Apple's Easy Google Money May Get Harder to Keep

Google is the Silicon Valley company most associated with "moonshots," but Apple might someday need one of its own -- replacing Google.

The two have long been rivals, particularly since their Android and iOS platforms dominate the world's mobile operating system market. But they are also joined at the hip through a lucrative agreement under which Google pays Apple billions of dollars annually to be the default search option on the company's Safari internet browser. That gives Google preferential access to Apple's iOS users while giving Apple a steady and high-margin revenue stream for its vital services business, which now accounts for 21% of its revenue and 35% of its gross income.

Neither company has ever been wild about discussing the arrangement publicly. Now the federal government's antitrust trial against Google that began last month has shone some light on the deal, forcing executives from both companies to take the stand to defend the practice. It also brought to the stand Microsoft Chief Executive Satya Nadella who, during testimony last week, described the setup as a "vicious cycle" that handicaps Google's potential competitors. They include Microsoft's Bing search engine, for which Nadella said the company tried for years to score a deal with Apple to take that default slot.

The trial is a long way from conclusion, and even an unfavorable ruling for Google will likely spark appeals that could leave the matter unsettled for years. But it also has come at an inconvenient time for Apple, which is facing worries about its latest iPhone cycle and its future business in China. Apple's stock price has slipped more than 7% over the last three months -- the worst performance among its Big Tech peers. That has cost the world's most valuable company more than $220 billion in market value.

Questions about iPhone 15 sales and China will at least get a little more clarity in the near-term. Apple's fiscal fourth-quarter report, scheduled for Nov. 2, will include a week of sales of the latest iPhones, which could at least indicate if reports about the new Pro models overheating had any cooling effect on actual sales. It will also give Apple a chance to address growing worries about its business in China, where authorities are cracking down on U.S. tech companies and where a once-hobbled local competitor, Huawei, seems to be making a comeback.

Questions about the ultimate fate of the company's deal with Google will likely persist. And they are expensive questions: Google-parent Alphabet now incurs nearly $50 billion a year in traffic acquisition costs, which are payments to partners and sites that generate traffic for the company's search engine. Apple has long been estimated to receive the lion's share of a subset of those -- Google's payments to distribution partners -- which totaled $12.6 billion in 2018 before Google stopped breaking out details of its TAC payments. Distribution TAC payments had grown by 34% annually on average over the five-year period ending in 2018, compared with an average of 9% growth for TAC payments to network partners -- sites that use Google's ad tools and refer traffic to its search engine.

Neither tech giant has ever disclosed the actual size of the payments to Apple. A government lawyer characterized the sum as more than $10 billion a year during opening arguments, which drew protests from both companies in a public trial that has been forced to shield a lot of nonpublic information. In a note last week, Goldman Sachs analyst Eric Sheridan estimated an amount in the range of $16 billion to $17 billion a year.

That would represent about 20% of Apple's projected services revenue for the fiscal year that ended in September. Its absence would make an even larger dent in the company's earnings, since it has very little incremental cost and thus commands much higher margins than other components of the services segment, such as TV+ and Apple Music. Morgan Stanley analysts estimate that losing all of Google's payments would take about 15% off Apple's per-share earnings in fiscal 2025, or 10% if the loss was limited to the U.S.

Apple needs to weigh its options carefully. Simply replacing Google's payments with an equal-sized revenue stream from a company like Microsoft could be problematic if the trial determines that such payments restrict overall competition. Apple has reportedly been developing its own in-house search engine alternative for years, and that effort could get a new push as the Google trial proceeds.

That wouldn't be simple, though: Google has had a 25-year head start to refine its technology, and Apple's recent stumbles in some of its in-house chip efforts show that even the deepest pockets can't always close a competitive gap. But Apple has billions of reasons to shoot for the moon.