Apple Arcade May Be Its Most Important New Subscription Service

Adam Levy, The Motley Fool

Apple's (NASDAQ: AAPL) forthcoming subscription mobile gaming service didn't get much attention when it was announced alongside News+ and TV+ at last month's event in Cupertino, California. The subscription will give iOS device owners access to over 100 premium games for a single monthly price -- no in-app purchases, no ads, just mobile gaming.

Apple is reportedly investing $500 million on content for Apple Arcade, according to the Financial Times (subscription required). That's certainly a big investment, but still not quite as much as Apple paid to develop original video content for TV+.

But Arcade could turn out to be more important to Apple than TV+ because it's going to cannibalize a business that's already showing signs of slowing down, just like Apple Music cannibalized iTunes with great success.

Apple Arcade on Apple TV, Mac, iPad, and iPhone.

Image source: Apple.

App Store downloads are declining

For the first time since the start of 2015, and perhaps ever, Apple saw a decline in App Store downloads last quarter, according to data from Morgan Stanley analysts. While App Store revenue continues to climb year over year, the drop in downloads indicates Apple may struggle to grow App Store sales going forward.

The App Store generated $3.7 billion in revenue in the last quarter of 2018, according to Morgan Stanley. That's extremely high-margin revenue, too. We should know more about how the company did in the first quarter of 2019 when Apple reports earnings on April 30.

Gaming is the largest source of revenue in the App Store. Both premium games and games with in-app purchases are key to that growth. Apple takes a 30% cut from each.

Morgan Stanley analysts attribute part of the decline in downloads to entertainment services like Netflix and Spotify removing the ability to subscribe in-app. That doesn't necessarily equate to the whole story, though, since mobile viewing or listening is still an important feature for subscription video and music subscribers, necessitating a download of the app even if they can't subscribe from within the app.

The problem may be more systemic than Morgan Stanley's analysts suggest, which means Apple may be seeing a decline in gaming revenue at some point in the near future. (But it could just mean iOS users weren't enamored with last quarter's game releases.)

Apple Arcade will cannibalize App Store downloads and in-app purchases

Not only is Apple spending a lot of money partnering with game developers for exclusive mobile games, it's also going to cannibalize regular App Store game downloads. That makes the total cost of launching the service much greater than the $500 million it's spending on content alone, and perhaps more comparable to the amount it's spending on TV+ content at launch.

Apple has a good history of successfully cannibalizing its own products. Most recently, Apple Music cannibalized iTunes. The company was arguably late to the game with its subscription music service, but that didn't stop it from soon becoming the most popular paid music service in the U.S. Apple said iTunes had its best quarter ever to end 2018 thanks to Apple Music. And despite the major changes in the music industry over the last decade, Apple has maintained its share of the market even with the intense competition.

Apple isn't the first company to launch a subscription gaming service either, but it's certainly ahead of where things were when it finally launched Apple Music. That could be key to ensuring continuous revenue growth from mobile gaming and dominating the industry.

Cloud gaming and other game subscriptions are a major threat to one of Apple's biggest moneymaking services. Apple can't necessarily rely on providing the distribution platform for its 900 million iPhone users anymore, and it's already starting to see downloads decline (even if revenue continues to climb). Apple Arcade could fend off the competition while replacing traditional downloads for many of its users, enabling it to remain dominant as a distributor of mobile games.

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Adam Levy owns shares of Apple. The Motley Fool owns shares of and recommends Apple and NFLX. 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.