Apple's Biggest Threat Isn't What You Think

Even the largest companies on the planet face risks, and Apple (AAPL -0.90%) is no exception. The consumer tech giant is currently grappling with difficulties on multiple fronts.

Struggles in China

When examining Apple, the most obvious risk is its business in China. After all, the company saw revenue from Greater China fall 13% in its most recent quarter.

Since emerging from pandemic lockdowns, Chinese consumers have been cautious, and the Chinese economy has not been growing as quickly as expected. Meanwhile, with U.S.-China tensions heightened in recent years, some U.S. companies could be feeling the backlash as Chinese consumers turn to homegrown brands.

On that front, Apple’s iPhone is suddenly seeing stiff competition from Huawei, whose Mate 60 Pro smartphone has been a huge hit in China. Huawei and other Chinese companies previously had trouble getting the chips needed to provide 5G connectivity due to U.S. sanctions, which gave Apple a big competitive advantage in the region. However, Huawei has been able to develop its own 5G chip, which is being produced by Chinese semiconductor foundry SMIC. Other Chinese competitors like Xiaomi and Oppo have also introduced competing smartphones at cheaper prices.

While China might appear to represent the largest threat to Apple’s business model because Huawei is seizing share at the tech titan’s expense, it’s not the biggest risk. There are a lot of questions surrounding whether Huawei will be able to fulfill demand given 5G chip manufacturing issues. In fact, the company recently decided to slow smartphone production in order to focus on producing artificial intelligence (AI) chips. With Chinese competitors being limited by manufacturing troubles, Apple could vault back into the smartphone lead in the country if it can innovate.

Legal risks

In the U.S., meanwhile, Apple is facing legal issues related to its App Store. Until recently, the iPhone maker made app developers use its payment system while collecting a 30% fee (or 15% for smaller developers) for all app or in-app purchases. However, Epic Games, the maker of Fortnite, pushed back and sued the company, ultimately winning its case. But Apple mostly sidestepped the verdict, allowing app developers to use external payment systems, but charging a 27% commission (or 12% for small developers) just for using its platform.

Earlier this month, a federal judge certified a class action lawsuit against Apple, allowing Apple account holders who have spent $10 or more in the App Store to sue the company over its policies leading to higher app prices.

Additionally, Bloomberg has reported that the Department of Justice is preparing an antitrust case against the tech giant regarding alleged anticompetitive behavior. The news outlet said the lawsuit could come as early as March. While the case has not been announced yet, it does seem likely to center around the App Store’s closed ecosystem and the commissions it charges.

Apple’s services business — which includes the App Store — is a key growth lever for the company. Services revenue increased 11% in the fiscal quarter ending in December. The segment also carries a much higher gross margin compared to its hardware division (approximately 73% versus 39%). Thus, any hit to this part of the business is a risk to Apple.

But I don’t think the threat here is as big as it might appear. Apple has already managed to sidestep one ruling, and app stores aren’t unique in taking a commission when selling third-party products. Retail stores mark up prices; Roku takes a cut of subscriptions sold through its streaming TV operating system; and eBay charges a commission when items are sold through its auctions.

While legal battles can be unpredictable, it could be a stretch to prove that Apple is hurting consumers with the App Store given that it is taking a commission that is less than the mark-up many retailers charge, as reflected in their gross margins. Kohl’s and Macy’s, for example, generally carry a gross margin of around 40%.

European App Store commissions reduced

While Apple has thus far been able to largely sidestep lowering App Store commissions in the U.S., it won’t be so lucky in the European Union. As a result of the E.U.’s Digital Markets Act, Apple announced some major changes to both its Safari web browser and the App Store. Importantly, the company will reduce the fees it charges for purchases on its own platform, taking them from 30% (or 15% for small developers) to 17% (or 10% for small developers) in the E.U. starting in March. It will also now allow users to download apps from third-party app stores, from which it would get no commission.

This change will directly impact the revenue that Apple generates from the App Store in the E.U. However, the E.U. App Store makes up only about 7% of Apple’s overall App Store sales, so ultimately it is a small headwind that the company should be able to overcome in other areas. It’s just not big enough to move the needle that much in either direction.

But this all ties into what I think is actually the most important risk facing Apple, which is: It’s not really playing offense anymore.

Apple’s biggest risk

Think about it — Apple just hasn’t been growing and innovating like it used to under former CEO Steve Jobs, and its stock multiple is not reflecting that risk. In fact, growth has been pretty lackluster recently. Revenue increased a scant 2% in its most recent fiscal quarter, and sales fell nearly 3% last fiscal year. Meanwhile, its price-to-earnings ratio has tripled since the end of 2011, the year of Jobs’ death. Do you think that Apple’s business should be worth 3 times the multiple it was in 2011? I don’t.

Especially because innovation has been lagging. While Apple’s Pro Vision augmented reality headset has gotten some good initial buzz, it is not a mass-market product at this time given its $3,500 price tag. It is also the company’s first major product category introduction since launching the Apple Watch nearly a decade ago. By contrast, Samsung has been quicker to incorporate new technologies and form factors, including foldable options, into its smartphones, while the iPhone has seen much more incremental improvements over the years.

With generative AI now starting to transform the technology landscape, Apple could find itself playing catch-up and being ripe for disruption. Once at the forefront of tech innovation, Apple has just not shown itself to be the same innovative company it was in the past.

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