Apple Earnings: Rising R&D Costs and Falling China Sales

By Markets Fool.com

Two important themes that emerged from Apple's (NASDAQ: AAPL)most recent earnings release were rising R&D costs alongside falling sales in Greater China.

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In this clip fromIndustry Focus: Tech, Motley Fool analystsDylan Lewis and Evan Niu, CFA, discuss both trends and whether investors should be concerned.

A full transcript follows the video.

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This podcast was recorded on Oct. 28, 2016.

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Dylan Lewis: Thiscame up in the conference call from a couple different folks. I've seen some people worried about what's going on with the R&D spend, research and development side of Apple's expenses, and what's going on in China for them. Do you want to hit on that a little bit?

Evan Niu:I think there are some questions about, why is R&D expenditure growth growing at thisaccelerated pace? Apple is really good atefficiently spending on R&D. A few years ago, it used toalways be 2% to 3% of revenue range, which is tiny. A lot of other tech companies are like 10% to 15%.GoogleandMicrosoft,that's how much they spend of their revenue on R&D. It's not as if the more you spend, the more innovative. It's not linear. It can bewasteful sometimes, if you're spending on projectsthat you never actually commercialize,which I think Microsoft has a tendency to do. Apple has always been really good at only reallyputting this money into things they know they can commercialize later on. But now, in the past few quarters, we're seeing this number rise to this 5% to 6% of sales,at the same time that revenue is slowing down, so there's a lot of questions of, "What's going on here?" Theobvious answer is, they'respending money on these things for the pipeline that they won't talk about.

Lewis:Which is maddening as an investor. They're like, "Don't worry, we're spending it well, we're allocating resources great, just trust us."

Niu:"Just trust us." Yeah. There was this talk of a car, and clearly a car isincredibly expensive to develop. Who knows if they actually do it, there'sall these conflicting reports on whereApple is or is not heading with this car idea. But,that is certainly, as far as expenses go,extremely expensive on the R&D front. There's things like augmented reality, virtual reality, AI. There are a lot of things Apple is certainly exploring here, but they can't talk about. So, there's a real question, I think, at this point. Yeah, we know they're spending this money,and we can probably guess on what,based not only on where Apple-specific rumors are coming from,but also where the tech industry is going. We know,everyone is working on these things. So the real question will be, can they do these things, and when they do launch them, will they be compelling, will they be better than everyone else's? Will they actually drive the business even more? And you just have to wait.

Lewis:Yeah,unfortunately it's a wait-and-see type of thingfor investors. I'm notfreaking out about it yet,but I think it's a good thing to monitor.

Niu:Definitely.

Lewis:What aboutwhat's going on in China?

Niu:China, there was this big thing, sales were down 30%. Last quarter, they were down 33%. Thequarter before that, they were down 26%. If you just look at these year-over-year numbers, it looks really bad. But you have to realize, they're just facing tough comps, because they did so well in 2015. If you zoom out a little bit and look at their business on an annual basis, this is still a $46 billion business in China. Last year, it was a $50-plus-billion business. And the year before, it was like $20-something billion. This is stillvery much headed in the right direction. I used to track their "Greater China" salesbefore they actually broke it outand exposed it in this lush detail. If you go back to fiscal 2009, I think, they did less than $1 billion in sales that year. You'd have tobasically stitch these numbers together from conference call comments, which I used to do. Now they give it to you directly. But I used to dig these numbers up. I think it was $900 million in fiscal 2009. That was seven years ago.

Now they're basically $45 [billion] to $50 billion. You can't argue with the long-term trajectory of it. And there's still a lot of room to grow; this isnowhere near the end game. China is stillnowhere near saturated, there's still tons of first-time smartphone buyers. The middle class is still booming. There's just a couple of tough comparisonsbecause they did so well last year. I wouldn't worry too much. It's just this noisy, quarterly trends, quarter to quarter, it's tough to call. And yeah, there's certainly some competition coming in from these lower-end Android makers likeXiaomi and all these other local players. At the same time, I don't think there's a lot to worry about. There's still a lot of room to grow in terms of physical geographic footprint. They don't have that many stores, still, they only have about 40 stores or so. I don't think there's anything to worry about, even if these past few quarters look scary on paper.

Lewis:Yeah, if you choose to look at theirnumbers on a two-year comp instead of a year-over-year comp,they look pretty darn impressive, right?

Niu:Right.

Lewis:So,that's something to keep in mind.

Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of Microsoft and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.