Apple’s New Content Rules Signal A Turning Point in Their Business

It’s been a confusing week in the Apple ecosystem. Over the past couple of days there have been contradicting interpretations of Apple’s new rules about content purchases within apps coming hard on the heels of somewhat disorienting keynote presentation from Steve Jobs where all the focus was on software and services. For a company that is noted for its strength in hardware, Apple’s shift to an emphasis on the software suggests a turning point that makes the new app rules more significant than they might first appear.

On Monday, I happened to be having a drink with an Indian developer a few minutes after he emerged from the Moscone Center. His verdict: “I think this is the weakest WWDC I’ve been to in years.” My friend’s point was that, from a developer’s perspective, little had changed about the underlying code and no new hardware had been announced for developers to take advantage of. Everything on offer from iCloud to features meant to take over innovative ideas like Instapaper or Dropbox created by outside developers was Apple going on offense to play defense.

As my friend from Bangalore and I mooted about the cloud, I wondered if the shift from device to the cloud meant that there would be little meaningful innovation in either hardware or operating systems for the near future. All the big gains, I posited, would now come from the development of cloud-based software services that exist outside of the device. And even though we seem to have forgotten that Apple survived for some many years by being superior software company (not a hardware one) the shift to the cloud brings a whole new dimension where Apple’s only success has been iTunes.

That’s a massive success but now the question is whither Apple? (I do recognize how absurd that question may seem in light of Apple’s enormous cash horde and $300b market cap.) It can’t pivot away from hardware because that business is still growing massively. If they can foresee the future–and who else would be able to foresee the digital future–the company elders must see the looming transition from hardware to software that cloud portends. (It is oddly similar to IBM’s transition from making computer systems to providing consulting services.)

For Apple, that’s an enormous threat. iPads and iPhones stand little chance of becoming a commodity soon. But if the locus of innovation shifts from hardware to software services, Apple’s margins will inevitably come under attack. The forces lining up against Apple won’t have to be external (competition from other devices has been minimal si far.) The very success of Apple’s products will begin to put pressure on their own margins as they chase incremental sales if innovation takes place outside of Apple’s control. In other words, they’ll have to keep lowering the price of the hardware to get more sales if they can’t bring out better products that require upgrades.

Here’s an anecdotal way of looking at Apple’s dilemma: I recently stopped into an AT&T store inquiring about an iPhone for a family member. The salesman was a smart guy and he said that he wouldn’t expect a new iPhone until 2012. Why? “What else,” he asked rhetorically, “can they do to improve it?”

The iPhone is an incredibly powerful device. Cloud services take much of the computing power necessary within a smartphone and handle that processing on the server end. With great basic features, the iPhone is fairly complete. The upgrades coming–as the keynote demonstrated–with new software to change the way some of the buttons work like on the camera.

The more computing power gets handled within the cloud, the easier it will be to reduce the complexity and power of the devices. That will reduce the cost of the devices and their margins.

That brings us to the App store’s new content rules. On Thursday, set off a storm with this observation gained from reading the fine print of Apple’s new subscription policies:

Apple has quietly changed its guidelines on the pricing of In-App Subscriptions on the App Store. There are no longer any requirements that a subscription be the “same price or less than it is offered outside the app”. There are no longer any guidelines about price at all. Apple also removed the requirement that external subscriptions must be also offered as an in-app purchase.

What this means is not immediately clear to anyone. Some, like All Things Digital’s Peter Kafka, took it to mean that Apple had blinked and was backing down a little. Though a closer look would suggest that Apple is just trying to push harder on excluding outside payment links from their apps by conceding on a previous price issue.

Keeping Apple’s share of payments within the apps is priority because of the aforementioned transition from hardware to the cloud that has the potential to sideline Apple. The company rightly wants to get some value from having created this new platform for content. Previously I’ve suggested that the issue is not Apple’s desire to take a toll but its insistence on charging a usurious 30% when even luxury shopping malls (which make large capital investments to create a retail platform) don’t ask for more than 10% of their tenants’ take.

Here’s the glaring issue: 30% is not a viable surcharge for most businesses. And it isn’t necessary for Apple to get repaid for all its innovative work in creating the smartphone and tablet platform. The volume of commerce that Apple can expect to see flow through that platform is large enough to allow the company to charge a lower rent. Looking at Apple’s 10-Q, content seems to be a $6 billion-a-year business already with more media being diverted through the app store every day.

Sadly, with money and margin at stake, the battle over how much compensation Apple deserves for creating and maintaining the platform is likely to be drawn out and bitter. The collateral damage will be all the companies hoping to create exciting new businesses via apps and the consumers who want to use them.

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