How Do App Store Ads Affect Apple Valuation?

The move by Apple Inc. AAPL to revamp its App Store by introducing paid search ads and a new subscription model should boost gross profit, according to a note from Credit Suisse.

Plans For App Store Ads

"Apple plans to introduce a single paid ad at the top of search results in the App Store. The paid search ads, launched only in the U.S. initially, will be chosen on an auction process similar to Google's AdWords," the report stated. This will allow developers to focus their spending on the places where people actually go to search for and download apps.

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"Given Apple's App Store generates ~2x's as much revenue as Google's PlayStore and 65 percent of app downloads are driven by search, we believe this could represent a significant opportunity for both Apple and its app developers. We note that ad revenue would be incremental to our model," analyst Kulbinder Garcha wrote in a note.

Further, Apple's new subscription should yield more sustainable recurring revenues from App Store, which the analyst says is "highly GM accretive at ~87 percent at the net level and should accelerate growth going forward."

70/30 Could Become 85/15

Apple is now allowing all developers to sell subscriptions. While the traditional 70/30 percent split will stay in place, developers able to maintain a customer subscription for 1+ year will see Apple's cut reduced to 15 percent.

The analyst believes the App business will make up $8 billion–$9 billion (+40 percent year-over-year) in net revenue for 2016 ($29 billion–$30 billion gross) and $7 billion–$8 billion in gross profit.

Garcha noted that Apple's business is shifting from hardware to services with services' gross profit expected to more than double from about $14 billion in 2015 to about $34 billion by 2020.

"Given high retention rates, an installed base that could grow to ~1.4 billion long term, a superior ecosystem, and a multi-product compute advantage, we believe FCF of ~$67 billion should be sustainable long term," Garcha added.

Garcha maintains an Outperform rating and $150 price target on Apple stock, which closed Wednesday's regular trading at $98.94.