An Apple R&D Bonanza

After a brief lull, Apple's R&D expenditures are once again exploding higher. Apple's 2Q18 financial guidance implies the company will soon report the largest year-over-year increase in quarterly R&D expense in its history. Management is on track to spend $14 billion on R&D in FY2018, nearly double the amount spent on R&D just four years ago. The dramatic rise in Apple R&D expenditures raises questions regarding the company's product pipeline and whether management's overall approach to R&D is changing.

The Numbers

Apple's pace of R&D expenditures is nothing like the company has ever seen. The $14 billion of R&D expense that Apple will spend in FY2018 will be more than the amount Apple spent on R&D from 1998 to 2011. The CAGR for Apple's R&D expenditures has been a remarkable 32% since 1998. As seen in Exhibit 1, the ramp in Apple R&D expense spanning more than two decades has been breathtaking. 

Exhibit 1: Apple R&D Expense (Annual)

Another way to demonstrate the dramatic rise in Apple R&D is to look at the year-over-year increase in expenditures on a quarterly basis. As seen in Exhibit 2, beginning in FY2Q17, Apple R&D expense growth has been on an uptrend. The expected $725 million increase year-over-year in Apple R&D expenditures in FY2Q18 will be nearly 25% higher than the previous R&D expense growth record. This $725 million figure is obtained by using Apple's guidance for operating expenses and backing into estimates for SG&A and R&D expenses. The recent ramp in R&D expenditures suggests Apple is definitely up to something.  

Exhibit 2:  Year-Over-Year Increase in Apple R&D Expense (Quarterly)

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R&D Growth Drivers

It's easy to assume that the increase in Apple R&D expenditures over the years simply reflects Apple's expanding product line. However, there is more behind Apple's R&D expenditures. Three items are responsible for the growth in Apple R&D expenditures:

  1. Existing products. Apple is doing more these days given a broader product portfolio.  
  2. In-house tech development. Apple has positioned controlling the core technologies powering its devices as a main goal. 
  3. New products. Apple is developing products for which it has no guarantee of future commercial viability. 

Once a project's commercial viability has been established, it becomes that much more difficult for Apple to classify subsequent manufacturing or evolutionary product updates as R&D. This means that cash spent on developing new versions of existing products may not necessarily qualify as R&D. Instead, such expenses may have to be marked as a capital expenditure and amortized or depreciated over the life of the asset. 

Another item that isn't contributing to Apple R&D expense is Apple Park construction. Real estate construction costs related to general corporate usage, or even design labs where some R&D may take place, cannot be categorized as R&D expense. Instead, for real estate to be classified as R&D, there has to be uncertainty regarding future commercial viability. As an example, the numerous buildings Apple bought, or began leasing, in the mid-2010s specifically for Project Titan likely boosted R&D at the time. (A map of Project Titan buildings is available to Above Avalon subscribers.)

New Products

Whereas Project Titan was a leading R&D driver a few years ago, there are likely two new items now driving the recent surge in R&D expenditures: 

  1. Smart glasses. We know Apple is working on smart glasses given the company's M&A track record (Vrvana, SensoMotoric Instruments, patents, and subtle clues found in Apple management commentary. The team dedicated to the effort is likely massive.
  2. Content distribution efforts. Apple appears to have settled on a broader strategy for content, and it involves doubling down as a content distributor. Apple is investing big when it comes to delivering music, video, apps, news, and written content to more than 850 million users (of which 500 million visit the App Store on a weekly basis). Apple's effort to launch a video streaming service from scratch is likely being classified as R&D. For example, Apple has no guarantee that money spent on script development will lead to a commercially viable video streaming product. We also know Apple is reportedly spending $1 billion on original video content. 

Apple is also continuing to work on doubling down on hardware to control the brains powering its products. As long as the byproduct of such efforts leads to products that are significantly different from existing products, Apple is likely able to qualify such efforts as R&D. Ongoing costs associated with Project Titan are also likely substantial, especially relative to smaller product-specific projects found throughout Apple. 

Changes

Although Apple remains an incredibly focused company when it comes to products, the amount of money spent on R&D would seem to suggest that management may be relaxing its focus mantra a bit when it comes to researching new ideas. As seen in Exhibit 3, Apple R&D expenditures as a percent of revenue now stand at a 14-year high. This tells us that Apple is spending more on R&D for every dollar of sales earned despite the dramatic rise in sales over the years. For some companies this may not mean much, but for Apple it can't be ignored. 

Exhibit 3: Apple R&D Expense as a Percent of Revenue

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There are a few possible explanations for the growth in Apple R&D expenditures in recent years:

  1. Greater ambition. Apple finds itself in a position of being able to do a whole lot more. It is estimated that Apple spent $150 million to build the first iPhone in the mid-2000s. At the time, it was a significant amount of cash for Apple. Nearly ten years later, Apple finds itself spending that much money developing one show for its upcoming video streaming service. To a certain degree, Apple management may feel it has an obligation of having to do more given its size. As Tim Cook recently put it, "We can do more things than we used to do because we’re a bit bigger." 
  2. Competition. One factor driving Apple's ambition to do more is competition. It is no longer enough just to control hardware and software. Apple now finds itself needing to control the technologies powering its devices. Bringing development of fundamental technologies in-house doesn't come cheap. Apple has opened a series of R&D centers around the world (China, Japan, India, Indonesia, New Zealand, Canada, France, Italy, Israel, Sweden, and the U.K.), many of which are tasked with developing hardware. Some of these R&D outposts are a result of Apple acquiring teams of talent. 
  3. More experimentation. Apple is likely experimenting much more when it comes to new ideas and processes. While there is no evidence of Apple allowing more of these ideas to actually proceed to market, it sure looks like Apple management wants to be in a position where it can afford to say "no" to more ideas than in the past. 

The third point involving additional experimentation ends up being the most interesting. For a company that positions its ability to focus on a few things at any one time as a core competency, increased experimentation seems to be at odds with this value.

Apple R&D Theory

My theory on the dramatic rise in Apple R&D expenditures is that management is becoming more ambitious. Apple's future is found in new industries. Just as Apple moved from desktops/laptops to personal music players, smartphones, and watches, the company will need to enter new industries to remain relevant. This is not a company that is holding onto the iPhone as tight as possible for fear of change. Apple management is investigating new ideas and processes in order to support future moves into new industries.

This explains Apple's ongoing interest in transportation and Project Titan, an area that Apple has pretty much no expertise in. We have Apple building an entertainment arm from scratch despite having no experience developing scripted content. In each case, Apple has had to rely on outside hires and significant cash outlays to build core competencies. 

It's not that Apple has thrown its focus mantra out the window. Apple remains very selective in terms of both its M&A activity and deciding which products make it to market. Instead of funding significant R&D endeavors with no intention of them one day leading to a product, Apple's R&D remains focused on ideas that at least have the potential to see the light of day. The years of development behind making Face ID a reality would be a recent example. 

Much of this focus mantra is driven by the fact that Jony Ive and his Industrial Design group oversee Apple's product vision and the user experience found with Apple products. With only 20 or so members, Jony and team can only do so much at any given moment. In a way, Apple's organizational and leadership structure serve as safeguards preventing Apple from spreading itself too thin and doing too much. Instead of trying to expand the design team in order to work on more products, Apple's strategy appears to be to do the opposite and place bigger bets on a few products.

These bigger bets come in the form of owning the core technologies powering Apple devices. Apple wants to reduce dependency on others. We are quickly moving to the point at which every Apple product will be powered by core technologies developed in-house. Such a reality would have been a pipe dream just a few years ago. Apple believes this strategy will give them an advantage in the marketplace. It's a new twist to the Alan Kay line about "people who are really serious about software should make their own hardware." We are moving to the point at which companies serious about software should design their own silicon. Having $285 billion of cash on the balance sheet gives Apple the freedom to pursue this ambitious goal. It is this motivation to control more of the user experience while pursuing new industries to enter that is driving the remarkable increase in Apple R&D expenditures. 

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