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Apple (NASDAQ:AAPL) first introduced the App Store in July 2008. Five and a half years later it has evolved into a thriving business, surpassing the iTunes music business that was launched a few years before it. With gross iTunes revenues approaching $5 billion per quarter, the App Store is iTunes' fastest growing segment and its growth continues unabated.

While Apple's management are notoriously tight-lipped about future products, they often offer data on existing products and services with a surprising degree of granularity. In fact, the company tends to be more open in that regard than many of its competitors, such as Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN).

Recently, it was revealed that cumulative payments to developers have surpassed $15 billion. I have summarized major App Store milestones in a table below.

Time

Paid to Developers (billions)

Apps available (thousands)

Apps downloaded (billions)

Jun-10

1

225

5

Jun-11

2.5

425

14

Jun-12

5

650

30

Jan-13

7

775

40

Apr-13

9

800

45

Jun-13

10

900

50

Oct-13

13

1000

60

Jan-14

15

1000+

60+

(click to enlarge)

As we know, the store's model is such that developers get 70% of the sales, while 30% goes to Apple to cover the operating costs. Apple has always maintained that iTunes and the App Store are designed to run at break-even, as the company's intention is not to profit from them, but rather to sustain its hardware business. Apple first signaled that iTunes was running at "above break-even" in 2006 and has not changed its stance since then. However, given the rate of growth, the App Store's bottom line must be benefiting from significant economies of scale.

What can be observed is that the amount paid to developers has effectively doubled every year, and so has Apple's cut. In June 2012 it was announced that $5 billion had been paid to developers. By June 2013 that figure had doubled to reach $10 billion. Knowing that developers get 70% of the total revenue, the amount that Apple kept to itself over the one year span comes to $2.14 billion. With $2.14 billion more in six months since the June announcement, Apple is well on its way to double the figure by the next WWDC, given the strong sales of the new iPhone and iPad models, recent deals with NTT Docomo and China Mobile (NYSE:CHL), and considering that the first calendar quarter is generally very strong, as that's when a large number of gift cards are redeemed.

While the growth may slow in 2015, it will likely still remain robust. I estimate that the App Store will generate around $5 billion in revenue for Apple in fiscal 2014, and over $7.5 billion in 2015. However, should Apple introduce the long rumored iTV with an open SDK, or the iWatch, the growth will likely intensify.

So, what are the major expenses that Apple incurs in running the App Store? There are hosting and distribution costs, payment processing costs, and finally, there are expenses associated with approving and administering the apps. Let's analyze what some of those expenses may be.

1. Hosting and delivery. What we know is the number of apps in the App Store and that is over 1 million. We also know that the average size of an app is just over 20MB, which means that the size of the App Store is a little above 20TB- hardly a huge amount of data these days. Of course, Apple has a multitude of servers hosting the apps spread across several geographic locations, but nonetheless, the number is rather negligible as compared to data storage demands of services like iCloud. Then there are bandwidth costs. Again, we know the number of quarterly downloads, which is currently sitting at over 6 billion apps, so the amount of data transferred each quarter for app downloads is in the neighborhood of 120 petabytes. Of course, the overall number is several times higher, taking into account updates and other types of communication with Apple's servers done by apps.

Let's use Netflix (NASDAQ:NFLX) as a proxy to get an idea as to what kind of expenses Apple may have. From one of the latest Netflix's 10-Qs we know that the number of Netflix users is 40 million. According to a study, Netflix subscribers, on average, watch 5 TV shows and 3 movies per week.

Given these numbers, it's easy to estimate the amount of data transferred every quarter. Assuming the average size of a TV show at 0.75 GB and of an average movie, with the blend of both HD and SD, at 2 GB, we have 126 GB of data per user per quarter. Multiplying by 40 million gives us over 5000 petabytes, which is quite a bit more than the amount of data Apple has to deal with when it comes to apps. So, how much does Netflix spend on technology and development? $95.5 million per quarter.

There's another recent report by an internet monitoring firm, suggesting that Netflix accounts for over 30% of the internet traffic, while iTunes for only 3.3%.

Given all that, it's reasonable to assume that Apple doesn't spend more than Netflix on hosting and distribution.

2. Payment processing costs. What we know is that Apple pays a certain amount for every purchase transaction that takes place. Only Apple knows how much exactly, but it's possible to get at least a rough idea. Without getting into too much detail on the credit card fee structure, the fees are comprised of base costs and markups, with the latter being negotiable to an extent. Given its size and leverage, it's safe to assume that Apple has negotiated the best possible rates for itself. Further, there are fixed fees, and transaction volume fees. For small transactions, such as $0.99, the fixed fees will take a good bite out of the 30% Apple cut, while the transaction volume fees will be quite small in comparison.

To help reduce that impact, Apple typically doesn't charge a credit card right away upon a small purchase. Rather, the transaction is put on hold and then bundled with any subsequent purchases that may take place within the next few days. Apple's margin improves quite a bit with a higher transaction amount. As an example to better illustrate that, Apple may have to pay $0.2 out of its cut of $0.297 for a $0.99 purchase, but only $0.21 for a purchase of $1.99, or $0.24 for $4.99.

After a quick check, of the top 100 paid apps, 42% are priced at $0.99, 21% at $1.99, with the rest being $2.99 or more.

Recently, however, the so called freemium model has grown more and more dominant. What it means is that while an app itself is typically free of charge, some additional features come at a price. It is now estimated that over 70% of the App Store's revenue comes from freemium apps. Indeed, it's easy to see that out of 100 top grossing apps in the App Store, the vast majority are free to download, meaning that the only revenue they generate is through in-app purchases and ads. Unsurprisingly, most of the top grossing apps are games. I've checked the most popular titles and it appears that they have the minimum in-app purchase set from $2.99 to $4.99, while the maximum goes as high as $49.99. It's easy to see that Apple's margin related to payment processing has benefited from the freemium model getting more popular.

Adding iTunes gift cards and the iAd revenue into the mix, I estimate that no more than 25% of Apple's cut is spent on payment processing.

3. The third major expense item is what Apple spends on administering the App Store. Currently, there are under 1000 new apps being submitted to the App Store every day. On average, it takes a few days for an app to get approved. So how many people does Apple employ to get this job done? I would assume that the app approval process is somewhat automated. Things like undocumented APIs can be found relatively easily. Other things will take longer. If it takes an employee 4 days to approve an app, the number of employees involved in managing the App Store shouldn't be significantly greater than 4000. Estimating quarterly costs per employee at $40,000, there would be $160 million in expenses.

Additionally, these costs, at least partly, are covered by the $99 developer fee that Apple charges per year. A few months ago Apple announced that the number of iOS developers in China alone has surpassed half a million, so the amount that Apple receives in annual developer fees is not insignificant.

The App Store is relatively young, but while the revenue is still growing at a fast clip of 100% a year, the number of apps and downloads is not increasing at the same pace. What this means is that Apple no longer needs to invest as much into the store's continued expansion relative to how much revenue it brings. The trend continues to benefit the margin and the bottom line as a result.

(click to enlarge)

(click to enlarge)

Conclusion

It was only two years ago, in 2011, when all of Apple's operating expenses amounted to $10 billion a year. If at the end of 2015 Apple keeps maintaining that the store is still running at break-even, while generating over $7.5 billion a year for the company, it's bound to raise a few eyebrows.

Here comes an important question. If Apple indeed starts making a sizable profit from the App Store, what is the company going to do next? I believe that Apple doesn't want to be seen as profiting off of content producers, as it could become harder for the company to negotiate content distribution deals in the future. At the same time, the profitable iTunes segment will give Apple an edge over competition, who don't enjoy the same level of profitability and economies of scale, as well as a free hand in various business strategies.

With its thriving ecosystem and stabilizing gross margins, Apple remains a buy at current prices. Albeit no longer as attractive as in the first half of 2013, it's still not expensive at 14 times trailing earnings, or only 10 times ex-cash.

Source: What's In Store For Apple's App Store?