Surprising news emerged from the Department of Justice's (DOJ) antitrust lawsuit against Google parent Alphabet (GOOG -2.82%) (GOOGL -2.86%) recently. According to media reports, a witness stated that Apple (AAPL 2.98%) receives 36% of the Google Search revenue that goes through the Safari browser that Apple pre-installs on its devices. This was a startling figure and I think it highlights a weakness Apple investors need to be aware of now.
Apple and Google's search relationship
To put some context on Apple and Google's search distribution relationship, let's go back a few years. When Apple products saw a resurgence in popularity during the early 2000s, Google went to the hardware maker and struck a deal with it to make Google the default search engine on Apple's pre-installed Safari internet browser.
Recent reporting from The New York Times indicates that Google paid Apple around $18 billion in 2021 for the privilege, though it's not clear if that's on top of the 36% or not. Since search advertising provides the majority of Alphabet's $300 billion in annual revenue, it makes sense Google was willing to pay up to be the default.
Details of the Apple-Google agreement have been kept under wraps for many years, but thanks to the DOJ's current lawsuit , outsiders can now start to piece things together, including a witness's assertion that Apple receives 36% of the Google Search revenue earned through the Safari browser. In other words, for every $100 in revenue Alphabet earns through Safari, it pays $36 to Apple.
While many people were surprised by this testimony, some big numbers had been circulating -- as much as $20 billion annually that Alphabet pays to Apple each year. If $20 billion were the figure, at a 36% cut, that would mean Google Search earns about $55 billion in revenue through Safari.
Whatever the exact numbers are, suffice it to say Apple is receiving billions of dollars a year from Alphabet in exchange for making Google the default search engine on its mobile devices.
If the courts decide this deal is anticompetitive and the worst happens, that revenue stream could evaporate for Apple. While Apple could have ways to try to make up any lost revenue, there would be a lot of uncertainty in the situation, and that would be worrisome for Apple investors.
Estimating the potential impact to Apple
Over the 12 months ended in late September, Apple generated $383 billion in revenue. In that context, one might think that losing even the max rumored annual payment from Google ($20 billion) would be no big deal for the tech giant, as that's only 5% of the recent 12-month total. However, this would overlook the fact that Alphabet's distribution payments to Apple likely come at close to a 100% profit margin. Making Google the default search engine on Safari requires minimal work on Apple's part.
In that light, it's clearer why losing the search engine deal could have a major impact on Apple's financials. Over the 12 months ended in late September, Apple generated $114 billion in operating income. Shaving $20 billion off this number would amount to a 17.5% cut in its operating income. At the lower end of the rumors about annual payments -- $10 billion -- that would look like almost 9%.
The big risk for investors
Looking at Apple's stock price, I don't think investors are pricing in the possibility of Apple losing this distribution payment. The stock currently trades at a price-to-earnings ratio of 31, which is well above the market average. And it's not like Apple is lighting the world on fire with growth. After the pandemic-driven demand boom, its revenue has been stagnating, as have its earnings.
AAPL Revenue (Annual) data by YCharts
If the courts rule against Alphabet, it is unlikely that Apple would be able to replicate its deal with any other search engine provider. First, there's no other company in a position to make such a payment and, more importantly, if the courts rule against such preferential placement, then it's not allowed for anyone. Logically, it is all or nothing for Apple here.
Perhaps Apple could make it up with an internal Apple search engine product, but launching this would require a ton of development costs and would be going up against Google's 25 years of product improvements, creating a ton of uncertainty.
A big drop in earnings would likely result in at least a matching drop in Apple's share price. Yes, the company has a great brand, but it trades at 31 times earnings, is delivering no revenue growth, and is at risk of losing billions in annual profits at the hammer of a gavel. That doesn't seem like a recipe for good stock returns.
You can find a better blue chip to add to your portfolio than Apple right now. Avoid this stock for the time being.
