The iWatch Debacle Is Due To Apple's Low R&D Spend

| About: Apple Inc. (AAPL)

This week, the Financial Times released a story stating that Apple's (NASDAQ:AAPL) iWatch would probably not be launched until the second half of 2014. On the surface, this seems like a remarkable slippage of time. Back in February, Bloomberg reported that the iWatch, with 100 product designers on board, was "beyond the experimentation stage" implying that they had created functional prototypes which could soon be ready for market. Then in July, we read both The Verge and Bloomberg report with supposedly corroborating sources that the iWatch would be ready by the end of 2013. So now that the media has to recalibrate its expectations around a late 2014 launch, we can use this as an opportunity to re-evaluate what is really happening. This slippage isn't due to problems with the iWatch, it is only a symptom of a deeper underlying cause. Simply put, Apple doesn't invest enough in R&D.

Before I move on to explain why this is so, I think this chart sums up Apple's predicament best. It lists the 50 largest R&D spenders in the world as of 2012.

Top 50 R&D Spenders in the World
(Click to enlarge)

Source: European Commission

At the top of the list in 2012, the biggest R&D investor in the world was Toyota (NYSE:TM), closely followed by Microsoft (NASDAQ:MSFT). This chart is a checklist in some of the world's most famous companies and others known for their deep commitment to research. So it is unsurprising to see companies across the spectrum, from Samsung (OTC:SSNLF) to BMW and Boeing (NYSE:BA) on this list. There is something striking though. I had to look at the table 4-5 times before I figured it out. Apple isn't on the list. It can actually be found in the report's appendix at number 59, just beaten by Astellas Pharma (OTCPK:ALPMF), a mid-tier Japanese pharmaceutical company.

To be fair, Apple's R&D spending is increasing as the following chart shows which includes some of its competitors.

AAPL R&D Expense Annual data by YCharts

If we extrapolate from these trends and with the knowledge we have of Apple and Nokia (NYSE:NOK), we can expect that by the end of this year, Apple will be a larger investor in R&D than Nokia. This is nothing to crow about however considering the fundamental disparity in size between the two companies with Apple having a market capitalization 26 times greater than Nokia as of 16th July 2013. It will also still leave Apple considerably behind Microsoft (MSFT) and Samsung who continue to increase their R&D investments year-on-year.

So just why is Apple's R&D spending so modest? There are a number of reasons for this which I've documented below.

1. Steve Jobs was a visionary leader - By all accounts, Steve Job was a tremendous leader with very definite ideas on what he wanted Apple to be. One of the stories told about him, possibly apocryphal but true to his personality was about when he was first shown a prototype iPod. After taking a look at it, he demanded to the presenting engineers that it be made smaller. When they replied that it was as small as they could make it, he promptly threw it into an aquarium. As the air bubbles filtered out of the iPod he supposedly snapped "Those are air bubbles. That means there's space in there. Make it smaller." This is the type of innovative thinking that doesn't require millions spent on design testing, focus groups, committees, endless meetings and so forth debating over specifications. Jobs wanted a small iPod and through his committed vision, he ensured that is exactly what Apple delivered.

However there is a reason that we remember people like Jobs, there are very few of them and no matter the amount of leadership training programs, impossible to replicate. So now with him gone, Apple is just another technology company which now finds its R&D efficiencies returning to the levels of its competitors.

2. Jobs' legacy - Of course strictly speaking, Apple isn't just another technology company. Jobs left behind a very strong imprint at Apple. He made it exactly the way he wanted to work for him and succeeded on those terms. Apple thus now appears to have an organisational culture which revolves around strong visionary leadership. This mantle has now been assumed by Tim Cook whose vision and personal focus now direct the company. I do not think it is appropriate to criticize Cook for doing the best he can. What is apparent however is that he is a supply chain expert. It is his expertise that has made Apple have the world's best supply chain according to a Gartner survey as the following table shows.

Source: Gartner

I think the MacBook Air in particular is a great testament to Tim Cook's abilities. If we consider only its specifications, it is for its price, one of the best laptops in the world as Microsoft expert Peter Bright himself admitted. This is possible because by simplifying its product range, Apple is able to bring economies of scale to all its products and deliver them affordably. This is an iterative, evolutionary process which requires constant fine-tuning.

But of course, Apple is not a Wal-Mart (NYSE:WMT) or Amazon (NASDAQ:AMZN) whose success is built solely on their excellent supply chains. Apple is in a highly innovative market with several consecutive product revolutions over the last decade which it can take much of the credit for, especially with the iPod, iPhone, iPad and MacBook Air.

But the pace of innovation has continued and seems to have done so increasingly without Apple. So I do not find it surprising that it was Samsung which popularized the "phablet" concept with its Galaxy Note, or that it was Google (NASDAQ:GOOG) which provided the platform for the mini tablet phenomenon through Android, or indeed that it was the venerable Nokia and not Apple that brought to the world the first 41 Megapixel camera.

As this innovation accelerates with Apple no longer at the helm, instead of a visionary interested in new products, we have a technocrat who is interested in evolution.

Under such circumstances, it isn't surprising that the iWatch hasn't had significant resources invested in it to bring it to market as quickly as possible. Instead, Apple continues to refine its existing range in the way it sees best which brings us to point 3.

3. Product success can make companies complacent - Over the last decade, Apple's revenues have grown stratospherically as we can see in the following chart.

AAPL Revenue Quarterly data by YCharts

This growth was built upon successful product launch after successful product launch. In such a scenario, it is easy to imagine that Apple executives are convinced that they are "doing something right" and that growth will continue QoQ and YoY. While that is just speculation, we do know its inverse to be true. We know that companies are especially likely to restructure and reform themselves when they are either in deep trouble or spy future existential threats. So it's not surprising that Samsung in 1993, in the famous "Frankfurt Room", decided to change the entire culture of the company, or Nokia had the "burning platform memo" in 2011 or even that as of now, Microsoft is fundamentally re-organizing itself.

The question then becomes, how long will Apple wait to reform itself? Will it be pro-active in this and prepare for the future, or will it wait till its existential crisis manifests itself and only act then? It must be noted that the corporate crises of the competitors mentioned above did not arise unexpectedly but were the result of several years of trends reaching a crescendo. Apple still has some time before it experiences its own crisis, but it needs to start reacting more forcefully to what it's facing.

4. Apple still thinks too frugally - Apple for a very long time was an underdog against Microsoft and even had to be bailed out by the latter at one stage. It is easy to believe this left a lasting impression on the Apple board as they developed their company. As the company found success, much of its profits went into its over-large cash pile, a conservative reaction which was probably so it would never have to find itself in debt or owing favors to other companies ever again. But as this pile grew too big, shareholder clamouring grew and that is why Apple has now started a dividend and share buyback programme. But instead of spending $60 billion on share buy backs, imagine what it could have done for Apple if it had chosen instead to increase its R&D spend by $60 billion in total over the next 10 years. Would this have benefited Apple more than supporting its share price? The obvious answer to this I believe is yes. Sadly however, Apple lost much of its goodwill by not doing anything with its cash before Einhorn made his move, so it is unsurprising that it lacked the clout to oppose this move and so chose to buy its own shares instead of invest in itself.

Final Thoughts

While the market recalibrates its expectations about a 2H14 launch for the iWatch I would invite Seeking Alpha readers to ponder on the following. If you are long Apple and love its innovations, ask yourself genuinely and dispassionately if you think its R&D spend is enough to make the company succeed in the long term. If you do so, I would then ask what Apple has that makes it uniquely able to spend less and yet derive greater benefits than its rivals.

In my eyes, Apple has had significant success over the past decade; that is undeniable. Jobs did something special at Apple which will be talked about for several decades to come. Yet, if I was to select which technology companies will be the biggest in 10 years' time, I'd be much more inclined to select Huawei (with 60,000 employees in R&D) and Samsung than Apple.

Disclosure: I am long NOK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.