Apple (NASDAQ:AAPL) recently announced their plans to make major changes to the way their app store functions. Some of the changes should give investors a solid case for optimism as they represent a fundamental shift to a more sustainable and intelligent business model.
The App Store
The Verge recently had an interview with Apple's senior VP of worldwide marketing, Phil Schiller. Their article included the following update:
"Part of that energy has been channeled into figuring out how to sell developers on subscription services, and not only that, but how to keep them keeping on with those subscriptions. Previously, only apps classified as news, cloud services, dating apps, or audio/video streaming apps could sell subscription content. Now it's open to all product categories."
The old system, which limited the genres for subscription sales, was downright terrible. The largest genre for app sales is games and it isn't a close contest. 75% of all app revenue came from games. Apple had a major shortcoming in the way they approach the app store by disadvantaging the most effective genre. If Apple wants to grow revenue from their services segment, then they will need to become friendlier to game developers.
Subscriptions Are The Future
The nature of a subscription is inherently more sustainable than an app designed to generate a single sale. An app designed to generate a single sale has a very minor incentive to worry about the long run usage of the app. The biggest incentive would be to encourage higher ratings of the product as a way to stimulate future downloads. While that incentive may encourage some further development of the app, it doesn't generate the same level of continued investment that exists for a subscription system.
The difficulty of making major upgrades and monetizing them could encourage talented engineers to simply call it "good enough" and move on to a new project. This results in a poor experience for both engineers and users with an abundance of poor quality apps.
Thus far most of the monetization has come through the "freemium" model in which the game itself is initially free but certain features or substantial advantages are available by paying for them. The weakness in this model is that the entire developing team must be supported by a fairly small portion of the player base. According Swrve's monetization report .19% of players (notice the decimal!) paid 48% of total revenues to the mobile gaming companies.
The amount of revenue that could be generated from the platform is substantially impacted by the percentage of users that are actually willing to pay for the game. In the month of February Swrve found that only 1.9% of the player base made any purchases. If these players aren't making purchases in the app and are not paying any subscription revenues, they are not generating any revenue for Apple or for the developer of the game. If Apple really wants to generate revenue from services it makes sense to encourage a recurring cost structure.
However, the recurring structure can lead to some fairly absurd estimations.
Within the news piece there was a short excerpt from conversion with the co-founder of Lightricks Itai Tsiddon:
"Tsiddon says his company makes around $10 million a year from its premium apps, which are sold for a one-time purchase fee of $3.99 or $4.99. Lightricks has sold 8 million app downloads to date. Tsiddon hasn't fully committed to a subscription model yet, only saying that he's 'excited to experiment with the business model,' but based on back-of-the-envelope math he believes if his company saw 4 million downloads while charging a $4 monthly subscription fee, he could make 10 times his current annual revenue."
His math is accurate, but only if we take the enormous leap of assuming that he could essentially charge the full purchase price every month and still have 60% of the original purchases. I've never seen a business where that works. If Netflix (NASDAQ:NFLX) was $15 for life, it would be in almost every home in America. It also would be a terrible business strategy that was doomed to fail. Netflix understood the importance of creating subscription content and generated a great business from it.
Going a Little Deeper on the Comparison
If Netflix operated based off selling service for the customer's life in exchange for a single payment it would need to be something in the range of $500 to $1,000 for the method to have any chance at being viable. That is based on a simple estimate that it would need to be worth around 5 to 10 years of monthly subscription fees. If Netflix operated that way, I would expect them to cash out the business and try to avoid the cost of producing new content. That is the world where most app developers live. They collect an upfront fee and eventually need to move on to a new product if they can't find a way to generate recurring revenue.
Hopefully every investor can recognize that if Netflix had a lifetime fee and was changing to annual subscriptions they couldn't hope to charge $500 to $1,000 per year (or per month…) and keep even 40% of their customers.
The Middle Ground
While developers shouldn't bother with delusions of charging their entire price as an annual fee, the switch to subscription revenue should encourage further development of existing apps. Data on the number of live subscriptions also should provide Apple with exceptionally useful data for determining the proper search rankings. An application that is frequently downloaded but cancelled indicates that the application has better advertising than content.
Reaping Advertising Revenues
Apple also introduced advertising to the app store by allowing developers to buy placement in the ratings. It shouldn't dominate the ratings but it will allow Apple to push a few apps that are paying a premium for every click on their application. I don't see any major issues here because the developer only pays if their ad is clicked and from there it is on the developer to convert the customer.
The bigger reason this matters is because Apple wants to develop an entire ecosystem that encourages users to have Apple devices for everything. The strategy can often seem like a pipe dream to me because it forces users to become so heavily invested in Apple technology. For the diehard fans that will be just fine but for customers who already have a few devices from other brands it creates an incentive to avoid having any Apple products. If Apple wants to encourage those potential customers to make the switch they will need to have exceptionally useful toys. To ensure they have quality apps developed by third parties they needed to embrace the subscription system.
Apple made a smart move that was long overdue. Since the company wants to grow their revenue from services they needed to embrace the type of apps that are generating real revenue. Switching to a subscription system is a great way to encourage development of higher quality games. Rather than attempting to build entirely new products, engineers will be able to emphasize refining and improving existing products to strengthen their subscription revenue.
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