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Apple 10-Q 2005
UNITED
STATES Washington, D.C. 20549
Form 10-Q
(Mark One)
Commission file number 0-10030
APPLE COMPUTER, INC. (Exact name of Registrant as specified in its charter)
Registrant’s telephone number, including area code: (408) 996-1010
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o
408,585,970 shares of common stock issued and outstanding as of January 25, 2005
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
APPLE COMPUTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in millions, except share and per share amounts)
See accompanying notes to condensed consolidated financial statements.
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APPLE COMPUTER, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) (in millions, except share amounts)
See accompanying notes to condensed consolidated financial statements.
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APPLE COMPUTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in millions)
See accompanying notes to condensed consolidated financial statements.
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APPLE COMPUTER, INC.
Notes to Condensed Consolidated Financial Statements (Unaudited)
Note 1 — Summary of Significant Accounting Policies
Apple Computer, Inc. and its subsidiaries (the Company) designs, manufactures and markets personal computers and related software, services, peripherals and networking solutions. The Company also designs, develops and markets a line of portable digital music players along with related accessories and services including the online distribution of third-party music and audio books. The Company sells its products worldwide through its online stores, its own retail stores, its direct sales force and third-party wholesalers, resellers and value added resellers. In addition to its own hardware, software and peripheral products, the Company sells a variety of third-party hardware and software products through its online and retail stores. The Company sells to education, consumer, creative professional, business and government customers.
Basis of Presentation and Preparation The accompanying condensed consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Interim information is unaudited; however, in the opinion of the Company’s management, all adjustments of a normal recurring nature necessary for a fair statement of interim periods presented have been included. The results for interim periods are not necessarily indicative of results to be expected for the entire year. Certain prior year amounts in these condensed consolidated financial statements and notes thereto have been reclassified to conform to the current period’s presentation.
These condensed consolidated financial statements and accompanying notes should be read in conjunction with the Company’s annual consolidated financial statements and the notes thereto for the fiscal year ended September 25, 2004, included in its Annual Report on Form 10-K for the year ended September 25, 2004 (the 2004 Form 10-K). Unless otherwise stated, references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years.
Research and Development Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers pursuant to Statement of Financial Accounting Standards (SFAS) No. 86, Computer Software to be Sold, Leased, or Otherwise Marketed. In most instances, the Company’s products are released soon after technological feasibility has been established; therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally all software development costs have been expensed.
In the fourth quarter of 2004, the Company began incurring substantial development costs associated with the upcoming upgrade of Mac OS X version 10.4 (code-named “Tiger”). Tiger enhances the features and functionality of the previous version of Mac OS X. Tiger achieved technological feasibility following its public demonstration in August 2004 and the subsequent release of a developer beta version of the product. Therefore, during the first quarter of 2005 and the fourth quarter of 2004, the Company capitalized approximately $14.8 million and $4.5 million, respectively, of costs associated with the development of Tiger. Amortization of this asset will commence when Tiger begins shipping and will be recognized on a straight-line basis over a 3 year estimated useful life. The planned release of the final version of the product is expected in the first half of calendar year 2005.
Stock-Based CompensationIn December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004) (SFAS 123R), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R eliminates the ability to account for share-based compensation transactions using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
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Employees, and generally would require instead that such transactions be accounted for using a fair-value-based method. The Company is currently evaluating SFAS 123R to determine which fair-value-based model and transitional provision it will follow upon adoption. The options for transition methods as prescribed in SFAS 123R include either the modified prospective or the modified retrospective methods. The modified prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock as the requisite service is rendered beginning with the first quarter of adoption, while the modified retrospective method would record compensation expense for stock options and restricted stock beginning with the first period restated. Under the modified retrospective method, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. SFAS 123R will be effective for the Company beginning in its fourth quarter of fiscal 2005. Although the Company will continue to evaluate the application of SFAS 123R, management expects adoption to have a material impact on its results of operations.
The Company currently measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25. The Company applies the disclosure provisions of SFAS No. 123, Accounting for Stock-based Compensation, as amended by SFAS No. 148, Accounting for Stock-based Compensation – Transition and Disclosure as if the fair-value-based method had been applied in measuring compensation expense. Under APB Opinion No. 25, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized.
As required under SFAS No. 123, the pro forma effects of stock-based compensation on net income and earnings per common share for employee stock options granted and employee stock purchase plan share purchases have been estimated at the date of grant and beginning of the period, respectively, using a Black-Scholes option pricing model. For purposes of pro forma disclosures, the estimated fair value of the options and shares is amortized to pro forma net income over the options’ vesting period and the shares’ plan period.
The Company’s pro forma information for the three month periods ended December 25, 2004 and December 27, 2003 follows (in millions, except per share amounts):
Earnings Per Share Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of outstanding options, restricted stock and restricted stock units is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from outstanding options, restricted
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stock and restricted stock units. Additionally, the exercise of employee stock options and the vesting of restricted stock and restricted stock units can result in a greater dilutive effect on earnings per share.
The following table sets forth the computation of basic and diluted earnings per share (in thousands, except net income and per share amounts):
Potentially dilutive securities, including stock options, restricted stock units, and restricted stock, to acquire approximately 826,000 and 14.4 million shares of common stock for the quarters ended December 25, 2004 and December 27, 2003, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive.
Note 2 – Financial Instruments
Cash, Cash Equivalents and Short-Term Investments The following table summarizes the fair value of the Company’s cash and available-for-sale securities held in its short-term investment portfolio, recorded as cash and cash equivalents or short-term investments as of December 25, 2004, and September 25, 2004 (in millions):
The Company’s short-term investment portfolio consists of investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities. The Company’s U.S. corporate securities consist primarily of commercial paper, certificates of deposit, time deposits and corporate debt securities. Foreign securities consist primarily of foreign commercial paper, certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. dollars. The Company had net unrealized losses, net of taxes, of $5 million and $4 million on its investment portfolio, primarily related to investments with stated maturities less than 1 year, as of December 25, 2004 and September 25, 2004, respectively. The Company occasionally sells short-term investments prior to their stated maturities. No material gains or losses were recognized on any such sales during either the first quarter of 2005 or 2004.
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As of December 25, 2004, and September 25, 2004, $449 million and $180 million, respectively, of the Company’s investment portfolio that was classified as short-term investments had maturities ranging from 1 to 5 years. The remainder of the Company’s short-term investments had underlying maturities between 3 and 12 months.
Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign exchange and interest rate risk. Foreign currency forward and option contracts are used to offset the foreign exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales. From time to time, the Company enters into interest rate derivative agreements to modify the interest rate profile of certain investments and debt. The Company’s accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments. As of the end of the first quarter of 2005, the general nature of the Company’s risk management activities and the general nature and mix of the Company’s derivative financial instruments have not changed materially from the end of fiscal 2004.
Foreign Exchange Risk Management The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risk associated with existing assets and liabilities, certain firmly committed transactions and forecasted future cash flows. Generally, the Company’s practice is to hedge a majority of its existing material foreign exchange transaction exposures. However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular exposures, or limited availability of appropriate hedging instruments.
Accounting for Derivative Financial Instruments The Company accounts for all derivatives at fair value. Derivatives that are not hedges are adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. As of December 25, 2004, the Company had a net deferred loss associated with cash flow hedges of approximately $12.8 million net of taxes, substantially all of which is expected to be reclassified to earnings by the end of the third quarter of fiscal 2005.
Note 3 – Condensed Consolidated Financial Statement Details (in millions)
Inventories
Other Current Assets
Property, Plant, and Equipment
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Other Assets
Accrued Expenses
Non-current Liabilities
Interest and Other Income, Net
Note 4 – Restructuring Actions
2004 Restructuring Actions The Company recorded total restructuring charges of approximately $23 million during the year ended September 25, 2004, including approximately $14 million in severance costs, $5.5 million in asset impairments, and a $3.5 million charge for lease cancellations. Of the $23 million charge, $16 million had been utilized by the end of the first quarter of 2005, with the remaining $7 million consisting of $3.7 million for employee severance benefits and $3.3 million for lease cancellations. These actions will result in the termination of 485 positions, 415 of which had been terminated prior to the end of the first quarter of 2005.
The following table summarizes activity associated with restructuring actions initiated during fiscal 2004 (in millions):
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2003 Restructuring Actions The Company recorded total restructuring charges of approximately $26.8 million during the year ended September 27, 2003, including approximately $7.4 million in severance costs, a $5.0 million charge to write-off deferred compensation, $7.1 million in asset impairments and a $7.3 million charge for lease cancellations. Of the $26.8 million charge, all had been utilized by the end of the first quarter of 2005, except for approximately $2.7 million related to operating lease costs on abandoned facilities.
The following table summarizes activity associated with restructuring actions initiated during fiscal 2003 (in millions):
Note 5 – Shareholders’ Equity
Preferred Stock The Company has 5 million shares of authorized preferred stock, none of which is outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors is authorized to determine or alter the rights, preferences, privileges and restrictions of the Company’s authorized but unissued shares of preferred stock.
Stock Repurchase Plan In July 1999, the Company’s Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. This repurchase plan does not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. The Company has not engaged in any transactions to repurchase its common stock since fiscal 2003. Since inception of the stock repurchase plan, the Company had repurchased a total of 6.55 million shares at a cost of $217 million. The Company was authorized to repurchase up to an additional $283 million of its common stock as of December 25, 2004.
Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under generally accepted accounting principles are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges.
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The following table summarizes components of total comprehensive income, net of taxes, during the three month periods ended December 25, 2004, and December 27, 2003 (in millions):
The following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company during the three month periods ended December 25, 2004, and December 27, 2003 (in millions):
The following table summarizes the components of accumulated other comprehensive income (loss), net of taxes (in millions):
Note 6 – Employee Benefit Plans
2003 Employee Stock Option Plan At the Annual Meeting of Shareholders held on April 24, 2003, the shareholders approved an amendment to the 1998 Executive Officer Stock Plan to change the name of the plan to the 2003 Employee Stock Option Plan (the 2003 Plan), to provide for broad-based grants to all employees in addition to executive officers and other key employees and to prohibit future “repricings” of employee stock options, including 6-months-plus-1-day option exchange programs, without shareholder approval. Based on the terms of individual option grants, options granted under the 2003 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of 4 years, based on continued employment, with either annual or quarterly vesting. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, restricted stock units, stock appreciation rights, and stock purchase rights.
1997 Employee Stock Option Plan In August 1997, the Company’s Board of Directors approved the 1997 Employee Stock Option Plan (the 1997 Plan), a non-shareholder approved plan for grants of stock options to employees who are not officers of the Company. Based on the terms of individual option grants, options granted under the 1997 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of 4 years, based on continued employment, with either annual or quarterly vesting. As a result of shareholder approval of amendments to the 1998 Executive Officer Stock Plan in April 2003, the Company terminated the 1997 Employee Stock Option Plan and cancelled all
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remaining unissued shares totaling 14,295,351 following the completion of an employee stock option exchange program in October 2003.
1997 Director Stock Option Plan In August 1997, the Company’s Board of Directors adopted a shareholder approved Director Stock Option Plan (DSOP) for non-employee directors of the Company. Initial grants of 30,000 options under the DSOP vest in three equal installments on each of the first through third anniversaries of the date of grant, and subsequent annual grants of 10,000 options are fully vested at grant.
Rule 10b5-1 Trading Plans Certain of the Company’s executive officers, including Mr. Timothy D. Cook, Mr. Peter Oppenheimer, Mr. Jonathan Rubinstein, Dr. Bertrand Serlet, and Dr. Avadis Tevanian, Jr., have entered into trading plans pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of 1934, as amended. A trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock including the exercise and sale of employee stock options and shares acquired pursuant to the Company’s employee stock purchase plan and upon vesting of restricted stock units.
Employee Stock Purchase PlanThe Company has a shareholder approved employee stock purchase plan (the Purchase Plan), under which substantially all employees may purchase common stock through payroll deductions at a price equal to 85% of the lower of the fair market values as of the beginning and end of six month offering periods. Stock purchases under the Purchase Plan are limited to 10% of an employee’s compensation, up to a maximum of $25,000 in any calendar year. The number of shares authorized for issuance is limited to a total of 1 million shares per offering period. As of December 25, 2004, approximately 1.4 million shares were reserved for future issuance under the Purchase Plan.
Stock Option Plan Activity A summary of the Company’s stock option activity and related information for the three month periods ended December 25, 2004 and December 27, 2003 follows (option amounts are presented in thousands) is set forth in the following table:
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The options outstanding as of December 25, 2004 have been segregated into six ranges for additional disclosure as follows (option amounts are presented in thousands):
The Company had 2.515 million restricted stock units outstanding as of December 25, 2004, which were excluded from the options outstanding balances in the preceding tables. None of these restricted stock units were vested as of December 25, 2004. The grant of these restricted stock units has been deducted from the shares available for grant under the Company’s stock option plans.
Note 7 – Stock-Based Compensation
The Company has provided pro forma disclosures in Note 1 of these Notes to Condensed Consolidated Financial Statements of the effect on net income and earnings per share as if the fair value method of accounting for stock compensation had been used for its employee stock option grants and employee stock purchase plan purchases. These pro forma effects have been estimated at the date of grant and beginning of the period, respectively, using the Black-Scholes option pricing model.
The assumptions used for the three month periods ended December 25, 2004 and December 27, 2003, and the resulting estimates of weighted-average fair value per share of options granted and for stock purchases during those periods are as follows:
Note 8 – Commitments and Contingencies
Lease Commitments The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off-balance-sheet financing arrangements. The major facility leases are for terms of 5 to 10 years and generally provide renewal options for terms of 3 to 5 additional years. Leases for retail space are for terms of 5 to 16 years and often contain multi-year renewal options.
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As of September 25, 2004, the Company’s total future minimum lease payments under noncancelable operating leases were $617 million, of which $436 million related to leases for retail space. As of December 25, 2004, total future minimum lease payments related to leases for retail space increased to $450 million.
Accrued Warranty and Indemnifications The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end-user. The Company also offers a 90-day basic warranty for Apple service parts used to repair Apple hardware products. The Company provides currently for the estimated cost that may be incurred under its basic limited product warranties at the time related revenue is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its preexisting warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future expectations.
The following table reconciles changes in the Company’s accrued warranties and related costs for the three month periods ended December 25, 2004 and December 27, 2003 (in millions):
The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against itself or an indemnified third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims subject to indemnification that would have a material adverse effect on its financial condition, liquidity or results of operations. Therefore, the Company did not record a liability for infringement costs as of either December 25, 2004 or September 25, 2004.
Contingencies Beginning on September 27, 2001, three shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and its Chief Executive Officer. These lawsuits are substantially identical, and purport to bring suit on behalf of persons who purchased the Company’s publicly traded common stock between July 19, 2000, and September 28, 2000. The complaints allege violations of the 1934 Securities Exchange Act and seek unspecified compensatory damages and other relief. The Company filed a motion to dismiss on June 4, 2002, which was heard by the Court on September 13, 2002. On December 11, 2002, the Court granted the Company’s motion to dismiss for failure to state a cause of action, with leave to Plaintiffs to amend their complaint within thirty days. Plaintiffs filed their amended complaint on January 31, 2003, and on March 17, 2003, the Company filed a motion to dismiss the amended complaint. The Court heard the Company’s motion on July 11, 2003 and dismissed Plaintiffs’ claims with prejudice on August 12, 2003. Plaintiffs have appealed the ruling. The parties have fully briefed the appeal and a hearing is set for February 17, 2005.
The Company is subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and have not been fully adjudicated. In the opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate have a material adverse effect on its financial condition, liquidity or results of operations. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. The Company settled certain matters
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during the first quarter of 2005, which did not individually or in the aggregate have a material impact on the Company’s results of operations.
Production and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement to provide customers the ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have recently been passed in several jurisdictions in which the Company operates including various European Union member countries, Japan and certain states within the U.S. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not have a material adverse effect on the Company’s results of operations and financial position.
Note 9 - Segment Information and Geographic Data
In accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, the Company reports segment information based on the "management" approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments.
The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments are comprised of the Americas, Europe, Japan, and Retail. The Americas, Europe, and Japan reportable segments do not include activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries as well as the Middle East and Africa. The Japan segment includes only Japan. The Retail segment operates Apple-owned retail stores in the U.S., Japan, and the U.K. Other operating segments include Asia-Pacific, which includes Australia and Asia except for Japan, and the Company’s subsidiary, FileMaker, Inc. Each reportable geographic operating segment provides similar hardware and software products and similar services, and the accounting policies of the various segments are the same as those described in the Company’s 2004 10-K in Note 1, “Summary of Significant Accounting Policies,” except as described below for the Retail segment.
The Company evaluates the performance of its operating segments based on net sales. The Retail segment’s performance is also evaluated based on operating income. Net sales for geographic segments are generally based on the location of the customers. Operating income for each segment includes net sales to third parties, related cost of sales, and operating expenses directly attributable to the segment. Operating income for each segment excludes other income and expense and certain expenses that are managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses, manufacturing costs and variances not included in standard costs, income taxes, and various nonrecurring charges. Corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard costs, and other separately managed general and administrative expenses including certain corporate expenses associated with support of the Retail segment. The Company does not include intercompany transfers between segments for management reporting purposes. Segment assets exclude corporate assets. Corporate assets include cash, short-term and long-term investments, manufacturing facilities, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets, and retail store construction-in-progress that is not subject to depreciation. Except for the Retail segment, capital expenditures for long-lived assets are not reported to management by segment. Capital expenditures by the Retail segment were $33 million and $28 million during the first quarters of 2005 and 2004, respectively.
Operating income for all segments, except Retail, includes cost of sales at manufacturing standard cost, other cost of sales, related sales and marketing costs, and certain general and administrative costs. This measure of operating income, which includes manufacturing profit, provides a comparable basis for comparison between the Company’s various geographic segments. Certain manufacturing expenses and related adjustments not included in segment cost of sales, including variances between standard and actual manufacturing costs and the mark-up above standard cost for product supplied to the Retail segment, are included in corporate expenses.
Management assesses the operating performance of the Retail segment differently than it assesses the operating performance of the Company’s geographic segments. The Retail segment revenue and operating income is intended
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to depict a comparable measure to that of the Company’s major channel partners in the U.S. operating retail stores so the Company can evaluate the Retail segment performance as if it were a channel partner. Therefore, the Company makes three significant adjustments to the Retail segment for management reporting purposes that are not included in the results of the Company’s other segments.
First, the Retail segment’s operating income includes cost of sales for Apple products at an amount normally charged to major channel partners in the U.S. operating retail stores, less the cost of sales programs and incentives provided to those channel partners and the Company’s cost to support those partners. For the first quarter of 2005 and 2004, this resulted in the recognition of additional cost of sales above standard cost by the Retail segment and an offsetting benefit to corporate expenses of approximately $99 million and $52 million, respectively.
Second, the Company’s extended warranty, support and service contracts are transferred to the Retail segment at the same cost as that charged to the Company’s major retail channel partners in the U.S., resulting in a comparable measure of revenue and gross margin between the Company’s Retail stores and those retail channel partners. The Retail segment recognizes the full amount of revenue and cost of sales at the time of sale of the Company’s extended warranty, support and service contracts. Because the Company has not yet earned the revenue or incurred the costs associated with the sale of these contracts, an offset to these amounts is recognized in other operating segments’ net sales and cost of sales. For the first quarter of 2005, this resulted in the recognition of net sales and cost of sales by the Retail segment, with corresponding offsets in other operating segments, of $19 million and $13 million, respectively. For the first quarter of 2004, the net sales and cost of sales recognized by the Retail segment for sales of extended warranty, support and service contracts were $12 million and $8 million, respectively.
Third, the Company has opened seven high profile stores in New York, Los Angeles, Chicago, San Francisco, Tokyo, Japan, Osaka, Japan, and London, England as of December 25, 2004. These high profile stores are larger than the Company’s typical retail stores and were designed to further promote brand awareness and provide a venue for certain corporate sales and marketing activities, including corporate briefings. As such, the Company allocates certain operating expenses associated with these stores to corporate marketing expense to reflect the estimated benefit realized Company-wide. The allocation of these operating costs is based on the excess amount incurred for a high profile store to that of a more typical Company retail location. Expenses allocated to corporate marketing resulting from the operations of these stores were $6.9 million and $2.2 million in the first quarters of 2005 and 2004, respectively.
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Summary information by operating segment follows (in millions):
(a) Other Segments consists of Asia-Pacific and FileMaker.
A reconciliation of the Company’s segment operating income to the consolidated financial statements follows (in millions):
(b) Corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard costs, and other separately managed general and administrative expenses including certain corporate expenses associated with support of the Retail segment.
Note 10 – Related Party Transactions and Certain Other Transactions
In March 2002, the Company entered into a Reimbursement Agreement with its CEO, Mr. Steven P. Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the operation of his private plane when used for Apple business. The Reimbursement Agreement became effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of the plane in May 2001. The Company recognized a total of $419,000 and $282,000 in expenses pursuant to the Reimbursement Agreement during the first quarters of 2005 and 2004, respectively. All expenses recognized pursuant to the Reimbursement Agreement have been included in selling, general, and administrative expenses in the condensed consolidated statements of operations.
Mr. Jerome York, a member of the Board of Directors of the Company, is a member of an investment group that purchased MicroWarehouse, Inc. (MicroWarehouse) in January 2000. Until September 7, 2003, he also served as Microwarehouse’s Chairman, President and Chief Executive Officer. MicroWarehouse was a reseller of computer hardware, software and peripheral products, including products made by the Company. On September 8, 2003, CDW Corporation (CDW) acquired selected North American assets of MicroWarehouse. MicroWarehouse subsequently filed for Chapter 11 bankruptcy protection in the U.S. MicroWarehouse accounted for 0.3% and 0.4% of the Company’s net sales in the first quarter of 2005 and 2004, respectively. Trade receivables from MicroWarehouse were $0.2 million and $4.3 million as of December 25, 2004 and September 25, 2004, respectively. During the first
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quarter of 2005, the Company wrote off $4.1 million of MicroWarehouse trade receivables, which were previously fully reserved. The Company has provided what it believes to be an adequate allowance on the outstanding receivable based on the Company’s secured interest position in selected MicroWarehouse assets and the expected payments to unsecured creditors. Sales to MicroWarehouse and related trade receivables were generally subject to the same terms and conditions as those with the Company’s other resellers.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-Q contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can be identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled “Factors That May Affect Future Results and Financial Condition” below. The following discussion should be read in conjunction with the 2004 Form 10-K and the condensed consolidated financial statements and notes thereto included elsewhere in this Form 10-Q. All information is based on the Company’s fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law.
Available Information The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available on its website at http://www.apple.com/investor when such reports are available on the Securities and Exchange Commission (SEC) website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. The contents of these websites are not incorporated into this filing. Further, the Company’s references to the URLs for these websites are intended to be inactive textual references only.
Executive Overview Apple designs, manufactures and markets personal computers and related software, services, peripherals and networking solutions. The Company also designs, develops and markets a line of portable digital music players along with related accessories and services including the online distribution of third-party music and audio books. The Company’s products and services include the Macintosh line of desktop and notebook computers, the iPod digital music player, the Xserve server and Xserve RAID storage products, a portfolio of consumer and professional software applications, the Mac OS X operating system, the online iTunes Music Store, a portfolio of peripherals that support and enhance the Macintosh and iPod product lines, and a variety of other service and support offerings. The Company sells its products worldwide through its online stores, its own retail stores, its direct sales force, and third-party wholesalers, resellers and value added resellers. In addition, the Company sells a variety of third-party Macintosh compatible products, including computer printers and printing supplies, storage devices, computer memory, digital video and still cameras, personal digital assistants, and various other computing products and supplies through its online and retail stores. The Company sells to education, consumer, creative professional, business and government customers. A further description of the Company’s products may be found below and in Part I, Item 1 of the Company’s 2004 Form 10-K.
The Company’s business strategy leverages its ability, through the design and development of its own operating system, hardware and many software applications and technologies, to bring to its customers around the world compelling new products and solutions with superior ease-of-use, seamless integration and innovative industrial design.
The Company participates in several highly competitive markets, including personal computers with its Macintosh line of computers, consumer electronics with its iPod line of digital music players and distribution of third-party digital music through its online iTunes Music Store. While the Company is widely recognized as an innovator in the personal computer market as well as a leader in the emerging market for distribution of digital music, these are highly competitive markets that are subject to aggressive pricing and increased competition. In order to remain competitive, the Company believes that increased investment in research and development (R&D) and marketing and advertising is necessary in order to maintain and extend its position in the markets where it competes. The Company’s R&D spending is focused on delivering timely updates and enhancements to its existing line of personal computers, displays, operating systems, software applications and portable music players; developing new digital lifestyle consumer and professional software applications; and investing in new product areas such as rack-mount
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servers, RAID storage systems, and wireless technologies. The Company also believes that investment in marketing and advertising programs is critical to increasing product and brand awareness.
The Company utilizes a variety of direct and indirect distribution channels. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware, software and peripheral integration, demonstrate the unique digital lifestyle solutions that are available only on Macintosh computers, and demonstrate the seamless compatibility of the Macintosh with the Windows platform and networks. The Company further believes that providing a high-quality sales and after-sales support experience is critical to attracting and retaining customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company has expanded and improved its distribution capabilities by opening its own retail stores in the U.S. and internationally. The Company had 101 stores open as of December 25, 2004.
The Company also staffs selected third-party stores with the Company’s own employees to improve the buying experience through reseller channels. The Company has deployed Apple employees in reseller locations around the world including the U.S., Europe, Japan and Australia. The Company also sells to customers directly through its online stores around the world.
To improve the accessibility to its iPod product line, the Company has significantly expanded the number of distribution points where iPods are sold. The iPod product line can be purchased in certain department stores, member-only warehouse stores, large retail chains, and specialty retail stores.
Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Company’s discussion and analysis of its financial condition and results of operations require the Company’s management to make judgments, assumptions, and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2004 Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates and such differences may be material.
Management believes the Company’s critical accounting policies and estimates are those related to revenue recognition, allowance for doubtful accounts, inventory valuation and exposures related to inventory purchase commitments, valuation of long-lived assets including acquired intangibles, warranty costs, and income taxes. Management believes these policies to be critical because they are both important to the portrayal of the Company’s financial condition and results, and they require management to make judgments and estimates about matters that are inherently uncertain. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors.
Revenue Recognition Net sales consist primarily of revenue from the sale of products (e.g., hardware, software, music products, and peripherals), and extended warranty and support contracts. The Company recognizes revenue pursuant to applicable accounting standards, including Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition.
The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Generally, product is considered delivered to the customer once it has been shipped, and title and risk of loss have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue recognition until the customer receives the product because the Company legally retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed not to be, fixed or determinable, revenue is deferred and subsequently recognized as amounts become due and payable.
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The Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives. The estimated cost of these programs is accrued as a reduction to revenue in the period the Company has sold the product and committed to a plan. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs and incur incremental price protection obligations that could result in additional reductions to revenue at the time such programs are offered. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company would be required to record additional reductions to revenue, which could have a material adverse impact on the Company’s results of operations.
Allowance for Doubtful Accounts The Company distributes its products through third-party resellers and directly to certain education, consumer, and commercial customers. The Company generally does not require collateral from its customers. However, when possible the Company does attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe and Asia and by arranging with third-party financing companies to provide flooring arrangements and other loan and lease programs to the Company’s direct customers. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. However, considerable trade receivables that are not covered by collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company’s distribution and retail channel partners.
The allowance for doubtful accounts is based on management’s assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition of those specific customers. The Company records an allowance to reduce the specific receivables to the amount that is reasonably believed to be collectible. The Company also records an allowance for all other trade receivables based on multiple factors including historical experience with bad debts, the general economic environment, the financial condition of the Company’s distribution channels, and the aging of such receivables. If there is a deterioration of a major customer’s financial condition, if the Company becomes aware of additional information related to the credit worthiness of a major customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, the Company may have to adjust its allowance for doubtful accounts, which would affect earnings in the period the adjustments are made.
Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory each period that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The personal computer and consumer electronic industries are subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the Company’s products are less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, the Company may be required to record additional write-downs which would negatively affect gross margins in the period when the write-downs are recorded.
The Company accrues necessary reserves for cancellation fees related to component orders that have been cancelled. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company’s requirements for periods ranging from 30 to 130 days. If there is an abrupt and substantial decline in demand for one or more of the Company’s products or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record additional reserves for cancellation fees that would negatively affect gross margins in the period when the cancellation fees are identified.
Valuation of Long-Lived Assets Including Acquired Intangibles The Company reviews property, plant, and equipment and certain identifiable intangible assets for impairment when events or changes in circumstances indicate the carrying amount of such an asset may not be recoverable.
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Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate. If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their fair market value. Although the Company has recognized no material impairment adjustments related to its property, plant, and equipment or identifiable intangibles during the past three fiscal years, except those made in conjunction with restructuring actions, deterioration in the Company’s business in a geographic region or business segment in the future, including deterioration in the performance of individual retail stores, could lead to such impairment adjustments in future periods in which such business issues are identified.
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, the Company performs a review of goodwill for impairment annually, or earlier if indicators of potential impairment exist. The review of goodwill for potential impairment is highly subjective and requires that: (1) goodwill be allocated to various reporting units of the Company’s business to which it relates; (2) the Company estimate the fair value of those reporting units to which the goodwill relates; and (3) the Company determine the book value of those reporting units. If the estimated fair value of reporting units with allocated goodwill is determined to be less than their book value, the Company is required to estimate the fair value of all identifiable assets and liabilities of those reporting units in a manner similar to a purchase price allocation for an acquired business. This requires independent valuation of certain internally developed and unrecognized assets including in-process research and development and developed technology. Once this process is complete, the amount of goodwill impairment, if any, can be determined.
Based on the Company’s estimates as of December 25, 2004 there was no impairment of goodwill. However, changes in various circumstances including changes in the Company’s market capitalization, changes in the Company’s forecasts, and changes in the Company’s internal business structure could cause one or more of the Company’s reporting units to be valued differently thereby causing an impairment of goodwill. Additionally, in response to changes in the personal computer and consumer electronics industries and changes in global or regional economic conditions, the Company may strategically realign its resources and consider restructuring, disposing, or otherwise exiting businesses, which could result in an impairment of property, plant, and equipment, identifiable intangibles, or goodwill.
Warranty Costs The Company provides currently for the estimated cost for product warranties at the time the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates its estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to warranty protection, and adjusts the amounts as necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liability would be required and could negatively affect the Company’s results of operations.
Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with SFAS No. 109, Accounting for Income Taxes, the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company is currently evaluating the repatriation provisions of the American Jobs Creation Act of 2004, which if implemented by the Company, would affect the Company’s tax provision and deferred tax assets and liabilities.
Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if the Company subsequently realizes deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in a positive adjustment to earnings or a decrease in goodwill in the period such determination is made. In addition, the
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calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s results of operations and financial position.
Products The Company offers a range of personal computing products including desktop and notebook personal computers, related devices and peripherals, and various third-party hardware products. In addition, the Company offers software products including Mac OS® X, the Company’s proprietary operating system software for the Macintosh®; server software and related solutions; professional application software; and consumer, education and business oriented application software. The Company also designs, develops and markets to Macintosh and Windows users its line of iPod® digital music players along with related accessories and services including the online distribution of third-party music through the Company’s iTunes Music Store®. A detailed discussion of the Company’s products may be found in the 2004 Form 10-K. Certain newly introduced products and/or upgrades to existing products are discussed below.
Mac® mini In January 2005, the Company introduced Mac mini, a Mac computer without a display, keyboard, or mouse, with a starting price of $499. Mac mini weighs 2.9 pounds and is available in two models, one containing a 1.25 GHz PowerPC G4 processor and a 40GB hard drive, and one containing a 1.42 GHz PowerPC G4 processor and an 80GB hard drive. Both models include ATI Radeon 9200 graphics with 32MB of dedicated DDR memory and a slot-load Combo drive for watching DVD movies and burning CDs. Mac mini includes one FireWire® 400 and two USB 2.0 ports, and a DVI interface that also supports VGA so consumers can connect to LCD or CRT displays. The Mac mini includes built-in 10/100BASE-T Ethernet and a 56K V.92 modem for Internet access, and offers optional support for an AirPort® Extreme Card for 54 Mbps 802.11g wireless networking along with an internal Bluetooth module for the latest in wireless communications.
iPod® shuffle In January 2005, the Company introduced iPod® shuffle, a flash-memory digital music player, which is based on iPod’s shuffle feature that randomly selects songs from the user’s music library or playlists. iPod shuffle works with iTunes® and its new patent-pending AutoFill feature that automatically selects songs to fill iPod shuffle from a user’s music library on their computer. iPod shuffle can also be used as a portable USB flash drive with up to 1GB of storage space. It is available in a 512MB model holding up to 120 songs and a 1GB model holding up to 240 songs.
In December 2004, the Company introduced the iTunes Music Store in Canada, followed by the availability of iTunes Music Store service in Ireland in January of 2005. The iTunes Music Store now serves customers in a total of 15 countries in North America and Western Europe.
iLife® ‘05 In January 2005, the Company announced iLife ‘05, an upgrade to its digital lifestyle suite, which features major new versions of iPhoto™, iMovie®, iDVD® and GarageBand™ and includes the latest version of iTunes®.
iPhoto™ 5 is the Company’s consumer-oriented digital photo software application. iPhoto 5 includes advanced editing tools, adds support for uncompressed RAW photos throughout the application and it includes a new slideshow builder, which allows users to apply effects, transitions and durations to each individual slide. iPhoto 5 features a new way to create hardcover and softcover photo books and lets users choose from new book layouts, double-sided printing, and ordering their book online from within iPhoto 5.
iMovie® HD, a consumer-oriented digital video editing software application, enables users to import and edit digital videos on their Mac. iMovie HD now allows users to capture and edit High Definition Video (HDV) from HDV camcorders. iMovie HD also includes Magic iMovie, which automatically imports the video into separate clips, adds titles, transitions and music. iMovie HD imports video from HDV and standard DV camcorders, and from video cameras that generate MPEG-4 video.
iDVD® is a consumer-oriented software application that enables users to turn iMovie files, QuickTime files and digital pictures into DVDs that can be played on most consumer DVD players. iDVD 5 includes 15 new themes
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featuring moving drop zones that can display video clips or photos in motion across DVD menus. iDVD 5 also features OneStep DVD, which automatically creates a DVD from footage from a user’s camcorder. With a compatible SuperDrive,™ iDVD 5 now supports all single-sided DVD formats.
GarageBand™ is a consumer-oriented music creation software application. GarageBand 2 adds 8-track recording so that users can record multiple instruments at once, plus pitch and timing correction to fix tracks. GarageBand 2 now displays and edits musical notation in real time for people who know how to read and write music or want to learn. With GarageBand Jam Packs, including the latest, Jam Pack 4: Symphony Orchestra, GarageBand users can create music in their favorite genre.
iLife ‘05 also includes iTunes® 4.7.1, the latest version of the Company’s digital music jukebox software application that allows users to purchase music from the Company’s iTunes Music Store. iTunes, organizes music using searching, browsing and playlists, also includes features such as iMix playlist sharing and provides integration with the complete family of iPods, including the new iPod shuffle.
iWork™ ‘05 In January 2005, the Company introduced iWork® ‘05, productivity software designed to take advantage of both Mac OS X and iLife ‘05 to help users create, present and publish documents and presentations. iWork ‘05 introduces Pages™, a new word processor, and also features Keynote™ 2, a new version of the Company’s presentation software.
Pages™ gives users the tools to create letters, newsletters, reports, brochures and resumes with advanced typography, multiple columns, footnotes, tables of content and styles. With features like text wrapping and alignment guides, Pages lets users create free-form arrangements of text, graphics, photos, tables and charts. An integrated iLife media browser lets users drag and drop photos from the iPhoto™ library directly into documents.
Keynote™ 2 is the Company’s presentation software that gives users the ability to create presentations, portfolios, interactive slideshows and storyboards. Keynote 2 contains slide animations to synchronize the movement of multiple objects and cinematic real-time animated text. The iLife media browser within Keynote allows users to insert photos, movies and music directly into presentations and with image masking, users can frame the exact part of the photo users want to display. Keynote 2 also has the ability to use a second monitor to display upcoming slides, notes and a timer.
Final Cut® Express HD In January 2005, the Company announced Final Cut Express HD, an update to Final Cut Express. This version enables users to capture, edit and output HDV over a single FireWire cable, without requiring any additional software or hardware. Final Cut Express HD supports Digital Cinema Desktop and includes sound editing tools including 99 audio tracks, real-time volume and audio filter adjustment and a voice-over tool. Final Cut Express HD includes LiveType™, which can add HD-quality animated text and motion graphics to videos. Final Cut Express HD also includes Soundtrack, music creation software that allows users to compose musical scores for their video.
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Net Sales Net sales and Macintosh unit sales by operating segment and net sales and unit sales by product follow (net sales in millions and unit sales in thousands):
Notes: (a) Other Segments include Asia Pacific and FileMaker. (b) Includes Xserve product line. (c) Includes eMac product line. (d) Other
Music Products consists of iTunes Music Store sales, iPod-related services, and
Apple-branded and third-party (e) Net sales of Peripherals and Other Hardware include sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories. (f) Net sales of Software include sales of Apple-branded operating system and application software and sales of third-party software. (g) Net sales per Macintosh unit sold is derived by dividing total Macintosh net sales by total Macintosh unit sales.
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Net sales during the first quarter of 2005 increased 74% or $1.484 billion from the same quarter in 2004. Several factors contributed to this increase including:
• Net sales of iPods rose $955 million or 373% during the first quarter of 2005 compared to the year-ago quarter. Unit sales of iPods totaled 4.6 million in the first quarter of 2005, which represents an increase of 525% from the 733,000 iPod units sold in the year-ago quarter and exceeded the total number of iPods shipped in all of fiscal year 2004. Strong iPod demand during the first quarter of 2005 continued to be experienced by all of the Company’s operating segments and was driven by several factors, including the introduction of the iPod photo and U2 special edition iPod during October 2004; better supply of critical iPod components; and increased expansion of the Company’s iPod distribution network. Since inception of the iPod product line in fiscal 2002, the Company has sold in excess of 10 million iPods.
• Net sales of Macintosh systems increased $336 million or 26% during the first quarter of 2005 compared to 2004; while unit sales of Macintosh systems increased by 217,000 units or 26% during the first quarter of 2005 compared to the year-ago quarter. These increases in net sales and unit sales were a result of strong demand for the Company’s consumer-oriented products, including the iMac and iBook. Net sales and unit sales of these consumer-oriented systems accounted for 57% and 70%, respectively of all Macintosh systems sold during the first quarter of 2005. Net sales of iMac and iBook increased 147% and 34%, respectively, during the first quarter of 2005 compared to the year-ago quarter. Unit sales showed year-over-year increases of 101% and 35% for iMac and iBook, respectively. Strong results of the iMac were attributable to the introduction of the iMac G5 in September 2004 and increased availability of iMac G5 components in the first quarter of 2005, which also resulted in an increase in channel inventory to within the Company’s typical range. The Company’s iBook sales were also strong in the first quarter of 2005 due to the introduction of upgraded iBooks in October 2004 and holiday demand. The Company’s average net sales per Macintosh unit sold remained flat on a year-over-year basis as a result of changes in overall unit mix towards relatively lower-priced products, offset by an increase in direct sales.
• The Retail segment’s net sales grew to $561 million during the first quarter of 2005 from $273 million during the same period in 2004, a 105% increase. Macintosh unit sales increased 63% year-over-year in the first quarter of 2005. These increases are largely attributable to the increase in total stores from 73 stores at the end of the first quarter of 2004 to 101 stores at the end of the first quarter of 2005, as well as a 48% year-over-year increase in average revenue per store. While the Company’s customers in areas where the Retail segment has opened stores may elect to purchase from the Retail segment stores rather than the Company’s preexisting sales channels in the U.S., Japan, and the U.K., the Company believes that a substantial portion of the Retail segment’s net sales is incremental to the Company’s total net sales. See additional comments below related to the Retail segment under the heading “Segment Operating Performance.”
• Other music products consists of sales associated with the iTunes Music Store and iPod related services and accessories. Net sales of other music products increased $130 million or 277% during the first quarter of 2005 compared to the year-ago quarter. The Company has experienced strong growth in sales of iPod services and accessories consistent with the increase in overall iPod unit sales for the first quarter of 2005. The year-over-year increase in sales from the iTunes Music Store relates to overall growth in the U.S. market and expanded availability of the iTunes Music store service, which in the first quarter of 2005 served 14 countries in North America and Europe compared to availability only in the U.S. during the first quarter of 2004.
• Net sales of peripherals and other hardware rose by 28% during the first quarter of 2005 compared to the year-ago quarter primarily due to an increase in net sales of displays and other computer accessories. Net sales of other computer accessories include AirPort cards and base stations, iSight digital video cameras, and third-party hardware products. The increase in total net sales of peripherals and other hardware is related to the overall increase in Macintosh unit sales and the introduction of new and updated peripheral products and was experienced predominantly by the Company’s Americas, Europe, and Retail segments.
• The Company experienced year-over-year improvement in its U.S. education channel during the first quarter of 2005 with net sales and unit sales increasing by approximately 20% and 11%, respectively, from the same quarter in 2004. Net sales generated in U.S. education for the first quarter of 2005 yielded the
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highest first quarter revenue level from this channel in 7 years. Net sales from both the higher education and K-12 markets showed strong growth of 25% and 15%, respectively, in the first quarter of 2005 compared to the year-ago quarter. These positive results were due in part to strong demand for the Company’s iMac G5 and iBook products.
• Service and other sales had a year-over-year increase of $33 million or 52% during the first quarter of 2005 compared to the same period in 2004. These increases are the result of significant year-over-year increases in net sales associated with AppleCare Protection Plan (APP) extended maintenance and support services, as well as increases in net sales associated with the Company’s .Mac Internet service. Increased net sales associated with APP are primarily the result of higher Macintosh unit sales and higher attach rates on APP over the last several years.
Offsetting the favorable factors discussed above, the Company’s net sales during the first quarter of 2005 were negatively impacted by the following:
• Net sales and unit sales of the Company’s professional-oriented products, including the Power Macintosh and PowerBook, declined in the first quarter of 2005 compared to the year-ago quarter. The Company’s Power Macintosh net sales and unit sales declined 4% and 19%, respectively, while PowerBook net sales and unit sales declined 23% and 22%, respectively. The year-over-year decline in Power Macintosh is partially attributable to strong sales in the first quarter of 2004, which was the first full quarter of sales for the new Power Mac G5 that had been introduced at the end of the fourth quarter of 2003. In addition, the Company believes that the Power Macintosh decline in the first quarter of 2005 may have resulted from a shift in customer preference away from the single processor Power Mac G5 towards the iMac G5. The decline in PowerBooks is believed to be attributable in part to a shift to the new iBooks, which were announced in October 2004. The Company believes such movement between its product lines is typical after new product introductions.
• Net sales of software decreased $32 million or 21% during the first quarter of 2005 compared to the same period in 2004 due primarily to higher net sales in the first quarter of 2004 that resulted from the October 2003 release of Mac OS X version 10.3 “Panther,” the Company’s current operating system software, partially offset by an increase in application software net sales. Net sales of Panther have been trending downward as customers await the upcoming release of Mac OS X version 10.4 “Tiger,” which is expected to be released by the Company in the first half of fiscal 2005.
Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments are comprised of the Americas, Europe, Japan, and Retail. The Americas, Europe, and Japan reportable segments do not include activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries as well as the Middle East and Africa. The Japan segment includes only Japan. The Retail segment currently operates Apple-owned retail stores in the U.S., Japan, and the U.K. Each reportable geographic operating segment provides similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Part I, Item 1 of this Form 10-Q in the Notes to Condensed Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data.”
Americas Net sales in the Americas segment during the first quarter of 2005 increased $713 million or 77% compared to the same quarter in 2004, while unit sales increased 26% year-over year. This increase was driven primarily by increased demand of the iPod as well as strong sales of the Company’s consumer-oriented iMac and iBook products. During the first quarters of 2005 and 2004, the Americas segment represented approximately 47% and 46%, respectively, of the Company’s total net sales. As noted above, the Company experienced a year-over-year increase in its U.S. education channel net sales of 20% and related CPU unit growth of 11% in the first quarter of 2005 compared to the same period in the prior year. Year-over-year increases in higher education and K-12 net sales of 25% and 15%, respectively, were due in part to strong demand for the Company’s iMac G5 and iBooks.
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Europe Net sales in Europe increased $328 million or 63% during the first quarter of 2005 as compared to the same quarter in 2004. Total Macintosh unit sales in Europe increased 33% on a year-over-year basis. Consistent with the Americas segment, Europe experienced similar strength in its consumer-oriented iPod, iMac and iBook products. The Europe segment also experienced strong sales of peripherals and other hardware, including sales of Apple-branded and third-party displays and other hardware accessories.
Japan Japan’s net sales increased 18% to $185 million during the first quarter of 2005 from $157 million in the same quarter in 2004. The increase in total net sales for the Japan segment was the result of strong iPod and iMac sales during the first quarter of 2005, partially offset by weak demand for the Company’s Power Macintosh, PowerBook and iBook products as well as lower sales of software. Macintosh unit sales in the Japan segment were down 17% in the first quarter of 2005 compared to the year-ago quarter. The relatively poor performance of the Japan segment in the first quarter of 2005, specifically a unit sales decline and lower net sales growth relative to the rest of the Company’s operating segments, may in part relate to a shift in sales from the Japan Segment to the Retail segment as a result of the Tokyo and Osaka store openings in fiscal 2004. When net sales from the Japan retail stores are added in the results for the Japan segment, the combined revenue in Japan resulted in a 26% year-over-year increase in first quarter of 2005 as compared to the same period in 2004. The Company has implemented several channel improvements, which it believes will improve the performance of the Japan segment in the future.
Retail During the first quarter of 2005, the Company opened fifteen new retail stores, including its third international store, which is located in London, England. In addition, approximately half of the stores opened during the first quarter were in the new “mini” store design, which is the Company’s smallest store format to date. The Company had 101 retail stores open at the end of the first quarter of 2005 compared to 73 open stores at the end of the first quarter of 2004. During the first quarter of 2005, the Retail segment’s net sales grew to $561 million as compared to $273 million in the same period in 2004, a 105% increase. With an average of 95 stores open during the quarter, average quarterly revenue per store increased 48% to $5.9 million in the first quarter of 2005, up from $4.0 million in the year-ago quarter.
As measured by the Company’s operating segment reporting, the Retail segment reported a profit of $45 million during the first quarter of 2005 compared to a profit of $9 million during the same period in 2004. This improvement in profitability is primarily attributable to the segment’s year-over-year increase in average quarterly revenue per store, the impact of the opening of 28 new stores, and the segment’s year-over-year increase in net sales, which resulted in higher leverage on occupancy, depreciation and other fixed costs.
Expansion of the Retail segment has required and will continue to require a substantial investment in fixed assets and related infrastructure, operating lease commitments, personnel, and other operating expenses. Capital expenditures associated with the Retail segment since its inception totaled $394 million through the end of fiscal 2004, and totaled $33 million during the first quarter of 2005.
As of December 25, 2004, the Retail segment had approximately 2,675 employees and had outstanding lease commitments associated with retail store space and related facilities of $450 million.
Gross Margin Gross margin for the three months ended December 25, 2004 and December 27, 2003 was as follows (in millions, except gross margin percentages):
Gross margin for the first quarter of 2005 was 28.5% compared to 26.7% for the same quarter in 2004. The year-over-year increase in gross margin during the first quarter of 2005 was primarily due to the following factors, including more favorable pricing on certain commodity components, higher revenue which provided for strong leveraging of fixed production costs and a more favorable mix of direct sales. In addition, gross margin during the
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first quarter of 2004 was lower than usual primarily due to pricing actions on certain Power Mac G5 models that were transitioned in that quarter and purchase order cancellation costs associated with those product transitions.
The Company expects gross margin to be approximately 125 basis points lower in the second quarter of 2005 than in the first quarter of 2005 primarily due to expected lower revenue which will provide less leverage on fixed production costs; lower pricing on certain products; and sales of the iPod shuffle and Mac mini which have lower gross margins than other products in their respective product families.
The foregoing statements regarding the Company’s expected gross margin and forecasted revenue for the second quarter of 2005 are forward-looking. Gross margin could differ from anticipated levels because of several factors, including certain of those set forth below in the subsection entitled “Factors That May Affect Future Results and Financial Condition.” There can be no assurance that current gross margins will be maintained, targeted gross margin levels will be achieved, or current margins on existing individual products will be maintained.
Operating Expenses Operating expenses for the three months ended December 25, 2004 and December 27, 2003 were as follows (in millions, except for percentages):
Research and Development (R&D) Expenditures for R&D increased 3% or $4 million to $123 million in the first quarter of 2005 compared to $119 million in the same quarter of 2004 due primarily to an increase in R&D headcount in the current year to support expanded R&D activities. In addition, during the first quarter of 2005, the Company capitalized approximately $14.8 million of costs associated with the development of Mac OS X Tiger. No software development costs were capitalized during the first quarter of 2004. The decrease in R&D as a percentage of net sales to 4% in the first quarter of 2005 from 6% in the first quarter of 2004 is due to the significant 74% increase in total net sales for the Company in the first quarter of 2005. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the Company’s core business strategy. As such, the Company expects continued heavy R&D investment for further innovation to remain competitive.
Selling, General, and Administrative Expense (SG&A) SG&A increased 37% or $127 million to $470 million in the first quarter of 2005 compared to $343 million in the same quarter of 2004. This increase is due primarily to higher direct and channel variable selling expenses resulting from the significant year-over-year increase in total net sales for the first quarter, the Company’s continued expansion of its Retail segment in both domestic and international markets, and a current year increase in discretionary spending on marketing and advertising.
Other Income and Expense Other income and expense for the three months ended December 25, 2004 and December 27, 2003 was as follows (in millions):
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Gains on Non-current Investments During the first quarter of 2004, the Company sold its remaining non-current investments in public companies consisting of 986,164 shares of Akamai Technologies for net proceeds of approximately $5 million and a gain before taxes of $4 million. As of December 25, 2004, the Company does not have any non-current public company investments reflected in its condensed consolidated balance sheet.
Interest and Other Income, Net Total interest and other income, net, increased $17 million to $26 million during the first quarter of 2005 compared to $9 million in the comparable quarter of 2004. This increase is attributable primarily to higher cash and short-term investment balances and increasing investment yields resulting from higher market interest rates. The weighted average interest rate earned by the Company on its cash, cash equivalents and short-term investments increased to 1.93% in the first quarter of 2005 compared to the 1.27% earned during the same period in 2004. The Company occasionally sells short-term investments prior to their stated maturities. No gains or losses were recognized on any such sales during either the first quarter of 2005 or 2004.
Interest expense in the prior year consisted primarily of interest on the Company’s $300 million aggregate principal amount unsecured notes, which were repaid upon their maturity in February 2004, partially offset by amortization of deferred gains realized in 2002 and 2001 that resulted from the closure of swap positions associated with the unsecured notes.
Provision for Income Taxes The Company’s effective tax rate for the first three months of 2005 was approximately 31% compared with approximately 28% for the first three months of 2004. The Company’s effective rate for both periods differs from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S. The higher tax rate in the first three months of 2005 versus 2004 is due primarily to an overall increase in earnings as well as a greater mix of earnings in the U.S.
The Internal Revenue Service (IRS) has completed its field audit of the Company’s federal income tax returns for all years prior to 2001 and proposed certain adjustments. Certain of these adjustments are being contested through the IRS Appeals Office. Substantially all IRS audit issues for these years have been resolved. In addition, the Company is also subject to audits by state, local, and foreign tax authorities. Management believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. Should any issues addressed in the Company’s tax audits be resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income tax in the period such resolution occurs.
On October 22, 2004, the American Jobs Creation Act (AJCA) was signed into law. The AJCA includes a provision for the deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA. The Company may elect to apply this provision to repatriations of qualifying earnings in either fiscal year 2005 or 2006. The Company is currently evaluating the effects of the repatriation provision. An important factor in the Company’s evaluation is additional clarification of key elements of the provision to be issued by the U.S. Treasury Department. Assuming there is sufficient guidance from the U.S. Treasury Department, the Company expects to complete its evaluation of the effects of the repatriation provision no later than the fourth quarter of 2005. A maximum of $755 million may be eligible for repatriation. However, given the preliminary stage of the Company’s evaluation, it is not possible at this time to determine the amount that may be repatriated or the related potential income tax effects of such repatriation.
Recent Accounting Pronouncements In March 2004, the FASB issued Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued FASB Staff Position (FSP) EITF 03-1-1, which delays the effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-1 to investments in securities that are impaired; however, the disclosure requirements are effective for annual periods ending after June 15, 2004. Although the Company will continue to evaluate the application of EITF 03-1, management does not currently believe adoption will have a material impact on the Company’s results of operations or financial position.
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In November 2004, the FASB issued SFAS No. 151, Inventory Costs, which amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of facility expense, freight, handling costs, and wasted material (spoilage). ARB 43, Chapter 4, previously stated that “under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges.” SFAS 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, SFAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for fiscal years beginning after June 15, 2005. Although the Company will continue to evaluate the application of SFAS 151, management does not currently believe adoption will have a material impact on the Company’s results of operations or financial position.
In December 2004, the FASB issued FSP 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. FSP 109-2 provides additional time to companies beyond the financial reporting period of enactment to evaluate the effects of the AJCA on their plans for repatriation of foreign earnings for purposes of applying SFAS 109, Accounting for Income Taxes. The Company is currently evaluating the repatriation provisions of AJCA, which if implemented by the Company would affect the Company’s tax provision and deferred tax assets and liabilities. However, given the preliminary stage of the Company’s evaluation, it is not possible at this time to determine the amount that may be repatriated or the related potential income tax effects of such repatriation.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, which amends Accounting Principles Board (APB) Opinion No. 29, Accounting for Nonmonetary Transactions. The guidance in APB Opinion 29 is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in APB Opinion 29, however, included certain exceptions to that principle. SFAS 153 amends APB Opinion 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for fiscal periods beginning after June 15, 2005. Although the Company will continue to evaluate the application of SFAS 153, management does not currently believe adoption will have a material impact on the Company’s results of operations or financial position.
In December 2004, the FASB issued SFAS No. 123 (revised 2004) (SFAS 123R), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R eliminates the ability to account for share-based compensation transactions using the intrinsic value method under APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that such transactions be accounted for using a fair-value-based method. The Company is currently evaluating SFAS 123R to determine which fair-value-based model and transitional provision it will follow upon adoption. The options for transition methods as prescribed in SFAS 123R include either the modified prospective or the modified retrospective methods. The modified prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock as the requisite service is rendered beginning with the first quarter of adoption, while the modified retrospective method would record compensation expense for stock options and restricted stock beginning with the first period restated. Under the modified retrospective method, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. SFAS 123R will be effective for the Company beginning in its fourth quarter of fiscal 2005. Although the Company will continue to evaluate the application of SFAS 123R, management expects adoption to have a material impact on the Company’s results of operations.
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Liquidity and Capital Resources The following table presents selected financial information and statistics for each of the fiscal quarters ended on the dates indicated (dollars in millions):
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