America’s monopoly drawback – Traders’ Chronicle
At the start of 2022, Apple (US:AAPL) became the first company to achieve a market capitalisation of over $3tn (£2.2bn). Any account of the company’s success must acknowledge a range of factors that helped trigger its rise to power, from individuals like Steve Jobs to groundbreaking products such as the iPhone and structural forces such as the cheap labour costs ushered in by globalisation.
But a less-heralded catalyst, and one that continues to this day, is the network effect: put most simply, the more users that join the Apple ecosystem, the more utility each user gets. In one way or another, network effects are common to all the dominant technology platforms of the age, and have helped turbocharge their share prices. Apple, Amazon (US:AMZN), Alphabet (US:GOOG) and Meta (US:FB) have been able to keep increasing revenues while becoming ever-more dominant in their main markets.
That dominance has attracted the attention of policymakers and regulators around the world, who have grown increasingly concerned over what they see as monopolistic practices. The counter-argument, increasingly put forward by big technology companies themselves, is that they are, in fact, belatedly witnessing the emergence of powerful competitors: each other. After years of ruling the roost in their respective niches, the tech giants are now increasingly encroaching on their rivals’ turf.
In the past, these skirmishes were settled by regulators. In 2012, a US Department of Justice (DoJ) lawsuit alleged that Apple and five book publishers conspired to raise the price of ebooks by up to $5 apiece in a deal that would see Apple receive a 30 per cent commission on each sale – a move widely seen as a bid to thwart Amazon’s disruptive $9.99 price model. The DoJ won the case, and Apple was ultimately unable to grab a foothold in the ebook market.
Amazon was in some ways a bystander to that case – it was not named as a defendant. Ten years on, however, and the stakes are much higher. Policymakers’ goals are much broader in scope than they were in 2012, and big tech’s battles are being played out in the public arena.
Providers are going up against suppliers, and that can mean both sides have a good amount of leverage in negotiations. The Amazon and Visa (US:V) spat, a ceasefire on which was announced last week, is a case in point.
Amazon vs Visa
At the end of last year, Amazon announced that it would no longer be accepting payment from Visa credit cards issued in the UK because of an increase in payment fees. When the UK was in the EU, credit card interchange fees were bound at 0.3 per cent by the European Commission. Last year, Visa reportedly decided to increase its fees on cross-border transactions to 1.5 per cent.
Like Apple and Google in the smartphone market, Visa and Mastercard (US:MA) currently have a duopoly over payments. As the IC wrote last November, Visa has 2.5bn cards in use and processes more than 100bn transactions a year, which means it is unlikely that Amazon would ever look to ban its cards permanently – the risk of losing Visa’s customers and reverting its network effect is too high.
On 17 January, Amazon said it would no longer proceed with the ban, announcing that the two companies were working on a “potential solution”.
That gives credence to those who say Amazon is, for once, in a weaker negotiating position. “If the Amazon co-brand portfolio flipped to Mastercard, we believe the earnings impact to Visa would be less than 1 per cent,” said Ken Suchoski, a payments analyst at research firm Autonomous.
Visa currently has an operating margin of 66 per cent while Amazon’s is just 4.4 per cent, meaning Amazon’s profit is much more sensitive to a rise in costs. Even a 1 per cent rise in its cost of sales could cause a 13 per cent drop in Amazon operating profit.
To partly detach itself from dependence on Visa and Mastercard, Amazon has entered into an agreement with buy-now-pay-later (BNPL) company Affirm (US:AFRM) in the US, while in the UK it has partnered with bank Barclays, which now offers a BNPL service called Instalments. Amazon has also joined forces with PayPal’s (US:PYPL) peer-to-peer payment service Venmo.
These alternative payment options provide avenues to avoid the credit card fees charged by Visa and Mastercard. However, they are still a long way from being a viable alternative. Affirm currently has just 8.7m active customers while Venmo has around 80m. That’s 0.3 per cent and 3 per cent, respectively, of the number of Visa cards currently in circulation. Until these numbers change significantly, Amazon needs to keep Visa and Mastercard on side – or risk losing some of the customers it has spent so long accumulating.
Other members of the ‘Faangs’ are finding their own negotiations with fellow US megacaps follow a similar pattern. In December, Google reached an 11th-hour agreement with Disney (US:DIS) to ensure a number of the latter’s channels, including the ESPN sports service, could continue to be shown on YouTube TV.
Bigger battles could lie ahead. Bernstein analysts noted last August that an estimated $15bn a year paid by Alphabet to Apple to ensure Google is the default search engine in Apple’s Safari browser represents an “inherently unstable” state of affairs.
Bernstein believes Google is paying Apple over the odds to maintain its dominant position in online searches (and the advertising revenue that accompanies it) – and block Microsoft’s Bing browser from occupying the space itself.
The analysts note there are risks to this revenue if “either Google or Microsoft were ever to unilaterally stop bidding”, and suggested Tim Cook’s company consider acquiring or building its own search engine. They also suggest the size of Google’s payments “could attract further regulatory scrutiny”.
And even those who have less negotiating leverage are finding the courts more sympathetic to their aims.
Similar to Amazon’s gripes with Visa, Epic Games – the developer of open-world shooter game Fortnite – believes the fees charged by Apple’s App Store are too high. Apple currently takes up to a 30 per cent cut of anything sold through the App Store including in-game purchases. In 2020, to bypass this fee, Fortnite introduced its own in-app payment system and Apple subsequently banned it from the App Store.
Epic then filed an antitrust lawsuit against Apple, claiming that the App Store had a monopoly and was using it to charge excessively high fees. This time, Apple won out, albeit perhaps temporarily. In September, judge Yvonne Gonzalez Rogers ruled that Apple did not yet have a monopoly and therefore was not required to cut the 30 per cent fee. Although Apple has around 55 per cent of the mobile gaming market and extremely high margins, the judge concluded: “These factors alone do not show antitrust conduct. Success is not illegal.”
However, the ruling did conclude that Apple was nearing a position of monopoly, which leaves the door open to future antitrust complaints. “The evidence does suggest that Apple is near the precipice of substantial market power, or monopoly power, with its considerable market share,” wrote Gonzalez Rogers. “Apple is only saved by the fact that its share is not higher, that competitors from related submarkets are making inroads into the mobile gaming submarket, and, perhaps, because [Epic] did not focus on this topic.”
Significantly for Apple, Gonzalez Rogers ruling mandated that Apple must allow all developers in the US to direct users to other external systems for in-app purchases. But the implementation of that change, due to come into effect in December, was delayed at the last minute following an appeal by Apple. The ultimate resolution could now be a long way off – though similar changes have already come into effect in South Korea and are mooted in other jurisdictions.
How much does any of this matter to giant companies with diversified revenue streams? Another lawsuit, filed against Alphabet’s Google Play Store by 37 US states last year, claimed that Google produced $11.2bn in revenue from its mobile app store in 2019 with an operating margin of over 62 per cent, according to Reuters. That would equate to around 7 per cent of total company revenues that year, although Google told the newswire the results “mischaracterise[d]” its operations.
Analysis by Goldman Sachs last September estimated that cutting Play Store commissions from 30 per cent to 15 per cent or lower could knock 6-17 per cent off its 2023 forecasts for Alphabet operating profit. In the event, Alphabet has since thrown down the gauntlet to Apple by cutting its fee to 15 per cent in many cases, albeit not for the most popular apps on the store.
On the day of the Gonzalez Rogers ruling, Apple’s share price dropped 3 per cent due to concerns the in-app purchase ruling could dent its $19bn of service revenue – its largest contributor behind iPhone sales.
Yet the shares had long since made up that fall by the time of December’s appeal ruling. One reason is the company’s growth in other areas: Morgan Stanley analysts said last autumn that ad growth would more than offset any hit to App Store policies. Goldman Sachs’ scenario analysis outlined above did not prevent it initiating coverage of Alphabet with a buy rating.
Likewise, the market is not worried about Meta’s unsuccessful attempts to dismiss the antitrust case brought by the US Federal Trade Commission, seeking to unwind its ownership of WhatsApp and Instagram. Meta’s failure to get the case thrown out on 11 January caused a mere 1 per cent fall in its share price.
The unsurprising conclusion is that few believe big tech is about to be broken up like the giants of the past, such as Standard Oil and AT&T, were before them. Even so, it is clear the antitrust landscape has changed in the US over the past decade.
Paving the way
One name overlooked in tech’s growth story is competition lawyer Robert Bork. Bork helped overhaul US antitrust laws in the 1980s, switching the focus from market share to “market power” – that’s to say prices paid by consumers.
In the 1980s, judging consumer welfare by prices made sense. In the age of internet platforms that are happy to offer their services below cost in the pursuit of scale, it’s less logical.
Take Amazon. To grow its platform, it acquired a string of ecommerce competitors along the way, such as Zappos (2009) and Quidsi (2010). Facebook remains predominantly an advertising business – so it needs to keep gaining users in order to benefit from further economies of scale. To protect its leading position, it purchased rivals WhatsApp (2014) and Instagram (2012).
Apple began life a little differently, starting as a hardware business. However, its dominance of the US smartphone market alongside Google has created a duopoly of mobile digital services. In the last quarter of 2021, services provided by the App Store, Apple Music and Apple Books contributed $18.27bn of sales, up 25 per cent from the year before.
All four companies’ ecosystems now stretch out far and wide. For those who agree with Bork’s stance, that is not a problem. But the continued success of these stock market giants, at a time when consumer incomes continue to stagnate (see chart), has gradually raised the stakes politically. Legal opinions are also on the move once again. In 2017, then-student Lina Khan reignited the issue of how to assess monopolistic behaviour when she published the widely read essay ‘Amazon’s Antitrust Paradox’.
In it she argued that current antitrust law “underappreciates the risk of predatory pricing and how integration across distinct business lines may prove anticompetitive”. To correct this, she suggested “restoring traditional antitrust principles to create a presumption of predation and to ban vertical integration by dominant platforms to help maintain competition in these markets”. In other words, the government should act earlier to prevent market dominance, rather than wait for increased prices to act as an indicator of lost consumer welfare.
That ship has clearly sailed in the case of big tech. But in June last year, President Biden appointed her chair of the Federal Trade Commission (FTC). Both Facebook and Amazon requested that Khan step back from the FTC’s antitrust investigations into their companies, arguing her criticism of them in the past meant she would “not be a neutral and impartial evaluator”.
That request has fallen on deaf ears. In the same judgement that denied Facebook’s attempt to throw out the FTC antitrust lawsuit, it was also concluded that Khan had no “axe to grind”. With big acquisitions booming, US competition agencies announced on 18 January that they intend to overhaul merger rules – with a focus on “non-price competition” and the “unique characteristics of digital markets”.
Not everyone thinks big tech has a monopoly
Not everyone believes current antitrust legislation is unfit for purpose. Joe Kennedy, senior fellow at the Information Technology and Innovation Fund, wrote that “antitrust policy is already capable of handling most clear (as opposed to imagined) threats to competition”.
He argues that the dominance of Google, Facebook and Amazon reflects the fact they have the best products, and notes they still need to invest to fight off competition from rivals such as Snapchat (US:SNAP) and TikTok, in the case of Facebook. As a result, the price of internet advertising has fallen by 40 per cent since 2010, which lowers operating costs for other businesses.
Nor are network effects a guarantee of perennial market dominance. In ‘Debunking the Network Effects Bogeyman’, professor David Evans, chairman of the Global Economic Group, says that while networks can have exponential expansion they can also suffer exponential decline: “We see the physical manifestation of reverse network effects all across America in the form of dead or dying malls. Fewer people come to the mall, stores pull out of the mall, leading to even fewer people coming.”
This reversal happened with MySpace, the dominant social media platform before Facebook, and is now arguably starting to happen to Facebook. Teenage users of the Facebook app in the US have declined by 13 per cent since 2019 and are projected to drop 45 per cent over the next two years, according to documents leaked by whistleblower Frances Haugen and shared with US technology news website The Verge. Stuttering user growth, coupled with new restrictions from Apple on advertising, saw Meta lower its guidance for future advertising revenue in its recent results.
This may be one reason why the company has rebranded and is pinning its hopes on the ‘metaverse’. Diversification strategies being pursued by most of the Faangs: Amazon is pushing deeper into retail and streaming services, Apple is shifting from products to services, and Google is expanding further into cloud computing. And most of these tech giants have capital expenditure plans that will extend to tens of billions this year.
Some of these expansion plans overlap with one another, but there is reason to think certain business lines can continue to expand in tandem. Goldman predicts Google Cloud’s Ebit margins will expand from -15 per cent this year to 18 per cent in 2026 (see chart), but it also estimates that Amazon Web Services – still the market leader in the cloud – will see its own margins rise from 28 per cent to 31 per cent.
Still, it is easy to view Meta, along with the rest of Big Tech, as sitting at a crossroads. In an extreme outcome, judges will rule the network effect to be a sufficient barrier to entry to prevent competition – in which case, Meta’s acquisitions of WhatsApp and Instagram may be unwound and the door opened to increased litigation against other platforms. Amazon’s ecommerce marketplace, as well as Apple’s App Store and Google’s Play Store would then be more firmly in the crosshairs.
The other scenario is that courts side with Dr Kennedy and Evans’ opinion: that network effects are overemphasised in their importance and these companies have not erected the large barriers to entry many believe. Investors will then be left to reconsider whether the tech giants truly justify the premium valuations on which they trade.