By | July 15, 2018

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An analyst suggested Apple is underinvesting in innovation, since their R&D spending is lower than peers with similar margins.

That mistakes a strength for a weakness.

Apple’s R&D spending has increased, not decreased.

Apple’s wearables business is a great example of Apple’s continuing innovation.

On July 13, an analyst at Bernstein suggested Apple (AAPL) is underinvesting in innovation. This suggestion is based on a regression that shows that Apple’s gross margins are higher than you’d expect, given the spending on research and development. In my view, this mistakes a strength for a weakness: Investors should be happy Apple is able to generate these margins without having to spend as much on R&D.

In fact, Apple’s R&D spending has not dropped. It has increased, both in absolute terms and as a percentage of revenue, in the past ten years. And that R&D spending has been fruitful: Apple recently reported that its wearables business has seen 50% year-over-year revenue growth, and is now a Fortune 300-level company on its own. In my view, Apple is a market leader and their shares are priced today well within their historic price range. I do not have any qualms about continuing to hold Apple as a “long-term core holding.”

Is Apple Underinvesting in Innovation?

On July 13, Bernstein analyst Toni Sacconaghi suggested that Apple is not spending enough money on innovation. According to Bernstein’s analyst, as quoted in Barron’s, “While Apple’s current R&D spending is large, our benchmarking analysis suggests that Apple appears to still be underspending on R&D today, perhaps by a factor of 2x.”

The rationale for suggesting Apple is “underspending on R&D” comes from a linear regression run by the team at Bernstein. In that regression, the team found a strong correlation between the GAAP R&D as a percentage of revenue and gross margin. Last year, Apple spent 5.1% of their revenue on R&D, and had a gross margin of 38%. According to Bernstein, a normalized tech company (based on their sample of 25) with gross margins of 38% would be spending 10% on R&D.