Apple R&D Reveals a Pivot Is Coming

People are focusing on the wrong thing when analyzing Apple's path forward in the face of slowing iPhone sales. Instead of debating how much Apple will try to monetize the iPhone user base with services (not as much as consensus thinks), the company is instead planning its largest pivot yet. There are only a handful of logical explanations for Apple's current R&D expense trajectory, and all of them result in a radically different Apple. In a few years, we are no longer going to refer to Apple as the iPhone company. 

Apple R&D: By the Numbers

As I pointed out last May, Apple's R&D expense saw a significant bump up beginning in mid-2014. It was clear Apple was up to something big. However, after looking at Apple's 2Q16 results, it appears I underestimated the situation. As depicted in Exhibit 1, Apple is now on track to spend more than $10 billion on R&D in 2016, up nearly 30% from 2015 and ahead of even my aggressive estimate. This is a remarkable feat considering that Apple was spending a little over $3 billion per year on R&D just four years ago.

Exhibit 1: Apple R&D Expense (Annual)

One of the more interesting aspects of Apple's R&D expense trajectory in recent years is that the increase has been outpacing revenue growth. As seen in Exhibit 2, given my current iPhone sales expectations for FY16 and FY17, Apple is on track to approach a multi-decade record in terms of amount spent on R&D as a percent of revenue. 

Exhibit 2: Annual Apple R&D Expense (Percent of Revenue)

Unusual R&D Perceptions

The most shocking aspect about the amount of money Apple is spending on R&D is how little attention it has garnered in Silicon Valley and on Wall Street. Other than my R&D post last year, there is rarely any mention of Apple's R&D, and this doesn't seem to make much sense.

I suspect most of this has been due to the fact that Apple does not draw attention to its product pipeline and long-term strategy, choosing instead to embrace secrecy and mystery. Now compare this to Mark Zuckerberg laying out his 10-year plan for Facebook. It is easy and natural for people to then label Facebook as innovative and focused on the future. The same principle applies to Larry Page reorganizing Google to make it easier for investors to see how much is being spent on various moonshot projects. Jeff Bezos is famous for his attitude towards failing often and in public view, giving Amazon an aura of being a place of curiosity and boldness when it comes to future projects and risk taking. 

Meanwhile, Tim Cook has remained very tight-lipped about Apple's future, which gives the impression that Apple isn't working on ground-breaking ideas or products that can move the company beyond the iPhone. Instead of labeling this as a mistake or misstep, Apple's product secrecy is a key ingredient of its success. People like to be surprised. Another reason Apple takes a much different approach to product secrecy and R&D is its business model. Being open about future product plans will likely have a negative impact on near-term Apple hardware sales. Companies like Facebook and Google don't suffer from a similar risk. The end result is that there is a legitimate disconnect between Apple's R&D trends and the consensus view of the company's product pipeline. Apple is telling us that they are working on something very big, and yet no one seems to notice or care. I find that intriguing.

Logical Explanations for Apple R&D

Even though Apple remains tight-lipped about its dramatic increase in R&D expense, there are three logical explanations for what may be happening.

1) Apple's expanded product line requires additional R&D. This theory represents the most straightforward explanation. Essentially, because Apple has grown significantly over the years, the company needs to spend more on R&D just to keep up with its more expansive product line and greater competition. The company is now invested in four hardware categories (iPhone, iPad, Mac and Apple Watch), not to mention various software and services initiatives. 

2) Apple plans on doing more. Keeping with another simple explanation, Apple's increased R&D spend could signal that the company is willing to try its hand at more things. The expectation would be that Apple will begin releasing a greater number of products in terms of hardware, software and services. 

3) Apple is looking to pivot. Apple is ramping up R&D because they have a few big bets that require a massive increase in investment. The two most logical areas for these bets are wearables and personal transport initiatives. In both cases, Apple is moving well beyond its comfort zone of selling pieces of glass that can be held in one's hand. Instead, Apple is literally building a new company with additional capabilities and strengths.

The Most Likely Explanation

After analyzing the three preceding possible explanations for Apple's R&D increase, we can conclude the only one that actually makes sense is the third choice: Apple is looking to pivot. The first two theories fail to hold much water since they do not mesh with Apple's functional organizational structure. Since each senior Apple executive is in charge of his or her domain across Apple's product line, it is not possible for Apple to simply keep expanding the product line without negative consequences. At a certain point, Apple's resources are just stretched too thin to be effective. Some have argued that Apple had experienced some of this resource strain towards the end of Apple Watch development. In reality, Apple is constantly suffering from this resource strain despite having $233 billion of cash and cash equivalents on the balance sheet. 

It is this functional organizational structure that explains why Apple management talks about the need to remain focused and saying no to certain products and industries even though Apple could conceivably see much success. This rules out the explanation that Apple is spending more on R&D with the intent of doing a greater number of things. Apple's R&D follows a similarly focused mantra. While there are always scattered teams of people focused on far-fetched ideas and products, these activities do not amount to much of Apple's $10 billion budgeted for R&D in 2016. Instead, sudden and dramatic increases in Apple R&D are a result of new product initiatives.

One way of validating the claim that R&D is very much product focused is to graph the year-over-year change in R&D in absolute terms. As shown in Exhibit 3, a step pattern becomes apparent over the past 10 years. There have been two discernible increases in R&D expenses followed by periods of flat growth. When taking this step pattern and then overlaying it with Apple product launches, three product development stages become apparent: iPhone and iPad in the mid-to-late 2000s, Apple Watch beginning in 2012, and something new beginning around the Spring 2014. I suspect this latest item is primarily related to Apple working on its own electric car (Project Titan).

Exhibit 3: Apple R&D Expense Growth (Quarterly)

Apple Will Pivot

Apple is not spending $10 billion on R&D just to come up with new Watch bands, larger iPads, or a video streaming service. Instead, Apple is planning on something much bigger: a pivot into the automobile industry. 

The word "pivot" has become a buzzword lately, often misused to simply mean change. In reality, pivoting is actually a sign of strength as a company takes what it learns from one business model in one market and applies it a new one with a different business model. Apple would be taking lessons learned from its long-standing view on the world based on the Mac, iPod, and broader iOS lineup to begin selling an electric car.

This sounds incredibly ambitious and bold, and that is the point. Apple wants to move beyond the iPhone. In this regard, pivot seems like the wrong word to use since the iPhone is a very successful product generating more cash flows than the rest of Apple's product line put together times two. However, it is this success that ultimately serves as the greatest motivation for Apple management to figure out the next big thing.

In terms of how Apple can physically pivot, Apple's functional organizational structure needs to once again enter the conversation. An ability to pivot is the primary reason Apple has a rare functional organizational structure in the first place. By allowing management to put all of its attention on the product, and not internal politics, Apple's organizational structure is a major strength, not weakness. Apple is designed to move from product to product, industry to industry. We see the company do just that by entering the smartphone market, followed by the wearables market and soon, the auto market. 

Project Titan: A Finished Product is Likely

It seemed like many in Silicon Valley and on Wall Street spent most of 2015 debating if Apple even wanted to design its own car. (The answer was obvious: yes.) The discussion has now turned to whether Apple will actually end up selling a car or if management will conclude there isn't enough there to actually lead to a finished product. While Apple does indeed say no to most products and projects, Project Titan is not just any R&D project. 

In reality, people are grossly underestimating the odds that Project Titan will lead to Apple actually shipping an electric car. At this point, I peg odds of Apple selling its own electric car to be at least 80 percent. There is one very simple reason for my high degree of confidence: Project Titan is a long-term pivot. I don't consider Titan to be just another project that Apple has been tinkering around with in the lab for years like an Apple television set or Apple Pencil. Instead, Project Titan is much more about building a foundation for Apple that will literally represent the company's future.

It was recently revealed that Apple has set up a web of Project Titan buildings and infrastructure spread across Santa Clara, Sunnyvale and San Jose. This means that it is incorrect to think of Project Titan as just being about one product or one feature. Instead, Apple is building an entire start-up focused on the electric car industry, giving me a high level of confidence that Apple's efforts will lead to products. When diving deeper into Project Titan, this is where there is greater unknown as to whether a certain technology will ever ship, such as various autonomous driving features, different features for new internal passenger compartments, unique car materials, and the list goes on. Each one of those items should be thought of as an individual project that may not see the light of day. 

Apple has likely spent upwards of a few billion dollars on Project Titan so far when including real estate and stock-based compensation. When considering that Apple will likely be spending upwards of $14 billion per year on R&D by 2017 or 2018, Project Titan could easily end up being a $10-$15 billion project before Apple even ships a product. This is uncharted territory not just for Apple, but for the entire auto industry.

There is much to be discovered from tracking just one line item on Apple's income statement. R&D expense tells me that Apple is planning its most significant pivot yet. 

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