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Why Innovation is Key to Apple's Future

By: Chris Ciaccia
Posted: 2/12/2014 9:45:00 AM
Referenced Stocks: AAPL

Apple (AAPL) has had its problems with activist investor Carl Icahn, and before that, Greenlight Capital hedge fund manager David Einhorn, about returning more cash to investors. Now that Apple has proxy firms on its side, and Icahn is out of the way, it's up to Apple to do some serious thinking about how it's going to spend its cash.

Apple received a vote of approval from two proxy-advisory firms, Institutional Shareholder Services and Egan-Jones, who said that Carl Icahn's proposal for Apple to buy back an additional $50 billion in stock should be rejected. ISS cited Apple's existing repurchase program, where the company is going to buy back $60 billion in stock. Last week, CEO Tim Cook announced Apple had accelerated that buyback program, buying $14 billion worth of its own stock in the past two weeks, following Apple's fiscal first-quarter earnings.

Following the announcement from ISS, Icahn issued a letter to shareholders, saying he agrees with ISS's observation, "taking into account that the company recently repurchased in 'two weeks alone' $14 billion worth in shares."

However, much of Apple's cash is overseas, with approximately $34 billion in cash on U.S. shores, prior to the accelerated buyback. In order for Apple to boost its buyback significantly, it would have to do another debt offering, like the $17 billion offering it did last year.

There's been a cry that Apple "needs" to do something with its cash. Of course, when you have $158.8 billion in cash and cash equivalents, shareholders are going to get a little antsy. However, the focus should be, no matter how loud the cries are, on innovating. Going up against competitors such as Google and Microsoft is important as Apple seeks to stay relevant in an ever changing technology world. Creating new products we didn't think we needed that we then can no longer live with out (see: iPod, iPhone, iPad) is of the utmost relevance for Apple.

Morgan Stanley analyst Katy Huberty notes that Apple has been increasing its research and development (R&D) spending, despite having already increased its R&D spending 30% year-over-year from 2010 to 2013. "Apple pointed to R&D investments in products and services, including unannounced products, as the reason for the upside," Huberty penned in the note. With the March R&D guide ahead of expectations and Cooks' recent comments, Apple is using its cash for what is best for the long-term, not the short-term: new products.

In a recent Wall Street Journal article, Cook said any "reasonable" person would consider what Apple is working on to be new products and services. One area Cook has already hinted at is mobile payments. "The mobile payments area in general is one that we've been intrigued with, and that was one of the thoughts behind Touch ID," Cook said on Apple's fiscal first-quarter earnings call.

Aside from mobile payments, there's rampant speculation Apple will release a smartwatch, currently being dubbed the iWatch. There have been job postings (subsequently taken down) for a physiologist for help with health and fitness data, as well as countless other job postings, related to something health and fitness related.

The iWatch could be a huge boon for Apple, with some projecting it could generate up to $17.5 billion in sales for the company. "Our working assumption is that iWatch will largely be adopted as an accessory device and therefore sold into the existing customer base like the iPad rather than to new customers like the iPod or iPhone," Huberty wrote in a research note last week. "Assuming an ASP of $299 and Apple customer base penetration rate similar to the iPad, we see up to $17.5B of revenue in the first 12 months compared to $12B for the iPad and $2.5B for the iPhone."

There's also the speculation 2014 could be the year Apple finally launches its Apple-branded television set. In the past, Cook has said the television watching experience is like being stuck in a time warp. "When I go into my living room and turn on the TV, I feel like I have gone backwards in time by 20 to 30 years," Cook told NBC's Brian Williams at the end of a 2012 interview. "It's an area of intense interest. I can't say more than that."

With the proxy firms firmly in Apple's court, Icahn's stance is neutered, and the focus can go back to product innovation. Cook and his team are smart enough to know that working on creating the "next big thing" is way more important than returning a couple of extra billion to shareholders, even if it is Carl Icahn.