Apple 10-Q 2007
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number: 000-10030
(Exact name of Registrant as specified in its charter)
Registrants telephone number, including area code: (408) 996-1010
Apple Computer, Inc.
(Former name or former address, if changed since last report.)
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
861,874,894 shares of common stock issued and outstanding as of January 24, 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)
(in millions, except share amounts)
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. (formerly Apple Computer, Inc.) and its wholly-owned subsidiaries (Apple or 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 sale of third-party audio and video products. 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 and iPod 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.
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 its 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.
Earnings Per Common 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 13.9 million and 2.9 million shares of common stock for the quarter ended December 30, 2006 and December 31, 2005, 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 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 December 30, 2006, 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, 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 $441,000 on its investment portfolio, primarily related to investments with stated maturities less than one year, as of December 30, 2006, and net unrealized losses totaling $687,000 on its investment portfolio, primarily related to investments with stated maturities less than one year, as of September 30, 2006.
As of December 30, 2006 and September 30, 2006, approximately $1.2 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 following table shows the gross unrealized losses and fair value for those investments that were in an unrealized loss position as of December 30, 2006 and September 30, 2006, aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions):
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 December 30, 2006, 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 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 30, 2006, the Company had a net deferred loss associated with cash flow hedges of approximately $4 million net of taxes, all of which is expected to be reclassified to earnings by the end of the third quarter of 2007. As of the end of the first 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
Other Income and Expense
Note 4 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 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 amounts of the RSUs expensed by the Company are 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 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-month periods ended December 30, 2006 and December 31, 2005 (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 30, 2006 and December 31, 2005 (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, 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 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. The number of shares authorized for issuance is limited to a total of 1 million shares per offering period. As of December 30, 2006, approximately 1.6 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 months ended December 30, 2006 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 exercise price multiplied by the number of options outstanding or exercisable. Total intrinsic value of options at time of exercise was $291 million and $473 million for the three months ended December 30, 2006 and December 31, 2005, respectively.
No stock-based compensation costs were capitalized as part of the cost of an asset as of December 30, 2006 or December 31, 2005. The income tax benefit related to stock-based compensation expense was $14 million for the quarters ended December 30, 2006 and December 31, 2005. As of December 30, 2006, $741 million of total unrecognized compensation cost related to stock options and RSUs is expected to be recognized over a weighted-average period of 3.40 years.
Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004) (SFAS No. 123R), Share-Based Payment, prohibits recognition of a deferred tax asset for an excess tax benefit that has not been realized. The Company will recognize a benefit from stock-based compensation in equity if an incremental tax benefit is realized by following the ordering provisions of the tax law. In addition, the Company accounts for the indirect effects of stock-based compensation on the research tax credit, the foreign tax credit, and the domestic manufacturing deduction through the income statement.
As of December 30, 2006, the Company had 4.68 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. The weighted-average grant date fair value of RSUs granted during the first three months of 2007 and 2006 was $86.67 and $72.01, respectively. Aggregate intrinsic value of RSUs at December 30, 2006 was $397 million. No RSUs vested during the three months ended December 30, 2006.
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 Black-Scholes-Merton 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 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-month periods ended December 30, 2006 and December 31, 2005 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 5 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 December 30, 2006, total future minimum lease payments related to leases for retail space increased to $906 million.
Accrued Warranty and Indemnifications
The following table reconciles changes in the Companys accrued warranties and related costs for the three-month periods ended December 30, 2006 and December 31, 2005 (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 30, 2006 or September 30, 2006.
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, certain 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 and consumer electronics industries, 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 prepaid $1.25 billion for flash memory components during 2006. None of the prepayment had been utilized by the Company as of December 30, 2006. These prepayments will be applied to certain inventory purchases made over the life of each respective agreement.
The Company is subject to certain 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 6 - 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 2006 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 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 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 $36 million and $40 million during the first quarters of 2007 and 2006, 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 are 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 2007 and 2006, 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 $232 million and $199 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 2007, this resulted in the recognition of net sales and cost of sales by the Retail segment, with corresponding offsets in other operating segments, of $51 million and $34 million, respectively. For the first quarter of 2006, this resulted in the recognition of net sales and cost of sales by the Retail segment of $38 million and $25 million, respectively.
Third, the Company had opened a total of eight high-profile stores as of December 30, 2006. 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 $10 million and $8 million in the first quarters of 2007 and 2006, respectively.
Summary information by operating segment is as follows (in millions):
(a) Other Segments consist 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) Represents the excess of the Retail segments cost of sales over the Companys standard cost of sales for products sold through the Retail segment.
(b) Corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard costs, and other separately managed general and administrative expenses including certain corporate expenses associated with support of the Retail segment.
Note 7 Related Party Transactions and Certain Other Transactions
In March 2002, 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 Reimbursement Agreement became effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of the plane in May 2001. The Company recognized a total of $204,000 in expenses pursuant to the Reimbursement Agreement during the first quarter of 2007. The Company did not recognize any expense
pursuant to the Reimbursement Agreement during the first quarter of 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 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, television shows, movies, and iPod games. The Companys products and services include the Macintosh® line of desktop and portable computers, the iPod® line of portable digital music players, the Xserve® server and Xserve RAID storage products, a portfolio of consumer and professional software applications, the Mac OS® X operating system, the iTunes Store, a portfolio of peripherals that support and enhance the Macintosh and iPod product families, and a variety of other 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 and iPod 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. A further description of the Companys products may be found below and in Part I, Item 1 of the Companys 2006 Form 10-K.
In January 2007, the Company announced the iPhone, which is expected to begin shipping in the U.S. in June 2007. The iPhone combines the functionality of a mobile phone, iPod, and Internet communications device into a single product. See further discussion below under the heading Products and Part II, Item 1A., Risk Factors.
The Company believes that for both professionals and consumers 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, digital video and still cameras, televisions, CD and DVD players, mobile phones, and other consumer electronic devices, including the Companys iPhone that is expected to begin shipping in June 2007. 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 the iPhone, the Company will also begin competing with mobile communication device companies that have substantial experience and technological and financial resources. While the Company is widely recognized as an innovator in the personal computer and consumer electronics 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, 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 the iPhone and wireless technologies. The Company also believes 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 170 stores open as of January 31, 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., Europe, Japan, 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.
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 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 American Institute of Certified Public Accountants 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 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 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 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 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.
The Company provides currently 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 costs that are 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. 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 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 line of iPod digital music players along with related accessories and services including the online distribution of third-party content through the Companys iTunes Store. A detailed discussion of the Companys products may be found in the 2006 Form 10-K. Certain newly introduced products and/or upgrades to existing products are discussed below:
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. The iPhone 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 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, up to 5 hours of talk/video/browsing battery life, up to 16 hours of audio playback battery life, and up to 8GB of storage. The Company has announced that AT&T Mobility LLC (formerly Cingular Wireless LLC) will be the exclusive U.S. carrier for the iPhone, and that it expects to begin shipping the iPhone in the U.S. in June 2007.
In January 2007, the Company announced Apple TV, a device that permits users to wirelessly play iTunes content, including movies, television shows, music, photos, and podcasts, on a widescreen television. Compatible with a Mac or PC, Apple TV has a 40GB hard drive to store up to 50 hours of video, 9,000 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 expects to begin shipping Apple TV in February 2007.
The first quarter of 2007 spanned 13 weeks while the first quarter of 2006 spanned 14 weeks. An 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, Mac Pro, Power Mac, and Xserve product lines.
(c) Includes MacBook, iBook, MacBook Pro, and PowerBook product lines.
(d) Consists of iTunes 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 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 2007 increased 24% or $1.4 billion from the first quarter of 2006 even though the first quarter of 2007 spanned 13 weeks while the first quarter of 2006 spanned 14 weeks. Several factors contributed to this increase including the following:
· Macintosh net sales increased $686 million or 40% during the first quarter of 2007 compared to the first quarter of 2006. Macintosh unit sales increased by 352,000 units or 28% during the first quarter of 2007 compared to the first quarter of 2006. The increases in Macintosh net sales and unit sales were driven by higher sales of portable products in all of the Companys operating segments. During the first quarter of 2007, net sales and unit sales of the Companys portable products on a year-over-year basis increased 79% and 65%, respectively. During the first quarter of 2007 compared to the same period in 2006, the Company experienced a shift in mix of desktop sales from the eMac, which was discontinued in 2006, and the Mac mini to the iMac, particularly the 24-inch iMac model introduced in September 2006, which resulted in a year-over-year increase in desktop net sales of 5% despite a decrease in desktop unit sales of 4%. The Company believes the decrease in desktop unit sales is largely attributable to a shift in sales to portable computers. Overall, net sales per Macintosh unit sold increased 9% year-over-year mainly due to a shift in product mix to higher-priced portable products, a higher average selling price for desktop products, and a higher mix of direct Macintosh sales.
· Net sales of iPods rose $521 million or 18% during the first quarter of 2007 compared to the first quarter of 2006. Unit sales of iPods totaled 21 million in the first quarter of 2007, which represents an increase of 50% over the 14 million iPod units sold in the first quarter of 2006. Strong sales of iPods during the first quarter of 2007 were driven by an update to the iPod product family announced in September 2006, channel development programs and expanded and well-supplied channel distribution. Net sales per iPod unit sold decreased 21% primarily due to lower average selling prices across the iPod product family and a higher mix of indirect iPod sales.
· Net sales of other music related products and services increased $143 million or 29% during the first quarter of 2007 compared to the first quarter of 2006 primarily due to increased net sales from the iTunes Store. The year-over-year increase in sales from the iTunes Store was the result of significant growth in the U.S. and Europe, growth of the iPod installed base, and expansion of audio and video content available for sale via the iTunes Store.
· Net sales of software, service, and other sales rose $22 million or 7% during the first quarter of 2007 compared to the first quarter of 2006. This growth was primarily attributable to increased net sales in AppleCare Protection Plan (APP) extended service and support contracts, Apple-branded and third-party software, and Internet services.
Partially offsetting the favorable factors discussed above, the Companys net sales during the first quarter of 2007 were negatively impacted by the following:
· Net sales of peripherals and other hardware decreased by 2% during the first quarter of 2007 compared to the first quarter of 2006 primarily due to a decrease in net sales of displays as a result of the continued trend toward portable Macintosh products as well as decreases in net sales of hardware accessories. The decrease in net sales of hardware accessories was due in part to the inclusion of iSight video cameras and AirPort Extreme wireless networking in the standard configurations of certain additional Macintosh computers in the first quarter of 2007.
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 2007. 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 6, Segment Information and Geographic Data.
Net sales in the Americas segment during the first quarter of 2007 increased $798 million or 30% compared to the first quarter of 2006, while Americas Macintosh unit sales increased 21% year-over-year. The increase in net sales during the first quarter of 2007 was primarily attributable to the significant year-over-year increase in sales of portable systems, iPods, and sales from the iTunes Store, while net sales of desktop systems remained relatively flat as compared to the first quarter of 2006. The increase in net sales of iPods was driven primarily by an update to the iPod product family announced in September 2006, channel development programs and well-supplied channel distribution. During the first quarters of 2007 and 2006, the Americas segment represented 49% and 47%, respectively, of the Companys total net sales.
Net sales in Europe increased $469 million or 38% during the first quarter of 2007 as compared to the same quarter in 2006. Total Macintosh unit sales in Europe increased 27% on a year-over-year basis. Consistent with the Americas segment, these increases were mainly a result of strong growth in net sales of iPods, Macintosh portable systems, and other music related products and services. The increase in other music related products and services was primarily due to an increase in sales from the iTunes Store.
Japans net sales decreased $70 million or 20% during the first quarter of 2007 compared to the same quarter in 2006. Total Macintosh unit sales in Japan decreased 14% on a year-over-year basis. The generally weak consumer market in Japan, particularly the weak market for PCs, is believed to be responsible for the year-over-year decrease in performance by this segment. The Company is continuing to evaluate ways to improve the future results in its Japan segment.
During the first quarter of 2007, the Company opened 5 new retail stores. The Company had 170 retail stores open at the end of the first quarter of 2007 compared to 135 stores at the end of the first quarter of 2006. Retail revenue grew by 6% year-over-year due to strong demand for portable products partially offset by a decrease in net sales of iPods. Macintosh unit sales increased by 60% due to strong demand for the MacBook, MacBook Pro, and the higher-priced 24-inch iMac model. The decrease in net sales of iPods was due to lower iPod price points and expanded and well-supplied channel distribution. Average quarterly revenue per store decreased to $6.7 million in the first quarter of 2007, which spanned 13 weeks, from $8.3 million in the first quarter of 2006, which spanned 14 weeks.
As measured by the Companys operating segment reporting, the Retail segment reported a profit of $89 million during the first quarter of 2007 compared to a profit of $90 million during the first quarter of 2006. The relatively flat profit was caused by higher expenses from the newly opened stores and continued investment in personnel costs to maintain service levels, which offset the increase in revenue. The profit excludes approximately $232 million and $199 million of manufacturing profit earned by the Company on net sales from the Retail segment in the first quarter of 2007 and 2006, respectively. Manufacturing profit is the difference between the amount charged to the Retail segment for Apple-branded products and the standard cost recognized by the Company for such products.
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 $765 million through the end of the first quarter of 2007.
As of December 30, 2006, the Retail segment had approximately 6,612 full-time equivalent employees and had outstanding lease commitments associated with retail space of $906 million.
Gross margin for the three months ended December 30, 2006 and December 31, 2005 was as follows (in millions, except gross margin percentages):
Gross margin percentage for the first quarter of 2007 was 31.2% compared to 27.2% for the first quarter of 2006. The year-over-year increase in gross margin percentage during the first quarter of 2007 was primarily due to favorable costs of certain commodity components including LCD flat-panel displays and NAND flash memory, along with higher overall revenue resulting in more effective leverage on fixed production costs.
The Company anticipates that its gross margin and the gross margin of the overall personal computer and consumer electronics industries will be under pressure in the future due to competition. The Company expects its gross margin percentage to decrease in the second quarter of 2007 from the first quarter of 2007. The decrease in gross margin percentage is expected mainly from reduced leverage on fixed production costs due to lower expected revenue, a shift in product mix to lower margin products including the updated iPod shuffle that only shipped for a portion of the first quarter of 2007, and an increase in iTunes Store sales partially due to iTunes gift card redemptions.
The foregoing statements regarding the Companys expected gross margin, forecasted revenue, product mix shift, and iTunes Store sales and gift card redemptions for the second quarter of 2007 are forward-looking. Gross margin could differ from anticipated levels because of several factors, including certain of those set forth below in Part II, Item 1A., Risk Factors. 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 30, 2006 and December 31, 2005 were as follows (in millions, except for percentages):
Research and Development (R&D)
Expenditures for R&D increased 1% or $2 million to $184 million in the first quarter of 2007 compared to $182 million in the first quarter of 2006, primarily due to an increase in R&D headcount in the current year to support expanded R&D activities, partially offset by the expenses associated with the 14th week added to 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 13% or $82 million to $714 million in the first quarter of 2007 compared to $632 million in the first quarter of 2006. This increase is primarily due to higher direct and indirect 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, and a current year increase in spending on marketing and advertising, partially offset by the expenses associated with the 14th week added to the first quarter of 2006.
Other Income and Expense
Other income and expense for the three months ended December 30, 2006 and December 31, 2005 was as follows (in millions):
Interest income increased $45 million or 51% to $133 million during the first quarter of 2007 compared to $88 million in the first quarter of 2006. This increase is attributable primarily to higher cash and short-term investment balances and increased investment yields resulting from higher market interest rates. The weighted-average interest rate earned by the Company on its cash, cash equivalents and short-term investments increased to 5.25% in the first quarter of 2007 from 3.89% in the first quarter of 2006.
Provision for Income Taxes
The Companys effective tax rate for the three months ended December 30, 2006 was approximately 31% compared with approximately 32% for the quarter ended December 31, 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 lower tax rate in the first three months of 2007 versus 2006 is primarily due to the Company recording a tax benefit as a result of legislation enacted on December 20, 2006, retroactively reinstating the research and development tax credit.
The Internal Revenue Service (IRS) has substantially completed its field audit of the Companys federal income tax returns for the years 2002 through 2003 and proposed certain adjustments. The Company intends to contest certain of these adjustments through the IRS Appeals Office. Substantially all IRS audit issues for years prior to 2002 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.
Recent Accounting Pronouncements
In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB No. 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in current year financial statements for purposes of determining whether the current years financial statements are materially misstated. SAB No. 108 is effective for fiscal years ending after November 15, 2006 and is required to be adopted by the Company in the fourth quarter of fiscal 2007. Although the Company will continue to evaluate the application of SAB No. 108, management does not currently believe adoption will have a material impact on the Companys results of operations or financial position.
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements, which defines fair value, provides a framework for measuring fair value, and expands the disclosures required for fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require fair value measurements; it does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company beginning in the first quarter of fiscal 2009. Although the Company will continue to evaluate the application of SFAS No. 157, management does not currently believe adoption will have a material impact on the Companys results of operations or financial position.
In June 2006, the FASB issued FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes by creating a framework for how companies should recognize, measure, present, and disclose in their financial
statements uncertain tax positions that they have taken or expect to take in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by the Company beginning in the first quarter of fiscal 2008. Although the Company will continue to evaluate the application of FIN 48, 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 30, 2006, the Company had $11.9 billion in cash, cash equivalents, and short-term investments, an increase of $1.8 billion over the same balance at the end of September 30, 2006. The principal components of this net increase were cash generated by operating activities of $1.8 billion, proceeds from the issuance of common stock under stock plans of $101 million, and excess tax benefits from stock-based compensation of $87 million. This increase in cash, cash equivalents, and short-term investments was partially offset by cash used to purchase property, plant, and equipment of $142 million and intangible assets of $115 million. The Companys short-term investment portfolio is primarily invested in high credit quality, liquid investments.
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 $142 million during the first quarter of fiscal 2007, consisting of $36 million for retail store facilities and $106 million for real estate acquisitions and corporate infrastructure including information systems enhancements. The Company currently anticipates it will utilize approximately $675 million for capital expenditures during 2007, including approximately $360 million for expansion of the Companys Retail segment. The remainder of approximately $315 million is projected to be used for real estate acquisitions including the Companys second corporate campus and to support normal replacement of existing capital assets and enhancements to general information technology infrastructure.
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 30, 2006, the Company had total outstanding commitments on noncancelable operating leases of approximately $1.2 billion, $887 million of which related to the lease of retail space and related facilities. 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. Total outstanding commitments on noncancelable operating leases related to the lease of retail space increased to $906 million as of December 30, 2006.
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 30, 2006, the Company had outstanding third-party manufacturing commitments and component purchase commitments of approximately $1.6 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 prepaid $1.25 billion for flash memory components during 2006. None of the prepayment had been utilized by the Company as of December 30, 2006. These prepayments will be applied to certain 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 30, 2006, the Company estimated that gross expected future cash flows of approximately $21 million would be required to fulfill these obligations.
Other obligations were approximately $35 million as of December 30, 2006, primarily related to Internet and telecommunications services.
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.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Companys market risk profile has not changed significantly during the first three months of 2007.
Interest Rate and Foreign Currency Risk Management
The Company regularly reviews its foreign exchange forward and option positions, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. However, given the effective horizons of the Companys risk management activities and the anticipatory nature of the exposures, there can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. In addition, the timing of the accounting for recognition of gains and losses related to mark-to-market instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Companys operating results and financial position.
Interest Rate Risk
While the Company is exposed to interest rate fluctuations in many of the worlds leading industrialized countries, the Companys interest income and expense is most sensitive to fluctuations in the general level of U.S. interest rates.
In this regard, changes in U.S. interest rates affect the interest earned on the Companys cash, cash equivalents, and short-term investments as well as costs associated with foreign currency hedges.
The Companys short-term investment policy and strategy is to ensure the preservation of capital, meet liquidity requirements, and optimize return in light of the current credit and interest rate environment. A portion of the Companys cash is managed by external managers within the guidelines of the Companys investment policy and to an objective market benchmark. The Companys internal portfolio is benchmarked against external manager performance, allowing for differences in liquidity needs.
The Companys exposure to market risk for changes in interest rates relates primarily to the Companys investment portfolio. The Company places its short-term investments in highly liquid securities issued by high credit quality issuers and, by policy, limits the amount of credit exposure to any one issuer. The Companys general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with initial maturities of three months or less are classified as cash equivalents; highly liquid investments with initial maturities greater than three months are classified as short-term investments. As of December 30, 2006, approximately $1.2 billion of the Companys short-term investments had underlying maturities ranging from 1 to 5 years. The remainder all had underlying maturities of less than 12 months. The Company may sell its investments prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company recognized no material net gains or losses during the first quarter of 2007 or 2006 related to such sales.
Foreign Currency Risk
In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, may negatively affect the Companys net sales and gross margins as expressed in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates.
The Company may enter into foreign currency f