Netflix Doesn't Want to Pay Apple's "App Store Tax" Anymore

Netflix (NASDAQ: NFLX) recently started testing a feature that directs subscribers to a separate browser window to process their payments on iOS. That move prevents Apple (NASDAQ: AAPL) from taking a cut of the payment through its App Store.

Apple currently takes a 30% cut of a user's first subscription and a 15% cut on future renewals. With Netflix ranking as the third-highest grossing app in the App Store, the new feature could take a serious bite out of Apple's growing services business.

Netflix is testing the feature in 33 countries across Europe, Latin America, and Asia. This move isn't surprising, since it could boost Netflix's revenue per subscriber and widen its moat against Apple, which is evolving into a streaming video competitor with its growing portfolio of original content.

However, this move also highlights a vulnerability in the app store business model that could cause headaches for Apple and similarly Alphabet's Google.

A growing revolt against mobile app stores

Netflix isn't the first company to revolt against OS-based app store fees. Back in 2015, Spotify offered subscribers cheaper prices on its website than the rates on its iOS app. Chinese tech giant Tencent hosts a growing number of "mini programs" in its WeChat mobile messaging app -- which bypass app store fees because they're downloaded from inside the app.

Earlier this year, Tencent-backed Epic Games launched Fortnite for Android through a downloadable APK (application package) on its website instead of the Google Play Store. Research firm Sensor Tower estimates that Epic's decision could cost Google over $50 million in lost revenue this year.

To top it all off, Apple faces an ongoing lawsuit from developers who claim that the company abuses the App Store's dominant position to take an unfair cut of developers' revenue. The Supreme Court is expected to eventually rule on the case.

How badly could these moves hurt Apple?

Apple and Google both lowered their second-year app subscription fees from 30% to 15% last year in response to those complaints. Yet those reduced rates probably won't prevent heavyweight players like Netflix and Spotify from redirecting subscribers to their websites for sign-ups.

Earlier this year, Apple announced that the App Store generated $26.5 billion in revenue for developers in 2017, representing about 30% growth from 2016. Based on that 30% cut, Apple generated as much as $11.5 billion from the App Store for the year -- which would account for 5% of its top line.

Macquarie analyst Ben Schachter expects Apple to generate $20 billion in annual App Store revenue in 2020, which would equal a quarter of its net earnings. If pressure from major companies or app developers forces Apple to slash its standard rate to 15%, for example, that figure would be cut in half. Schachter thinks Apple could potentially lower its cut to 5% to 15%, and as a result, it'd lose up to $16 billion annually in the worst-case scenario.

But let's not overreact

Those estimates look ugly, but investors should remember three key things. First, only major companies like Netflix and Spotify can afford to thumb their nose at Apple or Google. Smaller developers who lack the brand recognition still need the App Store's support.

Second, Apple is already fighting back against subscription-based services with first-party platforms like Apple Music. Apple is spending a lot of money on original video content, and it's widely expected to launch a Netflix competitor in the near future.

Those services have the potential to hurt Spotify and Netflix, while further boosting services revenue, which rose 31% annually last quarter and accounted for 18% of sales. The growth of those subscription services, along with other services like Apple Pay and AppleCare, will serve to reduce the weight of the App Store within the segment.

Lastly, developers can't ask customers to download and install iOS apps from third-party websites, as Epic did with Fortnite for Android, since Apple only allows app installations from the App Store. Therefore, only subscription-based apps are currently vulnerable to pop-up payment windows.

The key takeaways

Netflix's decision to redirect payments is clever, but it won't cripple the App Store model. Apple faces pressure to lower its fees, but most developers cannot afford to pull their apps off iOS. Therefore, investors should keep an eye on this story, but they really shouldn't fret about its impact on Apple's long-term growth.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Apple and Tencent Holdings. The Motley Fool owns shares of and recommends Alphabet (A and C shares), Apple, Netflix, and Tencent Holdings. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.