: Epic takes aim at Apple’s financial advantage in App Store model

United States

Define the market, then follow the money.

This was the crux of Epic Games Inc.’s legal argument much of Monday, and in all likelihood most of the week, as it makes its case in an antitrust lawsuit against Apple Inc. AAPL, -2.58% in federal court in Oakland, Calif.

The beginning of week two of the closely watched trial, the most significant in Silicon Valley in more than a decade, centered on the financial might of Apple’s App Store. Epic argues the 30% commission fee charged by the store to developers, as well as a “walled garden” strategy that makes it difficult for cloud-gaming services to compete on the platform, constitutes anticompetitive behavior.

Epic’s main economic expert, David Evans, chairman of Global Economics Group, detailed Apple’s monopoly in smartphone operating systems as the relevant market in question. Smartphones and consoles are different types of markets, he added, with iOS and Android examples of a “general purpose operating system” used for multiple apps while games consoles are a special operating systems dedicated to gaming. 

Of the top 50 games on iOS, based on downloads and revenue, the majority aren’t available on game consoles, according to Evans’ testimony Monday. Game consoles, he continued, aren’t “substitutes” for smartphones — and vice versa. What is more, switching costs for consumers between the two computing platforms is pricey.

“Apple has substantial market power” in smartphone operating systems, Evans said. It and Google’s Android, he concluded, are a duopoly that have controlled 100% of the smartphone OS since 2013. Globally, excluding China, the split is 60%-40% Android; in the U.S., it’s about even, he said.

“Developers need to be where customers are,” Evans said. “They have to create iOS apps to reach iOS users and have to have an Android app to reach Android users.”

“My opinion is Apple has monopoly power in the iOS app distribution market” based on “high and persistent profit margins,” Evans said. (Those numbers, calculated by Evans based on data Apple provided in the lawsuit, were only shown to federal Judge Yvonne Gonzalez Rogers, who is deciding the case.)

“Apple’s restrictions harm competition” for app developers and consumers, leading to higher prices, poorer distribution and slower innovation, Evans concluded. Without providing numbers, he said the App Store’s R&D-to-sales ratio “is very low,” and below the median R&D ratio of online retailers Alibaba Group Holding Ltd. BABA, -2.57%, eBay Inc. EBAY, +2.78%, Rakuten Group Inc. 4755, +0.08%, Etsy Inc. ETSY, +0.98% and Mercado Libra Inc.

Underpinning Evans’ testimony is the notion that Apple customers are locked into its digital ecosystem, unaware of its overall costs. He estimated about 60% of iOS users exclusively play games on a smartphone. When Apple booted “Fortnite,” Epic’s popular game, off the App Store following the companies’ dustup last year, more than 80% of iOS players of “Fortnite” didn’t find a replacement.

Evans’ lengthy scheduled testimony is to be followed by Stanford University’s Susan Athey, Microsoft Corp.’s MSFT, -2.09% former top economist. (Apple will first counter with MIT’s Richard Schmalensee, who has a different definition of the market at issue in the case. He will testify that Apple owns a small share of the “digital games transaction market.” Ironically, Schmalensee and Evans are co-authors of “Matchmakers,” a book on “two-sided markets” where a company helps connect two types of customers.)

Read more: Apple v. Epic: Time is running out for Epic to make its antitrust case

Evans heads a group of economic experts from Epic tasked with showing the market dominance of the App Store — they argue it is an antitrust-busting monopoly — has catapulted Apple to a dizzying $ 2.2 trillion market value, the most of any U.S. company. (Privately held Epic is valued at $ 29 billion.)

Ultimately, the case hinges on what Judge Gonzalez Rogers considers the relevant market in this case.

Epic’s economic analysis and market definition of App Store, and its impact on the greater app economy, is a linchpin of its legal argument. Epic has devoted more hours to Evans than any other witness, and Apple has frequently cited him in its legal documents and comments. Another Epic witness, Ned Barnes of the Berkeley Research Group, is expected to offer an analysis of the App Store’s profits, which Apple has strongly objected to.

The Epic Games Store, a digital videogame storefront for Microsoft Windows and macOS as an alternative to the App Store, charges a commission of only 12%. By 2024, Epic projects the store will post a profit of between $ 15 million to $ 36 million, although it will run up total losses of between $ 654 million to $ 854 million to get there, according to Epic’s internal projections presented at the trial.

Apple’s App Store, which opened in 2008 – a year after the iPhone launched – quickly became profitable after ringing up $ 2.1 billion in billings in 2010, according to an Apple slide presentation last week.

Still, the trial has not revealed the precise profitability of the App Store. Apple doesn’t disclose the store’s financial results, but it is a crucial piece of the company’s services division, which generated $ 57 billion in revenue last year.

Apple contends Epic, through the guise of an internal corporate plan called Project Liberty, has angled for years to bypass in-app payment processing systems from Apple and Alphabet’s GOOGL, -2.56% GOOG, -2.38% Google, each of which charge a 30% commission. In doing so, Apple attorneys said, Epic breached its contract with Apple. “Epic purely aimed to enrich itself to the exclusion of other developers,” an Apple legal strategist told MarketWatch.

Apple could start arguing its case as early as Friday.