Apple 10-Q 2006
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended December 31, 2005
For the transition period from to .
Commission file number: 000-10030
APPLE COMPUTER, INC.
(Exact name of Registrant as specified in its charter)
Registrants 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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Large accelerated filer ý Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No ý
848,612,359 shares of common stock issued and outstanding as of January 25, 2006
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.
APPLE COMPUTER, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
(in millions, except share amounts)
See accompanying notes to condensed consolidated financial statements.
APPLE COMPUTER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
See accompanying notes to condensed consolidated financial statements.
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, audio books, music videos, short films, and television shows. 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. Certain prior year amounts in the consolidated financial statements and notes thereto have been reclassified to conform to the current year presentation.
These condensed consolidated financial statements and accompanying notes should be read in conjunction with the Companys annual consolidated financial statements and the notes thereto for the fiscal year ended September 24, 2005, included in its Annual Report on Form 10-K for the year ended September 24, 2005 (the 2005 Form 10-K).
The Companys fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Companys first quarter of fiscal year 2006 contained 14 weeks and the first quarter of its fiscal year 2005 contained 13 weeks. The Companys fiscal year 2006 will end on September 30, 2006 and include 53 weeks while fiscal year 2005 included 52 weeks. Unless otherwise stated, references to particular years or quarters refer to the Companys fiscal years ended in September and the associated quarters of those fiscal years.
Common Stock Split
On February 28, 2005, the Company effected a two-for-one stock split to shareholders of record as of February 18, 2005. All share and per share information has been retroactively adjusted to reflect the stock split.
Software Development Costs
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 products 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 Companys 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 Mac OS X version 10.4 Tiger subsequent to achievement of technological feasibility as evidenced by public demonstration in August 2004 and the subsequent release of a developer beta version of the product. During the first quarter of 2005, the Company capitalized approximately $14.8 million of costs associated with the development of Tiger. In accordance with SFAS No. 86, amortization of this asset to cost of sales began in April 2005 when the Company began shipping Tiger and is being recognized on a straight-line basis over a three-year estimated useful life.
On September 25, 2005, the Company adopted SFAS No. 123 (revised 2004) (SFAS No. 123R), Share-Based Payment, which addresses the accounting for stock-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 enterprises equity instruments or that may be settled by the issuance of such equity instruments. In January 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107, which provides supplemental implementation guidance for SFAS No. 123R. SFAS No. 123R eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and instead generally require that such transactions be accounted for using a fair-value-based method. The Company uses the Black-Scholes-Merton (BSM) option-pricing model to determine the fair-value of stock-based awards under SFAS No. 123R, consistent with that used for pro forma disclosures under SFAS No. 123, Accounting for Stock-Based Compensation. The Company has elected the modified prospective transition method as permitted by SFAS No. 123R and accordingly prior periods have not been restated to reflect the impact of SFAS No. 123R. The modified prospective transition method requires that stock-based compensation expense be recorded for all new and unvested stock options, restricted stock, restricted stock units, and employee stock purchase plan shares that are ultimately expected to vest as the requisite service is rendered beginning on September 25, 2005, the first day of the Companys fiscal year 2006. Stock-based compensation expense for awards granted prior to September 25, 2005 is based on the grant date fair-value as determined under the pro forma provisions of SFAS No. 123. The Company has recorded an incremental $32 million of stock-based compensation expense during the first quarter of 2006 as a result of the adoption of SFAS No. 123R. In accordance with SFAS No. 123R, beginning in the first quarter of 2006 the Company has presented excess tax benefits from the exercise of stock-based compensation awards as a financing activity in the Condensed Consolidated Statement of Cash Flows.
No stock-based compensation costs were capitalized as part of the cost of an asset as of December 31, 2005. The income tax benefit related to stock-based compensation expense was $14 million for the quarter ended December 31, 2005. As of December 31, 2005, $398 million of total unrecognized compensation cost related to stock options and restricted stock units are expected to be recognized over a weighted-average period of 2 years.
Prior to the adoption of SFAS No. 123R, the Company measured compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25. The Company applied the disclosure provisions of SFAS No. 123 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 Companys employee stock options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recognized.
The following table illustrates the effect on net income after taxes and net income per common share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation during the three-month period ended December 25, 2004 (in millions, except per share amounts):
Further information regarding stock-based compensation can be found in Note 6 of these Notes to Condensed Consolidated Financial Statements.
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 Companys common stock can result in a greater dilutive effect from outstanding options, restricted 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 1.6 million and 1.7 million shares of common stock for the quarters ended December 31, 2005 and December 25, 2004, 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 Companys 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 31, 2005, and September 24, 2005 (in millions):
The Companys 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 totaling $6.7 million on its investment portfolio, the majority of which related to investments with stated maturities less than one year as of December 31, 2005 and net unrealized losses of $5.9 million on its investment portfolio, approximately half of which related to investments with stated maturities less than one year as of September 24, 2005.
As of December 31, 2005 and September 24, 2005, approximately $172 million and $287 million, respectively, of the Companys short-term investments had underlying maturities ranging from one to five years. The remaining short-term investments had maturities of three to 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 Companys accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the balance sheet at fair value. Derivatives that are not hedges are adjusted to fair value through earnings. 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 31, 2005, the Company had a net deferred gain associated with cash flow hedges of approximately $5.5 million net of taxes, substantially all of which is expected to be reclassified to earnings by the end of the third quarter of fiscal 2006. As of the end of the first quarter of 2006, the general nature of the Companys risk management activities and the general nature and mix of the Companys derivative financial instruments have not changed materially from the end of 2005.
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, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Companys 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.
Note 3 Condensed Consolidated Financial Statement Details (in millions)
Other Current Assets
Property, Plant, and Equipment, Net
Other Income and Expense
Note 4 Restructuring Actions
2004 Restructuring Actions
The Company recorded total restructuring charges of approximately $23 million during 2004, including approximately $14 million in severance costs, $5.5 million in asset impairments, and a $3.5 million charge for lease cancellations in conjunction with the vacating of a leased sales facility related to a European workforce reduction during the fourth quarter of 2004. Of the $23 million charge, $20.4 million had been utilized by the end of the first quarter of 2006, with the remaining $2.6 million consisting of $0.2 million for employee severance benefits and $2.4 million for lease cancellations. These actions will result in the termination of 452 positions, 450 of which had been terminated prior to the end of the first quarter of 2006.
The following table summarizes activity associated with restructuring actions initiated during 2004 (in millions):
2003 Restructuring Actions
The Company recorded total restructuring charges of approximately $26.8 million during 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 primarily related to the closure of the Companys Singapore manufacturing operations during the first quarter of 2003. Of the $26.8 million charge, all had been utilized by the end of the first quarter of 2006, except for approximately $1.6 million related to operating lease costs on abandoned facilities.
The following table summarizes activity associated with restructuring actions initiated during 2003 (in millions):
Note 5 Shareholders Equity
The Company has 5 million shares of authorized preferred stock, none of which is outstanding. Under the terms of the Companys Restated Articles of Incorporation, the Board of Directors is authorized to determine or alter the rights, preferences, privileges and restrictions of the Companys authorized but unissued shares of preferred stock.
Restricted Stock Units
The Companys Board of Directors has approved several grants of restricted stock units to members of the Companys senior management team, excluding its CEO. These restricted stock units generally vest over four years either in two equal installments on the second and fourth anniversaries of the date of grant or in equal installments on each of the first through fourth anniversaries of the grant date. Upon vesting, the restricted stock units will convert into an equivalent number of shares of common stock. The value of the restricted stock units is based on the closing market price of the Companys common stock on the date of grant and are amortized on a straight-line basis over the four-year requisite service period. The restricted stock units have been reflected in the calculation of diluted earnings per share utilizing the treasury stock method.
CEO Restricted Stock Award
On March 19, 2003, the Company entered into an Option Cancellation and Restricted Stock Award Agreement (the Agreement) with Mr. Steven P. Jobs, its CEO. The Agreement cancelled stock option awards for the purchase of 55 million shares of the Companys common stock previously granted to Mr. Jobs in 2000 and 2001. Mr. Jobs retained options to purchase 120,000 shares of the Companys common stock granted in August of 1997 in his capacity as a member of the Companys Board of Directors, prior to becoming the Companys CEO. The Agreement replaced the cancelled options with a restricted stock award of 10 million shares of the Companys common stock. The restricted stock award generally vests three years from the date of grant. Vesting of some or all of the restricted shares will be accelerated in the event Mr. Jobs is terminated without cause, dies, or has his management role reduced following a change in control of the Company.
Stock Repurchase Plan
In July 1999, the Companys 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 2003. Since inception of the stock repurchase plan, the Company had repurchased a total of 13.1 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 31, 2005.
Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that under U.S. generally accepted accounting principles are recorded as an element of shareholders equity but are excluded from net income. The Companys 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.
The following table summarizes components of total comprehensive income, net of taxes, during the three-month periods ended December 31, 2005, and December 25, 2004 (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 31, 2005, and December 25, 2004 (in millions):
The following table summarizes the components of accumulated other comprehensive income (loss), net of taxes (in millions):
Employee Benefit Plans
2003 Employee Stock Option Plan
The 2003 Employee Stock Plan (the 2003 Plan) is a shareholder approved plan that provides for broad-based grants to employees, including executive officers. Based on the terms of individual option grants, options granted under the 2003 Plan generally expire seven to 10 years after the grant date and generally become exercisable over a period of four 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 Companys 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 seven to 10 years after the grant date and generally become exercisable over a period of four years, based on continued employment, with either annual or quarterly vesting. In October 2003, the Company terminated the 1997 Plan and no new options can be granted from this plan.
1997 Director Stock Option Plan
In August 1997, the Companys 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 the date of grant. Based on the terms of individual option grants, options granted under the DSOP generally expire 10 years after the grant date.
Rule 10b5-1 Trading Plans
Certain of the Companys executive officers, including Mr. Timothy D. Cook, Mr. Peter Oppenheimer, Mr. Jonathan Rubinstein, Mr. Philip W. Schiller, 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 Companys stock including the exercise and sale of employee stock options and shares acquired pursuant to the Companys employee stock purchase plan and upon vesting of restricted stock units.
The 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 employees 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 31, 2005, approximately 2.9 million shares were reserved for future issuance under the Purchase Plan.
Stock Award Activity
A summary of the Companys stock award activity and related information for the three-month periods ended December 31, 2005 and December 25, 2004 (option amounts are presented in thousands) is set forth in the following table:
The options outstanding as of December 31, 2005 have been segregated into six ranges for additional disclosure as follows (option amounts are presented in thousands):
Aggregate intrinsic value of options outstanding and options exercisable at December 31, 2005 was $3.3 billion and $2.1 billion, respectively. Aggregate intrinsic value represents the difference between the Companys closing stock price on the last trading day of the fiscal period, which was $71.89 as of December 30, 2005, and the exercise price multiplied by the number of options outstanding. Total intrinsic value of options exercised was $473 million and $395 million for the three-month periods ended December 31, 2005 and December 25, 2004, respectively.
The total fair value of options vested was $695 million and $377 million for the three-month periods ended December 31, 2005 and December 25, 2004, respectively.
The Company had 6.18 million restricted stock units outstanding as of December 31, 2005, which were excluded from the options outstanding balances in the preceding tables. The total weighted-average grant date fair value was $154 million. Aggregate intrinsic value of restricted stock units at December 31, 2005 was $444 million. None of these restricted stock units was vested as of December 31, 2005. The grant of these restricted stock units has been deducted from the shares available for grant under the Companys stock option plans. In conjunction with the amendments to the 2003 Plan that were approved at the Annual Meeting of Shareholders held on April 21, 2005, the number of shares available for grant under the 2003 Plan will be reduced by two times the number of restricted shares and restricted stock units granted. This amendment is effective for all grants made after April 21, 2005.
The total nonvested restricted stock outstanding at December 31, 2005 was 10 million shares. There were no grants, forfeitures, or vesting of any nonvested restricted stock during the quarter ended December 31, 2005. The weighted-average grant date fair value of outstanding nonvested restricted stock at December 31, 2005 was $7.48. As of December 31, 2005, total unrecognized compensation costs related to nonvested restricted stock was $2.3 million, which is expected to be recognized in the second quarter of 2006.
Note 6 - Stock-Based Compensation
SFAS No. 123R requires the use of a valuation model to calculate the fair value of stock-based awards. The Company has elected to use the BSM option-pricing model, which incorporates various assumptions including volatility, expected life, and interest rates. The expected volatility is based on the historical volatility of the Companys common stock over the most recent period commensurate with the estimated expected life of the Companys stock options, adjusted for the impact of unusual fluctuations not reasonably expected to recur and other relevant factors including implied volatility in market traded options on the Companys common stock. The expected life of an award is based on historical experience and on the terms and conditions of the stock awards granted to employees.
The assumptions used for the three-month periods ended December 31, 2005 and December 25, 2004 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 7 Commitments and Contingencies
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 five to 15 years and generally provide renewal options for terms of three to five additional years. Leases for retail space are for terms of five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 24, 2005, the Companys total future minimum lease payments under noncancelable operating leases were $865 million, of which $606 million related to leases for retail space. As of December 31, 2005, total future minimum lease payments related to leases for retail space increased to $705 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 its service parts used to repair the Companys hardware products. The Company provides currently for the estimated cost that may be incurred under its basic limited product warranties at the time the 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 Companys 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 estimates.
The following table reconciles changes in the Companys accrued warranties and related costs for the three-month periods ended December 31, 2005 and December 25, 2004 (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 31, 2005 or September 24, 2005.
Concentrations in the Available Sources of Supply of Materials and Product
Although most components essential to the Companys business are generally available from multiple sources, other key components (including microprocessors and application-specific integrated circuits (ASICs)) are currently obtained by the Company from single or limited sources. Some other key components, while currently available to the Company from multiple sources, are at times subject to industry-wide availability and pricing pressures. In addition, the Company uses some components that are not common to the rest of the personal computer industry, and new products introduced by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether there is a need for and subsequently qualifies additional suppliers. If the supply of a key single-sourced component to the Company were to be delayed or curtailed, or in the event a key manufacturing vendor delays shipments of completed products to the Company, the Companys ability to ship related products in desired quantities and in a timely manner could be adversely affected. The Companys business and financial performance could also be adversely affected depending on the time required to obtain sufficient quantities
from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components may be affected if producers were to decide to concentrate on the production of common components instead of components customized to meet the Companys requirements. Finally, significant portions of the Companys CPUs, logic boards, and assembled products are now manufactured by outsourcing partners, primarily in various parts of Asia. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Companys operating results could be adversely affected if its outsourcing partners were unable to meet their production obligations.
Long-Term Supply Agreements
During the first quarter of 2006, the Company entered into long-term supply agreements with Hynix Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND flash memory through calendar year 2010. As part of these agreements, the Company agreed to prepay $1.25 billion for flash memory components of which $750 million was paid during the first quarter of 2006 and the remaining $500 million was paid in the second quarter of 2006. These prepayments will be applied to inventory purchases made over the life of each respective agreement.
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.
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 Companys financial condition, liquidity, or results of operations.
Note 8 - 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 Companys reportable segments.
The Company manages its business primarily on a geographic basis. The Companys 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 Retail segment operates Apple-owned retail stores in the U.S., Canada, Japan, and the U.K. Other operating segments include Asia-Pacific, which includes Australia and Asia except for Japan, and the Companys 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 Companys 2005 Form 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 segments 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, stock-based compensation expense, 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 $40 million and $33 million during the first quarters of 2006 and 2005, 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 Companys 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 Companys geographic segments. The Retail segment revenue and operating income is intended to depict a measure comparable to that of the Companys 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 Companys other segments.
First, the Retail segments 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 Companys cost to support those partners. For the first quarter of 2006 and 2005, 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 $199 million and $99 million, respectively.
Second, the Companys service and support contracts are transferred to the Retail segment at the same cost as that charged to the Companys major retail channel partners in the U.S., resulting in a measure of revenue and gross margin for those items that is comparable between the Companys Retail stores and those retail channel partners. The Retail segment recognizes the full amount of revenue and cost of sales of the Companys service and support contracts at the time of sale. 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 2006, this resulted in the recognition of net sales and cost of sales by the Retail segment, with corresponding offsets in other operating segments, of $38 million and $25 million, respectively. For the first quarter of 2005, the net sales and cost of sales recognized by the Retail segment for sales of service and support contracts were $19 million and $13 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 31, 2005. These high profile stores are larger than the Companys 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 amount incurred for a high profile store in excess of that incurred by a more typical Company retail location. Expenses allocated to corporate marketing resulting from the operations of these stores were $7.6 million and $6.9 million in the first quarters of 2006 and 2005, respectively.
Summary information by operating segment is as follows (in millions):
(a) Other Segments consists of Asia-Pacific and FileMaker.
A reconciliation of the Companys segment operating income to the consolidated financial statements is as follows (in millions):
(b) Represents the excess of the Retail segments cost of sales over the Companys standard cost of sales for products sold through the Retail segment.
(c) 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 9 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 did not recognize any expense pursuant to the Reimbursement Agreement during the first quarter of 2006. The Company recognized $419,000 in expenses pursuant to the Reimbursement Agreement during the first quarter of 2005. All expenses recognized pursuant to the Reimbursement Agreement have been included in selling, general, and administrative expenses in the Condensed Consolidated Statements of Operations.
In the first quarter of 2006, the Company entered into an agreement with Pixar to sell certain of Pixars short films on the iTunes Music Store. Mr. Steven P. Jobs, the Companys CEO is also the CEO, Chairman, and a large shareholder of Pixar. During the first quarter of 2006, the Company recognized total expense under this arrangement of approximately $712,000.
Item 2. Managements 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 Companys 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 2005 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 Companys fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to the Companys 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.
The Companys 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 SECs Public Reference Room at 100 F Street, NE, Room 1580, 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 Companys references to the URLs for these websites are intended to be inactive textual references only.
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, audio books, music videos, short films, and television shows. The Companys products and services include the Macintosh line of desktop and notebook computers, the iPod digital music player, the Xserve G5 server and Xserve RAID storage products, a portfolio of consumer and professional software applications, the Mac OS X operating system, the 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 camcorders 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 Companys products may be found below and in Part I, Item 1 of the Companys 2005 Form 10-K.
The Companys 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 content through its online iTunes Music Store. While the Company is widely recognized as an innovator in the personal computer and consumer electronic markets as well as a leader in the emerging market for distribution of digital content, these are all highly competitive markets that are subject to aggressive pricing and increased competition. To remain competitive, the Company believes that increased investment in research and development (R&D) and marketing and advertising is necessary to maintain and extend its position in the markets where it competes. The Companys 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 servers, RAID storage systems, and wireless technologies. The Company also believes investment in marketing and advertising programs is critical to increasing product and brand awareness.
In June 2005, the Company announced its plan to begin using Intel microprocessors in its Macintosh computers and in January 2006 announced the new iMac® and MacBook Pro, which are the first Macintosh computers to run on Intel microprocessors. The Company expects to complete the transition of all of its Macintosh computers to Intel microprocessors by the end of calendar year 2006. There are potential risks and uncertainties that may occur during this transition, which are further discussed under the heading Factors That May Affect Future Results and Financial Condition.
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 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 136 stores open as of January 31, 2006.
The Company also staffs selected third-party stores with the Companys own employees and contractors in various geographic locations including the U.S., Europe, Japan, and Australia to improve the buying experience through reseller channels. Additionally, the Company sells to customers directly through its online stores around the world.
To improve access to the iPod product line, the Company has continued to expand 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, as well as through the channels listed above.
Critical Accounting Policies and Estimates
The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Companys discussion and analysis of its financial condition and results of operations require the Companys management to make judgments, assumptions, and estimates that affect the amounts reported in its condensed consolidated financial statements and accompanying notes. Note 1 of the Notes to Consolidated Financial Statements in the Companys 2005 Form 10-K describes the significant accounting policies and methods used in the preparation of the Companys 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 Companys critical accounting policies and estimates are those related to revenue recognition, allowance for doubtful accounts, inventory valuation and inventory purchase commitments, warranty costs, stock-based compensation, and income taxes. Management believes these policies to be critical because they are both important to the portrayal of the Companys financial condition and results, and they require management to make judgments and estimates about matters that are inherently uncertain. The Companys senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Companys Board of Directors.
Net sales consist primarily of revenue from the sale of hardware, software, peripherals, digital content, and service 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 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. 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 Companys 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 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.
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 the relevant program. The Company also records reductions to revenue for expected future product returns based on the Companys 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 Companys 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 Companys 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 Companys distribution and retail channel partners.
The allowance for doubtful accounts is based on managements 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 Companys distribution channels, and the aging of such receivables. If there is a deterioration of a major customers 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 fiscal quarter 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 Companys 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 Companys requirements for periods ranging from 30 to 150 days. If there is an abrupt and substantial decline in demand for one or more of the Companys products or an unanticipated change in technological requirements for any
of the Companys 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.
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 Companys 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 Companys results of operations.
The Company accounts for stock-based compensation in accordance with Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment. Under the provisions of SFAS No. 123R, stock-based compensation cost is estimated at the grant date based on the awards fair-value as calculated by the Black-Scholes-Merton (BSM) option-pricing model and is recognized as expense ratably over the requisite service period. The BSM model requires various highly judgmental assumptions including volatility, forfeiture rates, and expected option life. If any of the assumptions used in the BSM model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.
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 Companys 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 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 managements expectations could have a material impact on the Companys results of operations and financial position.
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 Companys 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 Companys iTunes Music Store®. A detailed discussion of the Companys products may be found in the 2005 Form 10-K. Certain newly introduced products and/or upgrades to existing products are discussed below.
In January 2006, the Company announced the new iMac® and MacBook Pro, which are the first Macintosh computers to run on Intel microprocessors. The iMac and MacBook Pro feature the Companys new translation technology, Rosetta, which allows most PowerPC-based Macintosh applications to run on these new Intel-based Macintosh computers.
The Companys new iMac featuring the Intel Core Duo processor is available in a 17-inch widescreen LCD display with a 1.83 GHz processor and 160GB Serial ATA hard drive. The iMac is also available in a 20-inch widescreen LCD display with a 2.0 GHz processor and 250GB Serial ATA hard drive. Both models include a built-in iSight video camera for video conferencing, Front Row with the Apple Remote, 512 MB of 667 MHz DDR2 SDRAM expandable to 2GB, 8x SuperDrive with double-layer support, and PCI Express-based ATI Radeon X1600 with 128MB GDDR3 memory. Every new iMac comes with iLife® 06.
The Companys new MacBook Pro featuring the Intel Core Duo processor is expected to begin shipping in February 2006. The MacBook Pro features an aluminum enclosure that is one-inch thin, weighs 5.6 pounds, includes a built-in iSight video camera for video conferencing, Front Row with the Apple Remote, iLife 06, two USB 2.0 ports, one FireWire® 400 port, a gigabit Ethernet port, built-in AirPort Extreme® wireless networking and Bluetooth 2.0+EDR, and a slot-load SuperDrive. The new MacBook Pro also features Apples new patent-pending MagSafe magnetic power connector.
iPod® Radio Remote
In January 2006, the Company announced iPod Radio Remote, a wired remote control with FM radio capabilities. The iPod Radio Remote allows users to skip tracks, adjust the volume of their iPods, and listen to FM radio stations while displaying station and song information on their iPod screens.
In January 2006, the Company introduced iLife 06, an upgrade to its consumer-oriented digital lifestyle application suite, which features iWeb, iPhoto® 6, iMovie® HD6, iDVD® 6, and GarageBand 3.
iWeb is a new application in the iLife06 suite. iWeb allows users to create online photo albums, blogs and podcasts and customize websites using editing tools and pre-designed templates.
iPhoto® 6 adds new photo management and editing features, supports up to 250,000 photos, and introduces Photocasting. Photocasting allows .Mac users to share and automatically update photo albums over the Internet with anyone who uses a Macintosh or Windows-based PC.
iMovie® HD 6 now includes new real-time effects that take advantage of Core Video technology, which uses the computers video cards graphics processing unit to deliver hardware acceleration to quickly preview video effects. iMovie 6 also provides a solution to make video podcasts, which can be published with iWeb, and includes audio enhancement tools and sound effects.
iDVD® 6 now allows users to take content shot with HDV and widescreen DV cameras and author custom DVDs with widescreen menus, movies, and high resolution slideshows. iDVD 6 features 10 new Apple-designed menu themes in both widescreen (16:9) and standard (4:3) formats.
GarageBand 3 now allows users to record, produce, and publish through iWeb their own podcasts, including artwork, sound effects, and music jingles.
In January 2006, the Company introduced iWork 06, a new version of the Companys suite of productivity software designed to help users create, present, and publish documents and presentations. iWork 06 includes Pages® 2 and Keynote 3.
Pages® 2 features mail merge with Mac OS® X Address Book, which allows users to personalize documents by dragging and dropping individual contacts into documents using templates with predefined
fields. Pages 2 also features new templates for newsletters, flyers, posters, school reports, scrapbooks, brochures, business proposals, and invoices. Pages 2 allows users to insert tables that have basic calculation functionality within any document and users can export their Pages 2 document to other formats.
Keynote 3 offers additional ways to create presentations and interactive slideshows. It features new cinematic transitions including vertical and horizontal blinds, revolving door, and swoosh. A new view mode, Light Table, allows users to view an entire presentation and reorganize slides using drag and drop.
The first quarter of 2006 spanned 14 weeks while the first quarter of 2005 spanned 13 weeks. This additional week is added to the first fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters.
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):
(a) Other Segments include Asia Pacific and FileMaker.
(b) Includes iMac, eMac, Mac mini, Power Mac, and Xserve product lines.
(c) Includes iBook and PowerBook product lines.
(d) Consists of iTunes Music Store sales, iPod services, and Apple-branded and third-party iPod accessories.
(e) Includes sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories.
(f) Includes sales of Apple-branded operating system software, application software, third-party software, AppleCare, and Internet services.
(g) Derived by dividing total Macintosh net sales by total Macintosh unit sales.
(h) Derived by dividing total iPod net sales by total iPod unit sales.
Net sales during the first quarter of 2006 increased 65% or $2.3 billion from the first quarter of 2005. The increase was due in part to the fact that the first quarter of 2006 spanned 14 weeks while the first quarter of 2005 spanned 13 weeks. Several other factors contributed to this increase including the following:
Net sales of iPods rose $1.7 billion or 140% during the first quarter of 2006 compared to the first quarter of 2005. Unit sales of iPods totaled 14.0 million in the first quarter of 2006, which represents an increase of 207% from the 4.6 million iPod units sold in the first quarter of 2005. Strong sales of iPods during the first quarter of 2006 continued to be experienced by all of the Companys operating segments and were driven by strong demand for the newest version of the iPod with video playing capabilities introduced in October 2005, the release of the iPod nano in September 2005, and expansion of the iPods distribution network. Net sales per iPod unit sold decreased 22% primarily due to the introduction of the lower priced iPod shuffle in January 2005 and a shift in sales towards the lower-priced iPod nano.
Net sales of other music related products and services increased $314 million or 177% during the first quarter of 2006 compared to the first quarter of 2005 primarily due to increased net sales from the iTunes Music Store and of iPod services and accessories. The year-over-year increase in sales from the iTunes Music Store relates to significant growth in U.S. sales, the expansion of the iTunes Music Store to seven additional countries by the end of the first quarter of 2006 from the first quarter of 2005, including Japan and Australia, and the introduction of video sales on the iTunes Music Store in October 2005. The Company has also experienced strong growth in sales of both Apple-branded and third-party iPod accessories and services, consistent with the increase in overall iPod unit sales for the first quarter of 2006.
The Retail segments net sales grew to $1.1 billion during the first quarter of 2006 from $561 million during the first quarter of 2005, a 91% increase, while Retail segment Macintosh unit sales increased 62%. These increases are largely attributable to the increase in total stores from 101 stores at the end of the first quarter of 2005 to 135 stores at the end of the first quarter of 2006, as well as a 41% year-over-year increase in average revenue per store.
Macintosh net sales increased $119 million or 7% during the first quarter of 2006 compared to the first quarter of 2005. Macintosh unit sales increased by 208,000 units or 20% during the first quarter of 2006 compared to the first quarter of 2005. The increases in Macintosh net sales and unit sales were driven by higher sales of portable products in all of the Companys operating segments. Net sales and unit sales of the Companys portable products increased 34% and 39%, respectively. The increase in Macintosh portable net sales was partially offset by a decrease in Macintosh desktop net sales of 9%, while Macintosh desktop unit sales increased by 7% year-over-year. The year-over-year increase in desktop unit sales with a corresponding decrease in desktop net sales was primarily due to the introduction of the Mac mini in the second quarter of 2005. The Mac minis starting price of $499 is significantly lower than the starting prices of the Companys other desktop products and contributed to a decrease in net sales per Macintosh unit sold of 10% year-over-year.
Net sales of peripherals and other hardware rose by 7% during the first quarter of 2006 compared to the first quarter of 2005 primarily due to an increase in net sales of RAID storage, iSight digital video cameras, printers, and other hardware accessories.
U.S. education channel net sales increased by approximately 16% during the first quarter of 2006 compared to the first quarter of 2005, while Macintosh unit sales were relatively flat compared to the first quarter of 2005. Net sales from the higher education market grew 31% in the first quarter of 2006 compared to the first quarter of 2005 due to strong iPod sales, as well as increases in Macintosh portable products and Apple-branded software sales. Net sales were relatively flat for K-12 year-over-year.
Net sales of software, service, and other sales rose $112 million or 53% during the first quarter of 2006 compared to the first quarter of 2005. This growth was primarily attributable to increased net sales in AppleCare Protection Plan (APP) extended service and support contracts, Mac OS X, and third-party software.
Segment Operating Performance
The Company manages its business primarily on a geographic basis. The Companys 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 Retail segment operated Apple-owned retail stores in the U.S., Canada, Japan, and the U.K. during the first quarter of 2006. Each reportable geographic operating segment provides similar hardware and software products and similar services. Further information regarding the Companys 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 8, Segment Information and Geographic Data.
Net sales in the Americas segment during the first quarter of 2006 increased $1.1 billion or 65% compared to the first quarter of 2005, while Macintosh unit sales increased 8% year-over-year. The increase in net sales during the first quarter of 2006 was primarily attributable to the significant year-over-year increase in iPod sales, sales of other music related products and services, sales of portable Macintosh systems, and sales of software, service, and other sales. These increases were partially offset by a 18% decrease in desktop net sales year-over-year. During both the first quarters of 2006 and 2005, the Americas segment represented approximately 47% of the Companys total net sales. The Company experienced a year-over-year increase in its U.S. education channel net sales of 16% compared to the first quarter of 2005 due to strong iPod sales, as well as increases in Macintosh portable products and Apple-branded software sales.
Net sales in Europe increased $395 million or 47% during the first quarter of 2006 as compared to the same quarter in 2005. Total Macintosh unit sales in Europe increased 21% on a year-over-year basis. Consistent with the Americas segment, Europe experienced strong sales of iPods, portable products, and other music related products and services. The Europe segment also experienced strong sales of Apple-branded and third-party displays and other hardware accessories. These increases were offset by a 9% decrease in desktop net sales on a year-over-year basis.
Japans net sales increased $170 million or 92% during the first quarter of 2006. Japan experienced increased net sales in iPod, portable products, and other music related products and services. iPod net sales increased by 277% and portable net sales increased by 27% on a year-over-year basis during the first quarter of 2006 compared to the first quarter of 2005. The increases in net sales of iPod and other music related products and services are believed to be partly attributable to the introduction of the iTunes Music Store in Japan in the fourth quarter of 2005 and an increase in marketing and advertising activities during the first quarter of 2006.
During the first quarter of 2006, the Company opened 11 new retail stores. The Company had 135 retail stores open at the end of the first quarter of 2006 compared to 101 stores at the end of the first quarter of 2005. During the first quarter of 2006, the Retail segments net sales grew to $1.1 billion as compared to $561 million in the first quarter of 2005, a 91% increase. With an average of 129 stores open during the quarter, average quarterly revenue per store increased 41% to $8.3 million in the first quarter of 2006, up from $5.9 million in the first quarter of 2005. The increase in average revenue per store was primarily due to strong sales of iPods, other music related products and services, and Macintosh portable products.
As measured by the Companys operating segment reporting, the Retail segment reported a profit of $90 million during the first quarter of 2006 compared to a profit of $45 million during the first quarter of 2005. This improvement in profitability is primarily attributable to the segments year-over-year increase in average quarterly revenue per store, the impact of opening 34 new stores, and the segments 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 $569 million through the end of the first quarter of 2006, of which $40 million was incurred during the first quarter of 2006.
As of December 31, 2005, the Retail segment had approximately 4,739 full-time equivalent employees and had outstanding lease commitments associated with retail store space and related facilities of $705 million.
Gross margin for the three months ended December 31, 2005 and December 25, 2004 was as follows (in millions, except gross margin percentages):
Gross margin percentage for the first quarter of 2006 was 27.2% compared to 28.5% for the first quarter of 2005. The year-over-year decrease in gross margin percentage during the first quarter of 2006 was primarily due to a relative increase in lower margin products, particularly the iPod product family and music-related services. Additionally, gross margins on Macintosh net sales were lower on a year-over-year basis primarily due to reductions in average selling prices from the first quarter of 2005.
The Company anticipates that its gross margin and the gross margin of the overall personal computer and consumer electronics industries will remain under pressure in light of price competition, especially for the iPod product line. The Company expects its gross margin percentage to increase slightly in the second quarter of 2006 primarily as a result of favorable costs of certain commodity components including LCD flat-panel displays, as well as a shift in the mix of revenue toward higher margin products.
The foregoing statements regarding the Companys expected gross margin and forecasted revenue for the second quarter of 2006 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 for the three months ended December 31, 2005 and December 25, 2004 was as follows (in millions, except for percentages):
Research and Development (R&D)
Expenditures for R&D increased 48% or $59 million to $182 million in the first quarter of 2006 compared to $123 million in the first quarter of 2005 due primarily to an increase in R&D headcount in the current year to support expanded R&D activities, a $13 million increase in stock-based compensation expense recognized as R&D resulting from the adoption of SFAS No. 123R, and higher overall expenses due to the 14th week added to the first fiscal quarter of 2006 to realign the Companys fiscal quarters with calendar quarters. 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 2006. The decrease in R&D as a percentage of net sales to 3% in the first quarter of 2006 from 4% in the first quarter of 2005 is due to the significant increase of 65% in total net sales for the Company in the first quarter of 2006. 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 Companys core business strategy. As such, the Company expects to make further investments in R&D to remain competitive.
Selling, General, and Administrative Expense (SG&A)
SG&A increased 34% or $162 million to $632 million in the first quarter of 2006 compared to $470 million in the first quarter of 2005. This increase is primarily due 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 Companys continued expansion of its Retail segment in both domestic and international markets, a $16 million increase in stock-based compensation expense recognized as SG&A resulting from the adoption of SFAS No. 123R, a current year increase in discretionary spending on marketing and advertising, and the associated expenses with the 14th week added to the first fiscal quarter of 2006.
Other Income and Expense
Other income and expense for the three months ended December 31, 2005 and December 25, 2004 was as follows (in millions):
Total other income and expense increased $55 million to $81 million during the first quarter of 2006 compared to $26 million in the first quarter of 2005. This increase is attributable primarily to higher cash and short-term investment balances and increasing investment yields resulting from higher market interest rates, and the 14th week added to the first fiscal quarter of 2006. The weighted-average interest rate earned by the Company on its cash, cash equivalents and short-term investments increased to 3.89% in the first quarter of 2006 from 1.93% in the first quarter of 2005.
Provision for Income Taxes
The Companys effective tax rate for the three months ended December 31, 2005 was approximately 32% compared with approximately 31% for the same period of 2005. The Companys 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 2006 versus 2005 is primarily due 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 Companys federal income tax returns for all years prior to 2002 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 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 Companys tax audits be resolved in a manner not consistent with managements 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 fiscal year 2006. The Company is continuing to evaluate the effects of the repatriation provision and expects to complete the evaluation in fiscal year 2006. A maximum of $755 million may be eligible for repatriation under the reduced tax rate provided by AJCA. However, given the uncertainties and complexities of the repatriation provision and the Companys continuing evaluation, the Company has not yet determined the amount that may be repatriated or the related potential income tax effects of such repatriation.
Recent Accounting Pronouncements
In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. FSP Nos. FAS 115-1 and FAS 124-1 amend SFAS No. 115, Accounting for Certain Investments in
Debt and Equity Securities, SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, as well as APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. This guidance nullifies certain requirements of EITF 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. FSP Nos. FAS 115-1 and FAS 124-1 include guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to not be other-than-temporarily impaired. FSP Nos. FAS 115-1 and FAS 124-1 also require other-than-temporary impaired debt securities to be written down to its impaired value, which becomes the new cost basis. FSP Nos. FAS 115-1 and FAS 124-1 are effective for fiscal periods beginning after December 15, 2005 and are required to be adopted by the Company in the second quarter of fiscal 2006. Although the Company will continue to evaluate the application of FSP Nos. FAS 115-1 and FAS 124-1, management does not currently believe adoption will have a material impact on the Companys 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 continuing to evaluate the repatriation provisions of AJCA, which if implemented by the Company would affect the Companys tax provision and deferred tax assets and liabilities. However, given the uncertainties and complexities of the repatriation provision and the Companys continuing evaluation, the Company has not yet determined the amount, if any, that will be repatriated or the related potential income tax effects of such repatriation. The Company expects to complete the evaluation in fiscal 2006.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections which replaces APB Opinion No. 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial StatementsAn Amendment of APB Opinion No. 28. SFAS No. 154 requires retrospective application to prior periods financial statements of a voluntary change in accounting principal unless it is not practicable. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and is required to be adopted by the Company in the first quarter of fiscal 2007. Although the Company will continue to evaluate the application of SFAS No. 154, management does not currently believe adoption will have a material impact on the Companys results of operations or financial position.
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):
(a) DSO is based on ending net trade receivables and most recent quarterly net sales for each period.
(b) Days supply of inventory is based on ending inventory and most recent quarterly cost of sales for each period.
(c) DPO is based on ending accounts payable and most recent quarterly cost of sales adjusted for the change in inventory.
As of December 31, 2005, the Company had $8.7 billion in cash, cash equivalents, and short-term investments, an increase of $446 million over the same balances at the end of 2005. The principal components of this net increase were cash generated by operating activities of $283 million that includes a $750 million prepayment made to certain vendors for the future supply of NAND flash memory components, proceeds from the issuance of common stock under stock plans of $134 million, and tax benefits from stock option exercises of $149 million. The Companys short-term investment portfolio is primarily invested in high credit quality, liquid investments. Approximately $4.8 billion of this cash, cash equivalents, and short-term investments is held by the Companys foreign subsidiaries and
would be subject to U.S. income taxation on repatriation to the U.S. The Company is currently assessing the impact of the one-time favorable foreign dividend provisions recently enacted as part of the AJCA, and may decide to repatriate earnings from some of its foreign subsidiaries.
In the second quarter of 2006, the Company made an additional prepayment of $500 million for the future supply of NAND flash memory components.
In addition, during the second quarter of 2006, 10 million shares of restricted stock and 2.4 million restricted stock units (RSUs) previously granted to certain Company executives are scheduled to vest. The majority of these are expected to be net-share settled, thus the Company will withhold from the executives sufficient shares to satisfy the executives obligation for their applicable income and other employment taxes, and will remit an equivalent amount of cash to the appropriate taxing authorities. The number of shares withheld will be based on the value of the restricted stock and RSUs on their respective vesting dates. The remaining shares net of those withheld will be delivered to the Company executives. The amounts of these tax withholdings and remittances in cash to the taxing authorities will be a function of the Companys stock price on the respective vesting dates, but using the closing price of the Companys stock on January 27, 2006 of $72.03 as a proxy, the total payments for the employees tax obligations to the taxing authorities would be approximately $398 million. These transactions will not represent expenses to the Company but will be accounted for as reductions to cash with corresponding reductions to shareholders equity. These net-share settlements will have the effect of share repurchases by the Company as they will reduce and retire the number of shares that would have otherwise been issued as a result of the vesting.
The Company believes its existing balances of cash, cash equivalents, and short-term investments will be sufficient to satisfy its working capital needs, capital expenditures, stock repurchase activity, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months.
The Companys total capital expenditures were $82 million during the first quarter of fiscal 2006, $40 million of which were for retail store facilities and equipment related to the Companys Retail segment and $42 million of which were for corporate infrastructure, including information systems enhancements and operating facilities enhancements and expansions. The Company currently anticipates it will utilize approximately $420 million for capital expenditures during 2006, approximately $210 million of which is expected to be utilized for expansion of the Companys Retail segment and the remainder utilized to support normal replacement of existing capital assets and enhancements to general information technology infrastructure.
Stock Repurchase Plan
In July 1999, the Companys 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. Since inception of the stock repurchase plan, the Company has repurchased a total of 13.1 million shares at a cost of $217 million. The Company did not repurchase any shares during the first quarter of 2006. The Company was authorized to repurchase up to an additional $283 million of its common stock as of December 31, 2005.
Off-Balance Sheet Arrangements and Contractual Obligations
The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company.
As of September 24, 2005, the Company had total outstanding commitments on noncancelable operating leases of approximately $865 million, $606 million of which related to the lease of retail space and related facilities. The major facility leases are for terms of five to 15 years and generally provide renewal options for terms of three to five additional years. Leases for retail space are for terms of five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. Total outstanding commitments on noncancelable operating leases related to the lease of retail space rose to $705 million as of December 31, 2005.
Purchase Commitments with Contract Manufacturers and Component Suppliers
The Company utilizes several contract manufacturers to manufacture sub-assemblies for the Companys products and to perform final assembly and test of finished products. These contract manufacturers acquire components and build product based on demand information supplied by the Company, which typically covers periods ranging from 30 to 150 days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase commitments typically cover the Companys forecasted component and manufacturing requirements for periods ranging from 30 to 150 days. As of December 31, 2005, the Company had outstanding third-party manufacturing commitments and component purchase commitments of approximately $2.0 billion.
During the first quarter of 2006, the Company entered into long-term supply agreements with Hynix Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND flash memory through calendar year 2010. As part of these agreements, the Company agreed to prepay $1.25 billion for flash memory components of which $750 million was paid during the first quarter of 2006 and the remaining $500 million was paid in the second quarter of 2006. These prepayments will be applied to inventory purchases made over the life of each respective agreement.
Asset Retirement Obligations
The Companys asset retirement obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. As of December 31, 2005, the Company estimated that gross expected future cash flows of approximately $17 million would be required to fulfill these obligations.
Other obligations increased to approximately $52 million as of December 31, 2005 primarily related to telecommunications services contracts that were renewed in the first quarter of 2006 for a 2 year period.
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 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.
Factors That May Affect Future Results and Financial Condition
Because of the following factors, as well as other factors affecting the Companys operating results and financial condition, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.
General economic conditions and current economic and political uncertainty could adversely affect the demand for the Companys products and the financial health of its suppliers, distributors, and resellers.
The Companys operating performance depends significantly on general economic conditions in the U.S. and abroad. At times in the past, demand for the Companys products has been negatively impacted by difficult global economic conditions. Additionally, some of the Companys education customers appeared to be delaying technology purchases due to concerns about the overall impact of the weaker economy and state budget deficits on their available funding. Although recent macroeconomic trends seem to indicate an economic recovery, continued uncertainty about future economic conditions makes it difficult to forecast future demand for the Companys products and related operating results. Should global and/or regional economic conditions deteriorate, demand for the Companys products could be adversely affected, as could the financial health of its suppliers, distributors, and resellers.
War, terrorism, public health issues and other business interruptions whether in the U.S. or abroad, have caused and could cause damage or disruption to international commerce by creating economic and political uncertainties that may have a strong negative impact on the global economy, the Company, and the Companys suppliers or customers.
The Companys major business operations are subject to interruption by earthquake, other natural disasters, fire, power shortages, terrorist attacks and other hostile acts, labor disputes, public health issues, and other events beyond its control. The majority of the Companys research and development activities, its corporate headquarters, information technology systems, and other critical business operations, including certain component suppliers and manufacturing vendors, are located near major seismic faults. Because the Company does not carry earthquake insurance for direct quake-related losses, the Companys operating results and financial condition could be materially adversely affected in the event of a major earthquake or other natural or manmade disaster.
Although it is impossible to predict the occurrences or consequences of any such events, such events could result in a decrease in demand for the Companys products, make it difficult or impossible for the Company to deliver products to its customers or to receive components from its suppliers, and could create delays and inefficiencies in the Companys supply chain. In addition, should major public health issues, including pandemics, arise, the Company could be negatively impacted by the need for more stringent employee travel restrictions, additional limitations in the availability of freight services, governmental actions limiting the movement of products between various regions, delays in production ramps of new products, and disruptions in the operations of the Companys manufacturing vendors and component suppliers. The Companys operating results and financial condition have been, and in the future may be, adversely affected by these events.
The market for personal computers and related peripherals and services, as well as digital music devices and related services, is highly competitive. If the Company is unable to effectively compete in these markets, its results of operations could be adversely affected.
The personal computer industry is highly competitive and is characterized by aggressive pricing practices, downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors, price sensitivity on the part of consumers, and a large number of competitors. Over the past several years, price competition in the market for personal computers and related peripherals has been particularly intense as competitors who sell Windows and Linux based personal computers have aggressively cut prices and lowered their product margins for personal computing products. The Companys results of operations and financial condition have been, and in the future may continue to be, adversely affected by these and other industry-wide pricing pressures and downward pressures on gross margins.
The personal computer industry has also been characterized by rapid technological advances in software functionality, hardware performance, and features based on existing or emerging industry standards. Further, as the personal computer industry and its customers place more reliance on the Internet, an increasing number of Internet devices that are smaller and simpler than traditional personal computers may compete for market share with the Companys existing products. Several competitors of the Company have either targeted or announced their intention to target certain of the Companys key market segments, including consumer, education, professional and consumer digital video editing, and design and publishing. Several of the Companys competitors have introduced or announced plans to introduce digital music products and/or online stores offering digital music distribution that mimic many of the unique design, technical features, and solutions of the Companys products. The Company has a significant number of competitors, many of whom have greater financial, marketing, manufacturing, and technological resources, as well as broader product lines and larger installed customer bases than those of the Company. Additionally, there has been a trend towards consolidation in the personal computer industry that has resulted in larger and potentially stronger competitors in the Companys markets.
The Company is currently the only maker of hardware using the Mac OS. The Mac OS has a minority market share in the personal computer market, which is dominated by makers of computers utilizing other competing operating systems, including Windows and Linux. The Companys future operating results and financial condition are substantially dependent on its ability to continue to develop improvements to the Macintosh platform in order to maintain perceived design and functional advantages over competing platforms. Additionally, if unauthorized copies of the Mac OS are used on other companies hardware products and result in decreased demand for the Companys hardware products, the Companys results of operations may be adversely affected.
The Company is currently focused on market opportunities related to digital music distribution and related consumer electronic devices, including iPods. The Company faces increasing competition from other companies promoting their own digital music products, including music enabled cell phones, distribution services, and free peer-to-peer music services. These competitors include both new entrants with different market approaches, such as subscription
services models, and also larger companies that may have greater technical, marketing, distribution, and other resources than those of the Company, as well as established hardware, software, and digital content supplier relationships. Failure to effectively compete could negatively affect the Companys operating results and financial position. There can be no assurance that the Company will be able to continue to provide products and services that effectively compete in these markets or successfully distribute and sell digital music outside the U.S. The Company may also have to respond to price competition by lowering prices and/or increasing features which could adversely affect the Companys music product gross margins as well as overall Company gross margins.
The Company also faces increased competition in the U.S. education market. U.S. elementary and secondary schools, as well as college and university customers, remain a core market for the Company. Uncertainty in this channel remains as several competitors of the Company have either targeted or announced their intention to target the education market for personal computers, which could negatively affect the Companys market share. In an effort to regain market share and remain competitive, the Company has been and will continue to pursue one-to-one (1:1) learning solutions in education. 1:1 learning solutions typically consist of iBook portable systems for every student and teacher along with a wireless network connected to a central server. These 1:1 learning solutions and other strategic sales are generally priced more aggressively and could result in significantly less profitability or even in financial losses, particularly for larger deals. Although the Company believes it has taken certain steps to strengthen its position in the education market, there can be no assurance that the Company will be able to increase or maintain its share of the education market or execute profitably on large strategic arrangements. Failure to do so may have an adverse impact on the Companys operating results and financial condition.
The Companys transition from PowerPC microprocessors used by Macintosh computers to microprocessors built by Intel is subject to numerous risks.
In June 2005, the Company announced its intention to transition from the use of PowerPC microprocessors to the use of Intel microprocessors in all of its Macintosh computers by the end of calendar year 2007. In January 2006, the Company announced the new iMac® and MacBook Pro, which are the first Macintosh computers to run on Intel microprocessors. The Company now expects to complete this transition by the end of calendar year 2006. This transition is subject to numerous risks and uncertainties, including the Companys ability to timely develop and deliver new products using Intel microprocessors, the timely innovation and delivery of related hardware and software products, including the Companys applications, to support Intel microprocessors, market acceptance of Intel-based Macintosh computers, the development and availability on acceptable terms of components and services essential to enable the Company to timely deliver Intel-based Macintosh computers, and the effective management of inventory levels in line with anticipated product demand for both PowerPC and Intel-based Macintosh computers. In addition, the Company is dependent on third-party software developers such as Microsoft and Adobe continuing to support current applications that run on PowerPC-based computers and timely developing versions of current and future applications that run on Intel and PowerPC-based Macintosh computers. The Companys inability to timely deliver new Intel-based products or obtain developer commitment both to continue supporting applications that run on PowerPC microprocessors and timely transition their applications to run natively on Intel-based products may have an adverse impact on the Companys results of operations. The Companys announcement of its intention to transition to Intel microprocessors may negatively impact sales of current and future Macintosh products containing PowerPC microprocessors, as customers may elect to delay purchases until the Intel-based products are available. Additionally, there can be no assurance that the Company will be able to maintain its historical gross margin percentages on its products, including Intel-based Macintosh computers, which may adversely impact the Companys results of operations.
Future operating results are dependent upon the Companys ability to obtain a sufficient supply of components, including