US Economy: Rebirth of Innovation

In his State of the Union address back in January, President Barack Obama invoked the need for the United States to engage in innovation no fewer than 11 times. He emphasized the critical role of the government in supporting the basic research that makes innovative enterprise possible:

“Our free enterprise system is what drives innovation. But because it’s not always profitable for companies to invest in basic research, throughout our history, our government has provided cutting-edge scientists and inventors with the support that they need. That’s what planted the seeds for the Internet. That’s what helped make possible things like computer chips and GPS. Just think of all the good jobs — from manufacturing to retail — that have come from these breakthroughs.”

Yes! The government has a big role to play in creating the knowledge base for an innovative economy. But how does the “free enterprise system” turn the basic research that government funds into innovative goods and services? And what impact can innovation have on the quantity and quality of jobs available to the US labor force?

Let’s check out a case study: Apple.

Right now, the most financially successful innovative enterprise in the United States, if not the world, is Apple, Inc. In fiscal 2010, this iconic American enterprise had sales of $65.2 billion and profits of $14.0 billion. And in the first nine months of fiscal 2011 (through June 25), Apple saw its sales rise to $80.0 billion (equivalent to about $107 billion on an annual basis), up an extraordinary 78% from the same nine-month period a year earlier.

A look at the strategic, organizational, and financial conditions that have underpinned Apple’s success can tell us a lot about how innovative enterprise coulld help the US break through the jobless recovery,

In exercising strategic control over the allocation of Apple’s resources, the key figure has been Steve Jobs, who co-founded the company in 1976. By 1980, Apple’s successful design, assembly and marketing of a personal computer impelled the mainframe leader IBM, a company with 350,000 employees, to enter what would become known as the PC industry. The result in the 1980s was a revolution in information technology that set the stage for the commercialization of the Internet in the 1990s and the integration of IT with mobile telephony in the 2000s.

In 1983, a 28-year-old Jobs deemed it necessary to recruit an experienced professional manager to Apple, and he brought on Pepsico’s John Sculley to run the business. By 1986, after conflicts with Sculley about the strategic direction of the company, Jobs resigned as Apple’s chairman, leaving to form NeXT to produce sophisticated computer workstations. A decade later, Apple acquired NeXT, which, as it turned out, had developed software that would be critical for Apple’s future. With the acquisition, Jobs rejoined Apple, first as a consultant, then in 1997 as interim CEO (with the company in the midst of sustaining huge losses), and in 2000 as permanent CEO.

Even then, with Jobs at the helm, Apple was struggling. It had just a small share of the computer market. In 2001 its sales of $5.3 billion were less than half what they had been six years earlier, and the company showed a small loss. But with the introduction of the iPod and the first Apple retail store in that year, Apple began to transform itself from a niche computer maker into a multimedia giant. In 2003 the online iTunes store debuted, giving a huge boost to iPod sales. In 2006, just before the launch of the iPhone, Apple had increased its total sales to $19.3 billion, with 50% coming from iPod and iTunes. Then came the iPhone in 2007, followed by the iPad in 2010. In the first nine months of fiscal 2011 iPhone sales were $36.1 billion and iPad sales $13.5 billion, accounting for 62% of Apple’s total revenues.

Critical to Apple’s growth has been the organizational integration of engineering professionals to develop consumer-oriented products with the company’s signature graphical user interfaces. A study on jobs and wages in the global iPod value chain calculated that in 2006 Apple employed about 6,100 managers, engineers, and other professionals in iPod work at its Cupertino, California headquarters, representing 64% of Apple’s US iPod labor force and 15% of Apple’s worldwide total labor force. The study estimated that the professional employees averaged $85,000 in annual earnings, whereas Apple’s non-professional US employees, predominantly working in Apple stores, averaged less than $26,000.

The $85,000 figure is significantly understated since it does not include the substantial gains that professional employees made from exercising stock options. According to my calculations, in 2006, across about 17,800 Apple employees worldwide, but excluding the five highest paid Apple executives (for whom we have direct information from proxy statements), the average gains per employee from exercising stock options was about $67,500. We can assume that the 6,100 professionals received some multiple of this average. We do know that the five highest paid Apple executives averaged $16.2 million in gains from exercising stock options in 2006.

Virtually all of the production of Apple products is done by contract manufacturers in Asia. The big expansion in Apple employment in the United States has been in Apple retail stores. From 2006 to 2010, Apple increased its US stores from 147 to 233, and its US retail employees from an estimated 5,200 to 19,500, representing about one-half of Apple’s total increase in employees worldwide from 2006 to 2010. These Apple jobs surely beat those at Wal-Mart, but the pay structure is designed to attract young singles. Prospects of long-term career paths remain to be seen.

How has Apple financed its growth? Backed as a startup by venture capital, Apple was already profitable when, in December 1980, it raised about $100 million in its initial public offering. Beyond that, virtually all of the company’s financial commitment has come from retained earnings plus about $4.3 billion (most of it recently) from the sale of stock to employees as part of compensation plans. Indeed, far from raising more money from the public stock market, between 1986 and 1993, under CEO Sculley, the company wasted $1.8 billion buying back its own stock (another $191 million of buybacks were done under CEO Jobs in 1999-2000). Between 1987 and 1996, Apple also paid out $457 million in dividends, but has not paid any dividends since then. In the mid-1990s the company took on debt of almost $1 billion, in large part to cover losses. But since 2003 has been debt-free.

Currently, Apple’s balance sheet shows $28.4 billion in cash and short-term marketable securities, plus another $47.8 billion in long-term marketable securities. Indeed, in the context of the US government’s debt ceiling crisis, it was noted that Apple had access to more cash than the US Treasury!

What will Apple do with all its money? Of the $76.2 billion in cash and securities, $47.6 billion, or 63%, is held outside of the United States. Under current tax rules it will remain there (a tax loophole enables US companies to avoid paying the 35% corporate tax on foreign profits as long as these earnings are not repatriated to the United States). Apple could do a huge one-time special dividend like the one that Microsoft did for $37 billion in 2004. With its soaring stock price, Apple’s executives are not interested in stock buybacks, but when the company’s stock price comes down they may very well succumb to this American disease.

One hopes that Apple will find more creative uses for its cash. Like upgrading the capabilities of the more ambitious and talented of its store personnel so that they can pursue productive careers. Or supporting strategic spinoffs that combine the company’s cash with its more entrepreneurial and experienced people to start new firms. And perhaps Apple will take a leadership position among US high-tech firms in collaborating with the US government to support national technology research initiatives.

As President Obama recognized, US government investment and subsidies played a major role in making it possible for a company like Apple to exist in the first place. Without that help, Apple would not have found such plumb opportunities for growth in the information and communication technology fields.

So how about returning the favor? Apple should allocate some of its accumulated wealth to upgrade and renew the nation’s knowledge base so that other US companies — some of them yet to be formed — can benefit from similar government support for innovation and job creation.

This article was originally published in the New Deal 2.0 blog.