Apple 10-Q 2007
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2007
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
Commission File Number: 000-10030
(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 x 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.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
869,640,955 shares of common stock issued and outstanding as of July 25, 2007
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(in millions, except share and per share amounts)
See accompanying Notes to Condensed Consolidated Financial Statements.
CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
See accompanying Notes to Condensed Consolidated Financial Statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
See accompanying Notes to Condensed Consolidated Financial Statements.
Notes to Condensed Consolidated Financial Statements (Unaudited)
Note 1 - Summary of Significant Accounting Policies
Apple Inc. and its wholly-owned subsidiaries (Apple or the Company) designs, manufactures, and markets personal computers, portable digital music players, and mobile phones and sells a variety of related software, services, peripherals, and networking solutions. The Company sells its products worldwide through its online stores, its 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, iPod and iPhone compatible products including application software, printers, storage devices, speakers, headphones, and various other accessories and supplies 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 condensed 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 30, 2006, included in its Annual Report on Form 10-K for the year ended September 30, 2006 (the 2006 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 2007 contained 13 weeks and the first quarter of fiscal year 2006 contained 14 weeks. The Companys fiscal year 2007 will end on September 29, 2007 and include 52 weeks while fiscal year 2006 included 53 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.
In March 2007, the Company began shipping Apple TV and in June 2007 began shipping iPhone. For Apple TV and iPhone, the Company indicated it may provide future unspecified features and additional software products free of charge to customers. Accordingly, Apple TV and iPhone handsets sales are accounted for under subscription accounting in accordance with the American Institute of Certified Public Accountants Statement of Position (SOP) No. 97-2, Software Revenue Recognition. As such, the Company defers the associated revenue and cost of goods sold at the time of sale, and recognizes both on a straight-line basis over the currently estimated 24-month economic life of these products. Costs incurred by the Company for engineering, sales, and marketing are expensed as incurred.
The Company records revenue net of taxes collected from customers that are remitted to governmental authorities. These taxes are recorded as current liabilities until remitted to the relevant government authority.
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 most software development costs have been expensed.
In the second quarter of 2007, the Company determined that both Mac OS X version 10.5 Leopard (Leopard) and iPhone achieved technological feasibility. During the second and third quarters of 2007, the Company capitalized approximately $27 million and $26 million, respectively, of costs associated with the development of Leopard and iPhone. In accordance with SFAS No. 86, the capitalized costs related to Leopard and iPhone are amortized to cost of sales commencing when each respective product begins shipping and are recognized on a straight-line basis over a 3 year estimated useful life of the underlying technology.
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, shares to be purchased under the employee stock purchase plan, unvested restricted stock and restricted stock units (RSUs) 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 RSUs. Additionally, the exercise of employee stock options and the vesting of restricted stock and RSUs 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 representing approximately 12.0 million and 3.0 million shares of common stock for the quarters ended June 30, 2007 and July 1, 2006, respectively, and 13.2 million and 3.3 million shares of common stock for the nine months ended June 30, 2007 and July 1, 2006, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive. Potentially dilutive securities include stock options, shares to be purchased under the employee stock purchase plan, and RSUs.
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 June 30, 2007, and September 30, 2006 (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 issued by foreign companies, and certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. dollars. As of June 30, 2007 and September 30, 2006, approximately $2.1 billion and $921 million, respectively, of the Companys short-term investments had underlying maturities ranging from one to five years. The remaining short-term investments had maturities less than 12 months.
The gross and net unrealized losses on the Companys investment portfolio were not significant as of June 30, 2007 and September 30, 2006. The unrealized losses on the Companys investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities were caused primarily by changes in interest rates. The Company typically invests in highly rated securities with low probabilities of default. The Companys investment policy requires investments to be rated single-A or better. Therefore, the Company considers the declines to be temporary in nature. As of June 30, 2007, the Company does not consider the investments to be other-than-temporarily impaired.
Market values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and the Companys ability and intent to hold the investment for a period of time, which may be sufficient for anticipated recovery in market value.
Derivative Financial Instruments
The Company uses derivatives to partially offset its business exposure to foreign exchange 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. 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. 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 designated as hedges and the ineffective portions of cash flow hedges are adjusted to fair value through earnings. The effective portions of cash flow hedges are recorded in other comprehensive income until the hedged item is recognized in earnings. Changes in value of fair value hedges are offset against the changes in fair value of the hedged assets, liabilities, or firm commitments through earnings. As of June 30, 2007, the Company had a net deferred loss associated with cash flow hedges of approximately $2.7 million, net of taxes, all of which is expected to be reclassified to earnings by the end of the first quarter of 2008. As of the end of the third quarter of 2007, 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 2006.
Note 3 Condensed Consolidated Financial Statement Details (in millions)
Other Current Assets
Property, Plant and Equipment, Net
Other Income and Expense
Note 4 Goodwill and Other Intangible Assets
The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 3 to 10 years.
The following table summarizes the components of gross and net intangible asset balances (in millions):
Note 5 Shareholders Equity
The Company has five million shares of authorized preferred stock, none of which is issued or 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 granted RSUs to members of the Companys senior management team, excluding its CEO. These RSUs generally vest over four years either at the end of the four-year service period, 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 RSUs will convert into an equivalent number of shares of common stock. The compensation expense incurred by the Company for RSUs is based on the closing market price of the Companys common stock on the date of grant and is amortized on a straight-line basis over the requisite service period. The RSUs have been reflected in the calculation of diluted earnings per share utilizing the treasury stock method.
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 and nine-month periods ended June 30, 2007 and July 1, 2006 (in millions):
The following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company during the three and nine-month periods ended June 30, 2007 and July 1, 2006 (in millions):
The following table summarizes the components of accumulated other comprehensive income, net of taxes (in millions):
Employee Benefit Plans
2003 Employee Stock 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 7 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, RSUs, stock appreciation rights, stock purchase rights and performance-based awards. In the third quarter of 2007, the Companys shareholders approved an amendment to the 2003 Employee Stock Plan to increase the number of shares authorized for issuance by 28 million shares.
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 7 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 Director Stock Option Plan (Director Plan) for non-employee directors of the Company, which was approved by shareholders in 1998. Pursuant to the Director Plan, the Companys non-employee directors are granted an option to acquire 30,000 shares of common stock upon their initial election to the Board (Initial Options). The Initial Options vest and become exercisable in three equal annual installments on each of the first through third anniversaries of the grant date. On the fourth anniversary of a non-employee directors initial election to the Board and on each subsequent anniversary thereafter, the director will be entitled to receive an option to acquire 10,000 shares of common stock (Annual Options). Annual Options are fully vested and immediately exercisable on their date of grant.
Rule 10b5-1 Trading Plans
Certain of the Companys executive officers, including Mr. Timothy D. Cook, Mr. Peter Oppenheimer, Mr. Philip W. Schiller, and Dr. Bertrand Serlet, 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 RSUs.
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. In the third quarter of 2007, the Companys shareholders approved an amendment to the Employee Stock Purchase Plan to increase the number of shares authorized for issuance by 6 million shares and limit the number of shares that may be purchased in any calendar year to 3 million shares. As of June 30, 2007, approximately 7.0 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 nine months ended June 30, 2007 is set forth in the following table (stock award amounts and aggregate intrinsic value are presented in thousands):
Beginning in April 2005, each RSU granted under the 2003 Plan has reduced the number of shares available for grant under that plan by two shares.
Aggregate intrinsic value represents the value of the Companys closing stock price on the last trading day of the fiscal period in excess of the weighted-average exercise price multiplied by the number of shares underlying the outstanding options. Total intrinsic value of options at time of exercise was $349 million and $961 million for the three and nine-month periods ended June 30, 2007, respectively, and $171 million and $1.1 billion for the three and nine-month periods ended July 1, 2006, respectively.
The income tax benefit related to stock-based compensation expense was $21 million and $49 million for the three and nine-month periods ended June 30, 2007, respectively, and $10 million and $36 million for the three and nine-month periods ended July 1, 2006. As of June 30, 2007, $675 million of total unrecognized compensation cost related to stock options and RSUs is expected to be recognized over a weighted-average period of 3.03 years.
As of June 30, 2007, the Company had 4.67 million RSUs outstanding with a total grant-date fair value of $245 million, which were excluded from the options outstanding balances in the preceding table. No RSUs were granted or vested during the third quarter of 2007. The weighted-average grant date fair value of RSUs granted during the first nine months of 2007 was $86.67. Aggregate intrinsic value of RSUs at June 30, 2007 was $570 million.
There were no grants or forfeitures of restricted stock during the three or nine-month periods ended June 30, 2007. There was no outstanding restricted stock as of June 30, 2007.
The Company uses the Black-Scholes-Merton (BSM) option-pricing model to calculate the fair value of stock-based awards. The BSM 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 and other relevant factors including implied volatility in market traded options on the Companys common stock. The Company bases its expected life assumption on its historical experience and on the terms and conditions of the stock awards it grants to employees.
The assumptions used for the three and nine-month periods ended June 30, 2007 and July 1, 2006 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 6 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 5 to 15 years and generally provide renewal options for terms of 3 to 5 additional years. Leases for retail space are for terms of 5 to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 30, 2006, the Companys total future minimum lease payments under noncancelable operating leases were $1.2 billion, of which $887 million related to leases for retail space. As of June 30, 2007, total future minimum lease payments related to leases for retail space increased $113 million to $1.0 billion.
Accrued Warranty and Indemnifications
The following table reconciles changes in the Companys accrued warranties and related costs for the three and nine-month periods ended June 30, 2007 and July 1, 2006 (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 June 30, 2007 or September 30, 2006.
Concentrations in the Available Sources of Supply of Materials and Product
Certain key components including, but not limited to, microprocessors, enclosures, certain LCDs, certain optical drives, and application-specific integrated circuits (ASICs) are currently obtained by the Company from single or limited sources which subjects the Company to supply and pricing risks. Many of these and other key components that are available from multiple sources including, but not limited to, NAND flash memory, DRAM memory, and certain LCDs, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. In addition, the Company has entered into certain agreements for the supply of critical components at favorable pricing, and there is no guarantee that the Company will be able to extend or renew these agreements when they expire. Therefore, the Company remains subject to significant risks of supply shortages and/or price increases that can adversely affect gross margins and operating margins. In addition, the Company uses some components that are not common to the rest of the global personal computer and consumer electronics industries, and new products introduced by the Company often 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, iPods, iPhones, logic boards, and other assembled products are now manufactured by outsourcing partners, primarily in various parts of Asia. A significant concentration of this outsourced manufacturing is currently performed by only a few of the Companys outsourcing partners, often in single locations. 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 commitments.
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 prepaid $1.25 billion for flash memory components during 2006, which will be applied to certain inventory purchases made over the life of each respective agreement. Approximately $142 million of the prepayment had been utilized by the Company as of June 30, 2007.
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 7 - 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. Accordingly, the Company determined its operating segments, which are generally based on the nature and location of its customers, to be the Americas, Europe, Japan, Asia-Pacific, Retail, and FileMaker operations. The Companys four geographical segments, together with the Retail segment, all sell the same products to the same types of customers. The Companys reportable operating segments are comprised of the Americas, Europe, Japan, and Retail operations. The Americas, Europe, and Japan reportable segments exclude 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, the U.K., and Italy. 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 as of June 30, 2007 the accounting policies of the various segments are the same as those described in the Companys 2006 Form 10-K in Note 1, Summary of Significant Accounting Policies.
The Company evaluates the performance of its operating segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of the customers, and net sales for the Retail segment are based on sales from the Companys retail stores. Operating income for each segment includes net sales to third parties, related cost of sales, and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses such as manufacturing costs and variances not included in standard costs, research and development, corporate marketing expenses, stock-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. Segment assets exclude corporate assets such as cash, short-term and long-term investments, manufacturing facilities, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets, and retail store construction-in-progress 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 $88 million and $54 million during the third quarters of 2007 and 2006, respectively, and $164 million and $136 million during the first nine months of 2007 and 2006, respectively.
From the establishment of the Retail segment in fiscal 2001 through the quarter ended March 31, 2007, Company management assessed the segments operating performance differently from the Companys other operating segments. Because the Companys Retail initiative was an unproven concept at inception, management chose to measure the Retail segments performance in a manner that would allow comparability to the Companys major channel partners operating retail stores in the U.S. There were three significant differences in the measurement of the Retail segments results relative to the Companys other operating segments. First, the Retail segments operating income reflected cost of sales for Apple products at amounts normally charged to Apples major U.S. channel partners for the same products, less the cost of the Companys sales programs and other costs to support those partners. Second, the cost of sales of the Companys service and support contracts, including the AppleCare Protection Plan (APP) and .Mac, were reflected in the Retail segments results at the costs charged to major channel partners for such contracts, and all associated revenue was reflected in the Retail segments results at the time of sale rather than being amortized over the lives of the respective agreements. Because the Company had not yet earned the revenue or incurred the cost associated with the sale of such contracts, an offset to these amounts was recognized in other segments net sales and cost of sales. Third, the Company allocated certain expenses related to the operation of its high-profile stores to corporate marketing expense.
Having operated the Companys Retail stores successfully for more than six years, management believes its Retail initiative is a proven concept that will continue to be an integral element of the Companys distribution and marketing strategies. Additionally, the Company expects sales of iPhone by the Companys geographic operating segments to generate significant levels of deferred revenue and deferred cost of sales over time. In consideration of these factors, management has determined that beginning with the quarter ended June 30, 2007, aligning measurements for the performance of the Retail segment with those used for the Companys other operating segments provides the most meaningful information. Accordingly, management has begun to measure the Retail segments operating performance in a manner generally consistent with the Companys other operating segments. The cost of sales of the Companys products sold through the Retail segment is now reflected at amounts similar to the cost of sales of the same products reflected in the Companys other operating segments. Revenue from APP and .Mac contracts sold through the Retail segment is now being recognized over the lives of the respective service agreements. Additionally, the Retail segment is applying the same subscription accounting to iPhone net sales and cost of sales that the Companys other operating segments apply. Management believes aligning measurements for the performance of the Retail segment with those used for the Companys other operating segments will provide greater comparability with the rest of the Companys segments and allow for more meaningful assessment of the Retail segments operating results. The Company has reclassified prior period operating segment results to reflect these changes in the measurement of the operating results for the Retail segment, along with the corresponding offsetting impact to the Companys other operating segments.
The Company will continue to allocate certain operating expenses associated with its high-profile stores to corporate marketing expense to reflect the estimated Company-wide benefit. 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. The allocation of these operating costs to corporate expense is based on the amount incurred for a high-profile store in excess of that incurred by a more typical Company retail location. The Company had opened a total of eight high-profile stores as of June 30, 2007. Expenses allocated to corporate marketing resulting from the operations of high-profile stores were $10 million and $9 million in the third quarters of 2007 and 2006, respectively, and $30 million and $24 million for the first nine months of 2007 and 2006, respectively.
Summary information by reportable segment, revised for all periods presented to reflect the Companys third quarter 2007 change in measurement of its Retail segments operating results along with the corresponding offsetting impact in the Companys other operating segments, is as follows (in millions):
(a) Other Segments consists of Asia-Pacific and FileMaker.
A reconciliation of the Companys segment operating income to the condensed consolidated financial statements is as follows (in millions):
(a) Other 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 8 Related Party Transactions and Certain Other Transactions
The Company entered into a Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the operation of his private plane when used for Apple business. The Company recognized a total of $10,000 and $573,000 in expenses pursuant to the Reimbursement Agreement during the three and nine-month periods ended June 30, 2007, respectively. The Company recognized a total of $112,000 in expenses pursuant to the Reimbursement Agreement during the three and nine months ended July 1, 2006. All expenses recognized pursuant to the Reimbursement Agreement have been included in selling, general, and administrative expenses in the Condensed Consolidated Statements of Operations.
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 Part II, Item 1A., Risk Factors. The following discussion should be read in conjunction with the 2006 Form 10-K filed with the SEC (the 2006 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 year. 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 the Companys 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 1-202-551-8090. 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, portable digital music players, and mobile phones and sells a variety of related software, services, peripherals, and networking solutions. The Companys products and services include the Macintosh® line of desktop and portable computers, the iPod line of portable digital music players, iPhone, Apple TV, Xserve®, and Xserve RAID, a portfolio of consumer and professional software applications, the Mac OS® X operating system, third-party digital content through the iTunes Store, and a variety of accessory, service and support offerings. The Company sells its products worldwide through its online stores, its 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, iPod and iPhone compatible products including application software, printers, storage devices, speakers, headphones, and various other accessories and supplies through its online and retail stores. The Company sells to education, consumer, creative professional, business, and government customers. Further discussion of the Companys products may be found below under the heading Products and Part II, Item 1A., Risk Factors, as well as in Part I, Item 1., Business of the Companys 2006 Form 10-K.
The Company believes that for both consumers and professionals the personal computer has become the center of an evolving digital lifestyle by integrating and enhancing the utility of advanced digital devices such as the Companys iPods, iPhones, digital video and still cameras, televisions, CD and DVD players, and other consumer electronic devices. The attributes of the personal computer that enable this functionality include a high-quality user interface, easy access to relatively inexpensive data storage, the ability to run complex applications, and the ability to connect easily to a wide variety of other digital devices and to the Internet. The Company is the only participant in the personal computer industry that controls the design and development of the entire personal computer from the hardware and operating system to sophisticated applications. This, along with its products innovative industrial designs, intuitive ease-of-use, built-in graphics, multimedia and networking capabilities, uniquely positions the Company to offer innovative integrated digital lifestyle solutions.
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 product family of portable digital music players, and distribution of third-party digital content through its online iTunes Store. With the introduction of iPhone, the Company has also begun to compete with mobile communication device companies that have substantial experience and technological and financial resources. While the Company is widely recognized as a leading innovator in the personal computer and consumer electronics markets as well as a leader in the emerging market for distribution of digital content, these markets are highly competitive and subject to aggressive pricing. To remain competitive, the Company believes that increased investment in research and development (R&D) and marketing and advertising is necessary to maintain or expand its position in the markets where it competes. The Companys R&D spending is focused on further developing its existing line of personal computers, operating systems, software applications, and portable digital music players; developing new digital lifestyle consumer and professional software applications; and investing in new product areas such as iPhone and wireless technologies. The Company also believes increased investment in marketing and advertising programs is critical to increasing product and brand awareness.
The Company utilizes a variety of direct and indirect distribution channels. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware, software, and peripheral integration, demonstrate the unique digital lifestyle solutions that are available only on Macintosh computers, and demonstrate the 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 185 stores open as of June 30, 2007.
The Company also staffs selected third-party stores with the Companys own employees to improve the buying experience through reseller channels. The Company has deployed Apple employees and contractors in reseller locations around the world including the U.S., Canada, Europe, Japan, Asia and Australia. The Company also sells to customers directly through its online stores around the world.
To improve access to the iPod product family, the Company has significantly expanded the number of distribution points where iPods are sold. iPods 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.
iPhone is currently distributed in the United States through the Companys online and retail stores as well as stores owned and operated by AT&T.
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 2006 Form 10-K and Note 1 of the Notes to Condensed Consolidated Financial Statements in this Form 10-Q 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 for software products (operating system software and applications software), or any product that is considered to be software-related in accordance with the guidance in EITF No. 03-5, Applicability of American Institute of Certified Public Accountants (AICPA) Statement of Position 97-2 to Non-software Deliverables in an Arrangement Containing More-Than-Incidental Software, (e.g., Macintosh computers, iPod portable digital music players and iPhone) pursuant to AICPA Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended. For products that are not software or software-related, (e.g., digital content sold on the iTunes Store and certain Macintosh and iPod supplies and accessories) the Company recognizes revenue pursuant to 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 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 and all other criteria for revenue recognition have been met.
The Company began shipping Apple TV in March 2007 and iPhone in June 2007. For both Apple TV and iPhone, the Company may provide future unspecified features and additional software products free of charge to customers. Therefore, sales of Apple TV and iPhone handsets are recognized under subscription accounting in accordance with Statement of Position (SOP) No. 97-2. The Company recognizes the associated revenue and cost of goods sold on a straight-line basis over the currently-estimated 24-month economic lives of these products. Costs incurred by the Company for engineering, sales, and marketing are expensed as incurred.
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. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. If refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. 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 distributors and resellers and directly to certain education, consumer, and commercial customers. The Company generally does not require collateral from its customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible the Company does attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe, Asia, and Australia 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 were 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 electronics 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 were recorded.
The Company accrues reserves for estimated cancellation fees related to component orders that have been cancelled or are expected to be 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 and recorded.
The Company provides for the estimated cost for hardware and software 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 periodically provides updates to its applications and system software in order to maintain the softwares compliance with specifications. The estimated cost to develop such updates is accounted for as warranty cost that is recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates include the number of units delivered, the number of updates expected to occur, and the historical cost and estimated future cost of the resources necessary to develop these updates.
The Company accounts for stock-based compensation in accordance with Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004) (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.
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. 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 portable 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 family of iPod digital music players along with related accessories and services including the online distribution of third-party content through the Companys iTunes Store.
In January 2007, the Company announced iPhone, a handheld device that combines in a single product a mobile phone, a widescreen iPod with touch controls, and an Internet communications device. iPhones user interface is based on the Multi-Touch display allowing users to control the device with their fingers. iPhone lets users make a call by pointing at a name or number in their address book, a favorites list, or a call log as well as select and listen to voicemail messages in whatever order they want. iPhone also allows users to play their iTunes® content, including movies, television shows, music, photos and podcasts, with the touch of a finger. iPhone features desktop-class email, web browsing, searching, and maps. iPhone is compatible with a Mac or PC and automatically syncs content from a users iTunes library, as well as contacts, bookmarks, and email accounts. iPhone is a quad-band GSM phone featuring EDGE and Wi-Fi wireless technologies for data networking, Bluetooth 2.0, a built-in 2 megapixel camera, a 3.5-inch touch screen with 480 by 320 resolution at 160 ppi, and providing up to 8 hours of talk time, 6 hours of Internet use, 7 hours of video playback or 24 hours of audio playback. AT&T Mobility LLC (formerly Cingular Wireless LLC) is the exclusive U.S. carrier for iPhone. The Company began shipping iPhone in the U.S. on June 29, 2007.
In January 2007, the Company announced Apple TV, a device that permits users to wirelessly play iTunes content on a widescreen television. Compatible with a Mac or PC, Apple TV includes either a 40GB or 160GB hard drive capable of storing up to 200 hours of video, 36,000 songs, 25,000 photos, or a combination of each and is capable of displaying content in high definition resolution up to 720p. Apple TV connects to a broad range of widescreen televisions and home theater systems and comes standard with HDMI, component video, and both analog and digital optical audio ports. Using high-speed AirPort® 802.11 wireless networking, Apple TV can auto-sync content from one computer or stream content from up to five additional computers directly to a television. The Company began shipping Apple TV in March 2007.
A detailed discussion of the Companys other products may be found in its 2006 Form 10-K.
The first nine months of 2007 spanned 39 weeks while the first nine months of 2006 spanned 40 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):