not been fully covered in most of the breathless coverage of Apple’s latest stealth tech weapon, which sees its billionth download just over 9 months after opening. The main intention of the App Store is not to be directly profitable, but it also doesn’t hurt.

It’s important to provide a context for this marketplace. Apple has sold about 30 million iPhone and iPod Touch devices combined through December 2008. iPhone sales of 17.4 million units are known with certainty, because Apple announces precise quarterly sales figures in its earnings releases, while iPod Touch sales are frequently estimated at between 12 and 15 million since introduction[1]. Incidentally, Q2 should see an additional 5 million devices sold, meaning that this device platform is still young enough to see sales that increase install base by double-digit percentages, on a quarter over quarter basis, and for a few more quarters at least.

A billion downloads for 30 million devices imply 30+ applications, on average, per device. That seems consistent with my anecdotal observations. If someone has 3 or more pages markers on their device, they have downloaded 30+ applications. Conduct your own survey if you are curious.

It’s not the focus of this article to compare the Apple App Store with those of the competition, but it should be noted objectively that Apple has the cleanest, most integrated, and most mature of App Store offerings, amongst wireless device companies. This is due to several unwavering strategies that Apple has pursued:

Device: Advanced processing, storage, mobile internet, and sophisticated inputs (accelerometer, touch screen, wheel inputs on both, plus microphone on iPhone) provide interesting capabilities for creative developers. With the one platform/one program model, developers also avoid having to modify applications to fit dozens of devices with various screen sizes and resolutions, as is happening with similar Nokia or RIM applications.

Transaction: The buying processes, including categorization, search, interface, payment, and download - are modeled upon iTunes, giving Apple a distinct advantage in fulfilling demand, as well as financial leverage when demand is scaled.

Incentive to Develop: Apple provides 70% of list price directly to developers, while keeping 30% for itself. This balance keeps developers motivated to write programs, while allowing Apple to achieve better than breakeven within the first year, as we shall see.

Influence on Customer Behavior: A handful of ‘gee whiz’ applications, often free, make users comfortable with downloading applications. In practice, the customer’s perception that they get early value for free leads directly to comfort with paying for later applications. I am convinced that this has some formal explanation in the field of Behavioral Economics. Shazam, Google (NASDAQ:GOOG) Mobile App, Microsoft (NASDAQ:MSFT) Seadragon, Pandora Radio, and Ocarina are amongst this category of mostly free and seemingly ubiquitous apps that please users and help sell more devices through user demonstration, while also subconsciously preparing users to pay for subsequent applications. Once the first paid download occurs, the next is easier. I call this the ‘breaking the seal’ effect.

If the App Store supports devices and customers, leading indirectly to more device sales, what are the direct financial benefits to Apple? According to Joan Hoover of Apple Investor Relations, the model is similar to iTunes. It’s intended to support device customers, with a vibrant and diverse application marketplace, while at least breaking even. In theory, it exists to sell more devices. In practice, however, Apple is nothing less than allergic to any loss leader strategy; it products simply must perform from a very early stage. While Apple may not expect the App Store to generate significant EPS in the first year, it also simply would not have engineered a system that required subsidy from other product lines.

In other words - they say it’s break even, but that’s typical Apple. They appear for the outside world to set the bar low, while internally, they are setting it higher and higher. Apple does not introduce every product and service that they discuss internally, but of those it does, the stakes are very high.

If we now switch back to the role of the customer, it’s possible to walk through the mechanics of the transactions that support the App Store. Let’s assume a customer has a new Apple device. The logistics of the App Store occur in the following manner (financial details provided by Joan Hoover, Apple Investor Relations):

  1. iTunes is required to synch and backup devices. Customer installs or uses previously existing copy. New device is registered when it is first synched.
  2. Customer uses iTunes to register a credit card number for app purchase. (The benefit of this point should not be neglected; the transactional hurdle of entering a credit card for every transaction would defeat the App Store. iTunes holds the credit card information and it’s used cleanly from both mobile device and base computer, for both iTunes and App Store.)
  3. Customer browses App Store from wireless or WiFi network and selects app with price of $3.99
  4. Apple recognizes $3.99 in cash for transaction
  5. Here’s the 30/70 split. Apple recognizes 30% of $3.99, or $1.197, as revenue. Apple creates a liability equaling $2.793 for Developer X, which will temporarily boost Apple’s cash balance, because it collects cash immediately but pays developer monthly.
  6. Simultaneously, the application is downloaded to the device.
  7. Future updates are downloaded for free, but these do not count in the download figures

Because of something that Steve Jobs said early in the App Store’s existence, it is possible to use historical information to derive the App Store’s financial contributions. After about 30 days, he said that the first 60 million downloads yielded $30 million in sales. But, keep in mind that this figure was prior to Apple paying 70% to developers.

Apple has publicly announced the following milestones in App Store traffic[2]:

So the fiscal Q2 download figure can be triangulated, within a 10% range, by assuming that Apple entered the quarter with between 400 and 425 million downloads and left with between 875 and 900 million downloads. This means that they provided at least 450 million and perhaps as many as 500 million downloads in fiscal Q2. To be conservative, let’s take the smaller figure.

450 million downloads at an average price of $0.50 means that Apple recognized $67.5 million in revenue from their 30% cut. Here is where the analysis becomes a guessing game. No credible source, to my knowledge, has unraveled iTunes financials in terms of Cost of Goods Sold (COGS) or below the line expenses, and the App Store joins that category. By making a few educated assumptions, however, we can arrive at an EPS figure.

When Apple reaches its billionth download, they will have booked $150 million of revenue ($500 million in sales * Apple’s 30% cut) that go to offset the expenses related to the App Store. Did it offset those expenses? It’s my assumption that a company such as Apple could set up and run the App Store for the first year, assuming iTunes hosting synergies, for $100 million in Selling, General & Administrative expenses.[3] That would leave $50 million in EBITDA, which after taxes, at a tax rate of 30%, translates to about $35 million in net income, or almost 4 cents EPS (per billion downloads).

For Q2, if Apple downloaded 400 million applications, they potentially posted EPS of about 1.6 cents. This means, assuming that Apple posts an EPS of $1.25 for Q2’09 (my estimate, about 15% above consensus and 25% above Apple’s guidance), that the App Store will have contributed 1.3% of total quarterly earnings. Not bad after 9 months of existence.

As Apple moves toward its billion downloads, it has listed the top paid and free applications. Table 1 shows an estimate of more than $40 million in revenue for the Top 20 applications alone. This is not inconsistent with the idea that one billion downloads, including more than 10,000 paid applications, could total $500 million or more.

The weighted average price of Top 20 apps from this ranking is $2.80, in the ballpark range of previous estimates. The Total Revenue is more than $43 million, which is a decent contribution toward the $500 million total estimate.

The compelling reason for the expense assumptions, and Apple’s advantage therein, is that any device manufacturer would face the same fixed (setup) and variable (hosting) costs with their version of an application store. Apple’s advantage, and it should not be underestimated, is that they know how this works and also can take advantage of scale based upon their iTunes history.

Remember, too, that this system is lucrative for developers who create and sell the content. In the background, the App Store is already on pace to surpass $500 million a year revenue for developers (1.6 billion downloads annually * $0.50 average per download * 70% for the developer).

So, there you have it. While the App Store is not yet a money printing machine, like some of Apple’s other offerings, it is a product enhancement strategy that will certainly achieve its main goal of increasing device sales. The icing on the cake is that it could generate reasonable future profits for Apple, as well as create a financial incentive to have a vibrant marketplace that creates profits for developers.

Disclosure: Long position in AAPL (Jul-09 Call Options)

[1] This number is extrapolated from multiple sources, including Piper Jaffray’s Gene Munster, who estimated 3.5 million were sold in the holiday 2007 quarter alone.

[2] Early milestones available on Apple website. Later milestones have been heavily covered by many media outlets, gathering massive, free App Store publicity

[3] For $100 million, Apple would be able to staff a standalone App Store with 300 well-paid employees, and still have $40 million toward other fixed and variable costs incurred with hosting and transactional requirements.