UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

Form 10-Q

 


 

(Mark One)

 

ý

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

For the quarterly period ended March 27, 2004 OR

 

 

 

 

 

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 0-10030

 


 

APPLE COMPUTER, INC.

(Exact name of Registrant as specified in its charter)

 

CALIFORNIA

 

942404110

(State or other jurisdiction
of incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

1 Infinite Loop
Cupertino, California

 

95014

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (408) 996-1010

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes    ý      No    o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes    ý      No    o

 

380,042,274 shares of common stock issued and outstanding as of April 30, 2004

 

 



 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

APPLE COMPUTER, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(in millions, except share and per share amounts)

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

March 27, 2004

 

March 29, 2003

 

March 27, 2004

 

March 29, 2003

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

1,909

 

$

1,475

 

$

3,915

 

$

2,947

 

Cost of sales

 

1,379

 

1,057

 

2,849

 

2,123

 

Gross margin

 

530

 

418

 

1,066

 

824

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

123

 

119

 

242

 

240

 

Selling, general, and administrative

 

345

 

300

 

688

 

599

 

Restructuring costs

 

10

 

3

 

10

 

26

 

Total operating expenses

 

478

 

422

 

940

 

865

 

Operating income (loss)

 

52

 

(4

)

126

 

(41

)

 

 

 

 

 

 

 

 

 

 

Other income and expense:

 

 

 

 

 

 

 

 

 

Gain on sales of non-current investments

 

 

 

4

 

 

Interest and other income, net

 

12

 

23

 

21

 

52

 

Total other income and expense

 

12

 

23

 

25

 

52

 

 

 

 

 

 

 

 

 

 

 

Income before provision for income taxes

 

64

 

19

 

151

 

11

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

18

 

5

 

42

 

3

 

 

 

 

 

 

 

 

 

 

 

Income before accounting change

 

46

 

14

 

109

 

8

 

 

 

 

 

 

 

 

 

 

 

Cumulative effect of accounting change, net

 

 

 

 

(2

)

 

 

 

 

 

 

 

 

 

 

Net income

 

$

46

 

$

14

 

$

109

 

$

6

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share before accounting change:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.13

 

$

0.04

 

$

0.30

 

$

0.02

 

Diluted

 

$

0.12

 

$

0.04

 

$

0.29

 

$

0.02

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.13

 

$

0.04

 

$

0.30

 

$

0.02

 

Diluted

 

$

0.12

 

$

0.04

 

$

0.29

 

$

0.02

 

 

 

 

 

 

 

 

 

 

 

Shares used in computing earnings per share (in thousands):

 

 

 

 

 

 

 

 

 

Basic

 

365,347

 

360,490

 

363,898

 

359,774

 

Diluted

 

378,230

 

362,243

 

375,168

 

361,591

 

 

See accompanying notes to condensed consolidated financial statements.

 

2



 

APPLE COMPUTER, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(in millions, except share amounts)

 

 

 

March 27, 2004

 

September 27, 2003

 

 

 

 

 

 

 

ASSETS:

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

3,158

 

$

3,396

 

Short-term investments

 

1,436

 

1,170

 

Accounts receivable, less allowances of $48 and $49, respectively

 

585

 

766

 

Inventories

 

63

 

56

 

Deferred tax assets

 

216

 

190

 

Other current assets

 

326

 

309

 

Total current assets

 

5,784

 

5,887

 

Property, plant and equipment, net

 

687

 

669

 

Goodwill

 

85

 

85

 

Acquired intangible assets

 

21

 

24

 

Other assets

 

158

 

150

 

Total assets

 

$

6,735

 

$

6,815

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY:

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

991

 

$

1,154

 

Accrued expenses

 

989

 

899

 

Current debt

 

 

304

 

Total current liabilities

 

1,980

 

2,357

 

Deferred tax liabilities and other non-current liabilities

 

265

 

235

 

Total liabilities

 

2,245

 

2,592

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Common stock, no par value; 900,000,000 shares authorized; 372,855,336 and 366,726,584 shares issued and outstanding, respectively

 

2,107

 

1,926

 

Deferred stock compensation

 

(110

)

(62

)

Retained earnings

 

2,503

 

2,394

 

Accumulated other comprehensive income (loss)

 

(10

)

(35

)

Total shareholders’ equity

 

4,490

 

4,223

 

Total liabilities and shareholders’ equity

 

$

6,735

 

$

6,815

 

 

See accompanying notes to condensed consolidated financial statements.

 

3



 

APPLE COMPUTER, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(in millions)

 

 

 

Six Months Ended

 

 

 

March 27, 2004

 

March 29, 2003

 

 

 

 

 

 

 

Cash and cash equivalents, beginning of the period

 

$

3,396

 

$

2,252

 

Operating Activities:

 

 

 

 

 

Net income

 

109

 

6

 

Cumulative effect of accounting change, net of taxes

 

 

2

 

Adjustments to reconcile net income to cash generated by operating activities:

 

 

 

 

 

Depreciation, amortization and accretion

 

69

 

60

 

Stock-based compensation expense

 

13

 

2

 

Non-cash restructuring

 

 

12

 

Benefit from deferred income taxes

 

(4

)

(12

)

Loss on disposition of property, plant, and equipment

 

 

2

 

Gain on sales of short-term investments, net

 

 

(18

)

Gain on sales of non-current investments

 

(4

)

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

181

 

73

 

Inventories

 

(7

)

4

 

Other current assets

 

(17

)

34

 

Other assets

 

(25

)

(14

)

Accounts payable

 

(163

)

10

 

Other liabilities

 

128

 

47

 

Cash generated by operating activities

 

280

 

208

 

Investing Activities:

 

 

 

 

 

Purchases of short-term investments

 

(976

)

(1,097

)

Proceeds from maturities of short-term investments

 

660

 

1,214

 

Proceeds from sales of short-term investments

 

52

 

849

 

Proceeds from sales of non-current investments

 

5

 

13

 

Purchases of property, plant, and equipment

 

(79

)

(60

)

Other

 

12

 

15

 

Cash (used for) generated by investing activities

 

(326

)

934

 

Financing Activities:

 

 

 

 

 

Payment of long-term debt

 

(300

)

 

Proceeds from issuance of common stock

 

108

 

16

 

Cash (used for) generated by financing activities

 

(192

)

16

 

(Decrease) increase in cash and cash equivalents

 

(238

)

1,158

 

Cash and cash equivalents, end of the period

 

$

3,158

 

$

3,410

 

 

 

 

 

 

 

Supplemental cash flow disclosures:

 

 

 

 

 

 

 

 

 

 

 

Cash paid for interest

 

$

10

 

$

10

 

Cash paid for income taxes, net

 

$

15

 

$

25

 

 

See accompanying notes to condensed consolidated financial statements.

 

4



 

APPLE COMPUTER, INC.

 

Notes to Condensed Consolidated Financial Statements (Unaudited)

 

Note 1 - Summary of Significant Accounting Policies

 

Apple Computer, Inc. and its subsidiaries (the Company) designs, manufactures and markets personal computers and related software, peripherals and personal computing and communicating solutions. The Company’s products include the Macintosh line of desktop and notebook computers, the Mac OS X operating system, the iPod digital music player, and a portfolio of software products and peripherals for education, creative, consumer and business customers. The Company sells its products through its online stores, direct sales force, third-party wholesalers and resellers, and its own retail stores.

 

Basis of Presentation and Preparation

The accompanying condensed consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Interim information is unaudited; however, in the opinion of the Company’s management, all adjustments of a normal recurring nature necessary for a fair statement of interim periods presented have been included.  The results for interim periods are not necessarily indicative of results to be expected for the entire year.  Certain prior year amounts in these condensed consolidated financial statements and notes thereto have been reclassified to conform to the current year presentation.

 

These condensed consolidated financial statements and accompanying notes should be read in conjunction with the Company’s annual consolidated financial statements and the notes thereto for the fiscal year ended September 27, 2003, included in its Annual Report on Form 10-K for the year ended September 27, 2003 (the 2003 Form 10-K). Unless otherwise stated, references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years.

 

Research and Development

Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers pursuant to Statement of Financial Accounting Standards (SFAS) No. 86, Computer Software to be Sold, Leased, or Otherwise Marketed. In most instances, the Company’s products are released soon after technological feasibility has been established. Therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally all software development costs have been expensed.

 

During the second quarter of 2004, the Company incurred substantial development costs associated with FileMaker Pro 7 subsequent to achievement of technological feasibility as evidenced by public demonstration and release of a developer beta version, and prior to the release of the final version of the product in March 2004. Therefore, during the second quarter of 2004, the Company capitalized approximately $2.3 million of costs associated with the development of FileMaker Pro 7.  In accordance with SFAS No. 86, amortization of this asset began in March 2004 when FileMaker Pro 7 was shipped and is being recognized on a straight-line basis over a 3 year estimated useful life.

 

Stock-Based Compensation

The Company measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. The Company applies the disclosure provisions of SFAS No. 123, Accounting for Stock-based Compensation, as amended by SFAS No. 148, Accounting for Stock-based Compensation – Transition and Disclosure as if the fair value-based method had been applied in measuring compensation expense. The Company has elected to follow APB Opinion No. 25 because, as discussed below, the alternative fair value accounting provided for under SFAS No. 123 requires use of option valuation models that were not developed for use in valuing employee stock options and employee stock purchase plan shares. Under APB Opinion No. 25, when the exercise

 

5



 

price of the Company’s employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized.

 

As required under SFAS No. 123, the pro forma effects of stock-based compensation on net income and earnings per common share for employee stock options granted and employee stock purchase plan share purchases have been estimated at the date of grant and beginning of the period, respectively, using a Black-Scholes option pricing model. For purposes of pro forma disclosures, the estimated fair value of the options and shares is amortized to pro forma net income over the options’ vesting period and the shares’ plan period.

 

The Black-Scholes option valuation model was developed for use in estimating the fair value of freely traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected life of options and the Company’s expected stock price volatility. Because the Company’s employee stock options and employee stock purchase plan shares have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not provide a reliable measure of the fair value of the Company’s employee stock options and employee stock purchase plan shares.

 

The Company’s pro forma information for the three and six month periods ended March 27, 2004 and March 29, 2003 follows (in millions, except per share amounts):

 

 

 

Three
Months Ended

 

Six
Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

 

 

 

 

 

 

 

 

 

 

Net income - as reported

 

$

46

 

$

14

 

$

109

 

$

6

 

 

 

 

 

 

 

 

 

 

 

Add: Stock-based employee compensation expense included in reported net income, net of tax

 

6

 

1

 

13

 

2

 

 

 

 

 

 

 

 

 

 

 

Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards, net of tax

 

(34

)

(51

)

(70

)

(105

)

 

 

 

 

 

 

 

 

 

 

Net income (loss) - pro forma

 

$

18

 

$

(36

)

$

52

 

$

(97

)

 

 

 

 

 

 

 

 

 

 

Net income per common share - as reported

 

 

 

 

 

 

 

 

 

Basic

 

$

0.13

 

$

0.04

 

$

0.30

 

$

0.02

 

Diluted

 

$

0.12

 

$

0.04

 

$

0.29

 

$

0.02

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per common share - pro forma

 

 

 

 

 

 

 

 

 

Basic

 

$

0.05

 

$

(0.10

)

$

0.14

 

$

(0.27

)

Diluted

 

$

0.05

 

$

(0.10

)

$

0.14

 

$

(0.27

)

 

Earnings Per Share

Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of outstanding options, restricted stock and restricted stock units is reflected in diluted earnings per share by application of the treasury stock method.  Under the treasury stock method, an increase in the fair market value of the Company’s common stock may result in a greater dilutive effect from outstanding options, restricted stock and restricted stock units.

 

6



 

The following table sets forth the computation of basic and diluted earnings per share (in thousands, except net income and per share amounts):

 

 

 

Three
Months Ended

 

Six
Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

 

 

 

 

 

 

 

 

 

 

Numerator (in millions):

 

 

 

 

 

 

 

 

 

Income before accounting change

 

$

46

 

$

14

 

$

109

 

$

8

 

Cumulative effect of accounting change, net of tax

 

 

 

 

(2

)

Net income

 

$

46

 

$

14

 

$

109

 

$

6

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average-shares outstanding, excluding unvested restricted stock

 

365,347

 

360,490

 

363,898

 

359,774

 

Effect of dilutive options, restricted stock units and restricted stock

 

12,883

 

1,753

 

11,270

 

1,817

 

Denominator for diluted earnings per share

 

378,230

 

362,243

 

375,168

 

361,591

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share before accounting change

 

$

0.13

 

$

0.04

 

$

0.30

 

$

0.02

 

Cumulative effect of accounting change, net of tax

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.13

 

$

0.04

 

$

0.30

 

$

0.02

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share before accounting change

 

$

0.12

 

$

0.04

 

$

0.29

 

$

0.02

 

Cumulative effect of accounting change, net of tax

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.12

 

$

0.04

 

$

0.29

 

$

0.02

 

 

Potentially dilutive securities, including stock options; restricted stock units; and restricted stock, to purchase approximately 6.8 million and 79.0 million shares of common stock for the three months ended March 27, 2004 and March 29, 2003, respectively, and 9.3 million and 78.3 million shares of common stock for the six months ended March 27, 2004, and March 29, 2003, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive.

 

Note 2 – Financial Instruments

 

Cash, Cash Equivalents and Short-Term Investments

The following table summarizes the fair value of the Company’s cash and available-for-sale securities held in its short-term investment portfolio, recorded as cash and cash equivalents or short-term investments as of March 27, 2004, and September 27, 2003 (in millions):

 

 

 

March 27,
2004

 

September 27,
2003

 

Cash

 

$

107

 

$

158

 

 

 

 

 

 

 

U.S. Treasury and Agency securities

 

62

 

87

 

U.S. corporate securities

 

2,161

 

2,368

 

Foreign securities

 

828

 

783

 

Total cash equivalents

 

3,051

 

3,238

 

 

 

 

 

 

 

U.S. Treasury and Agency securities

 

492

 

454

 

U.S. corporate securities

 

825

 

623

 

Foreign securities

 

119

 

93

 

 

 

 

 

 

 

Total short-term investments

 

1,436

 

1,170

 

 

 

 

 

 

 

Total cash, cash equivalents, and short-term investments

 

$

4,594

 

$

4,566

 

 

The Company’s short-term investment portfolio consists of investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities. The Company’s U.S. corporate securities consist primarily of commercial

 

7



 

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 gains of $500,000 as of March 27, 2004 and net unrealized losses of $1 million as of September 27, 2003, on its investment portfolio, primarily related to investments with stated maturities greater than 1 year. The Company occasionally sells short-term investments prior to their stated maturities. The Company recognized no net gains or losses during the three and six month periods ended March 27, 2004 and recognized net gains of $9 million and $18 million during the three and six month periods ended March 29, 2003. These net gains were included in interest and other income, net.

 

As of March 27, 2004, and September 27, 2003, $810 million and $629 million, respectively, of the Company’s investment portfolio that was classified as short-term investments had maturities ranging from 1 to 5 years.  The remainder of the Company’s short-term investments had underlying maturities between 3 and 12 months.

 

Non-Current Debt and Equity Investments and Related Gains

The Company has held significant investments in ARM Holdings plc (ARM), Akamai Technologies, Inc. (Akamai) and EarthLink Network, Inc. (EarthLink). These investments have been reflected in the condensed consolidated balance sheets as long term assets within other assets and have been categorized as available-for-sale requiring that they be carried at fair value with unrealized gains and losses, net of taxes, reported in equity as a component of accumulated other comprehensive income. All realized gains on the sale of these investments have been included in interest and other income.

 

During the first quarter of 2004, the Company sold all of its remaining non-current investments in public companies, consisting of 986,164 shares of Akamai for net proceeds of approximately $5 million, and a gain before taxes of $4 million.

 

During the first quarter of 2003, the Company sold 2,580,000 shares of EarthLink stock for net proceeds of approximately $13.7 million, an amount that approximated the Company’s carrying value of the shares. No sales of the Company’s non-current debt and equity investments were made in the second quarter of 2003.

 

Debt

The Company had debt outstanding in the form of $300 million of aggregate principal amount 6.5% unsecured notes that were originally issued in 1994 and were repaid upon their maturity in February 2004. The notes, which paid interest semiannually, were sold at 99.925% of par, for an effective yield to maturity of 6.51%.

 

Derivative Financial Instruments

The Company uses derivatives to partially offset its business exposure to foreign exchange and interest rate risk. Foreign currency forward and option contracts are used to offset the foreign exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales. From time to time, the Company enters into interest rate swap agreements to modify the interest rate profile of certain investments and debt. The Company’s accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the balance sheet at fair value.  As of the end of the second quarter of 2004, the general nature of the Company’s risk management activities and the general nature and mix of the Company’s derivative financial instruments have not changed materially from the end of fiscal 2003.

 

Foreign Exchange Risk Management

The Company enters into foreign currency forward and option contracts with financial institutions primarily to protect against foreign exchange risk associated with existing assets and liabilities, certain firmly committed transactions and certain probable but not firmly committed transactions. Generally, the Company’s practice is to hedge a majority of its existing material foreign exchange transaction exposures. However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular exposures, or limited availability of appropriate hedging instruments.

 

Interest Rate Risk Management

The Company has historically entered into interest rate derivative transactions, including interest rate swaps, collars, and floors, with financial institutions in order to better match the Company’s floating-rate interest income on its cash equivalents and short-term investments with its fixed-rate interest expense on any outstanding long-term debt, and/or

 

8



 

to diversify a portion of the Company’s exposure away from fluctuations in short-term U.S. interest rates. The Company may also enter into interest rate contracts that are intended to reduce the cost of the interest rate risk management program.  The Company does not hold or transact in such financial instruments for purposes other than risk management.

 

Accounting for Derivative Financial Instruments

The Company accounts for all derivatives at fair value. Derivatives that are not hedges are adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. As of March 27, 2004, the Company had a net deferred loss associated with cash flow hedges of approximately $2 million net of taxes, substantially all of which is expected to be reclassified to earnings by the end of the fourth quarter of fiscal 2004.

 

Note 3 – Condensed Consolidated Financial Statement Details (in millions)

 

Inventories

 

 

 

3/27/04

 

9/27/03

 

Purchased parts

 

$

1

 

$

2

 

Work in process

 

 

4

 

Finished goods

 

62

 

50

 

Total inventories

 

$

63

 

$

56

 

 

Other Current Assets

 

 

 

3/27/04

 

9/27/03

 

Vendor non-trade receivables

 

$

173

 

$

184

 

Other current assets

 

153

 

125

 

Total other current assets

 

$

326

 

$

309

 

 

Property, Plant, and Equipment

 

 

 

3/27/04

 

9/27/03

 

Land and buildings

 

$

350

 

$

350

 

Machinery, equipment, and internal-use software

 

436

 

393

 

Office furniture and equipment

 

78

 

74

 

Leasehold improvements

 

390

 

357

 

 

 

1,254

 

1,174

 

 

 

 

 

 

 

Accumulated depreciation and amortization

 

(567

)

(505

)

Total net property, plant, and equipment

 

$

687

 

$

669

 

 

Other Assets

 

 

 

3/27/04

 

9/27/03

 

Non-current deferred tax assets

 

$

55

 

$

60

 

Capitalized software development costs, net

 

26

 

28

 

Other assets

 

77

 

62

 

Total other assets

 

$

158

 

$

150

 

 

9



 

Accrued Expenses

 

 

 

3/27/04

 

9/27/03

 

Deferred revenue

 

$

432

 

$

368

 

Accrued marketing and distribution

 

133

 

124

 

Accrued compensation and employee benefits

 

119

 

101

 

Accrued warranty and related costs

 

80

 

67

 

Other current liabilities

 

225

 

239

 

Total accrued expenses

 

$

989

 

$

899

 

 

Interest and Other Income, Net

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

Interest income

 

$

15

 

$

18

 

$

29

 

$

41

 

Interest expense

 

(1

)

(2

)

(3

)

(4

)

Gain on sales of short term investments, net

 

 

9

 

 

18

 

Other income (expense), net

 

(2

)

(2

)

(5

)

(3

)

Interest and other income, net

 

$

12

 

$

23

 

$

21

 

$

52

 

 

Note 4 – Restructuring Actions

 

2004 Restructuring Actions

During the second quarter of 2004, the Company’s management approved restructuring actions that resulted in the recognition of a total restructuring charge of $9.6 million.  These actions were related to the closing of the Company’s Sacramento manufacturing operations within the Americas operating segment and headcount reductions related primarily to various sales and marketing activities in the Company’s Americas and Europe operating segments.  These restructuring actions will ultimately result in the termination of 348 positions, 69 of which had been terminated prior to the end of the second quarter of 2004.

 

The approved plan to cease manufacturing operations in Sacramento resulted in severance for 200 employees at a cost of $1.9 million, which is expected to be paid during the third quarter of 2004. The Company recognized a charge related primarily to restructuring actions associated with sales and marketing activities in the United States and Europe for employee severance costs of $7.7 million, the majority of which will be paid before the end of fiscal year 2004, for the termination of 148 positions.

 

The following table summarizes activity associated with employee severance costs resulting from the restructuring actions initiated during fiscal year 2004 (in millions):

 

Total charge

 

$

9.6

 

Total spending through March 27, 2004

 

(1.0

)

Accrual at March 27, 2004

 

$

8.6

 

 

2003 Restructuring Actions

The Company recorded total restructuring charges of approximately $26.8 million during the year ended September 27, 2003, including approximately $7.4 million in severance costs, a $5.0 million charge to write-off deferred compensation, $7.1 million in asset impairments and a $7.3 million charge for lease cancellations.

 

During the third quarter of 2003, approximately $500,000 of the amount originally accrued for lease cancellations was determined to be in excess due to the sublease of a property sooner than originally estimated and an approximately $500,000 shortfall was identified in the severance accrual due to higher than expected severance costs related to the closure of the Company’s Singapore manufacturing operations. These adjustments had a net neutral effect on reported operating expense.

 

During the second quarter of 2003, the Company’s management approved and initiated restructuring actions that resulted in recognition of a total restructuring charge of $2.8 million, including $2.4 million in severance costs and

 

10



 

$400,000 for asset write-offs and lease payments on an abandoned facility. Actions taken in the second quarter were for the most part supplemental to actions initiated in the prior two quarters and focused on further headcount reductions in various sales and marketing functions in the Company’s Americas and Europe operating segments and further reductions associated with PowerSchool-related activities in the Americas operating segment, including an accrual for asset write-offs and lease payments on an abandoned facility. The second quarter actions will ultimately result in the elimination of 93 positions worldwide, all but one of which were eliminated by the end of the second quarter of 2004.

 

During the first quarter of 2003, the Company’s management approved and initiated restructuring actions with a total cost of $24 million that resulted in the termination of manufacturing operations at the Company-owned facility in Singapore, further reductions in headcount resulting from the shift in PowerSchool product strategy that took place at the end of fiscal 2002, and termination of various sales and marketing activities in the United States and Europe. These restructuring actions resulted in the elimination of 260 positions worldwide.

 

Closure of the Company’s Singapore manufacturing operations resulted in severance costs of $1.8 million and costs of $6.7 million to write off manufacturing related fixed assets, whose use ceased during the first quarter of 2003. PowerSchool related costs included severance of approximately $550,000 and recognition of $5 million of previously deferred stock compensation that arose when PowerSchool was acquired by the Company in 2001 related to certain PowerSchool employee stockholders who were terminated in the first quarter of 2003. Termination of sales and marketing activities and employees, principally in the United States and Europe, resulted in severance costs of $2.8 million and accrual of costs associated with operating leases on closed facilities of $6.7 million. The total net restructuring charge of $23 million recognized during the first quarter of 2003 also reflects the reversal of $600,000 of unused restructuring accrual originally made during the first quarter of 2002.

 

Of the $26.8 million, nearly all had been spent by the end of the second quarter of 2004, except for approximately $200,000 of severance costs and approximately $4 million related to operating lease costs on abandoned facilities. The Company currently anticipates that all of the remaining accrual for severance costs of approximately $200,000 will be spent in fiscal 2004 and the remaining accrual for operating lease costs will be paid over the remaining lease terms.

 

The following table summarizes activity associated with restructuring actions initiated during fiscal 2003 (in millions):

 

 

 

Employee
Severance
Benefits

 

Deferred
Compensation
Write-off

 

Asset
Impairments

 

Lease
Cancellations

 

Totals

 

 

 

 

 

 

 

 

 

 

 

 

 

Total charge

 

$

7.4

 

$

5.0

 

$

7.1

 

$

7.3

 

$

26.8

 

Total spending through March 27, 2004

 

(7.7

)

 

 

(2.8

)

(10.5

)

Total non-cash items

 

 

(5.0

)

(7.1

)

 

(12.1

)

Adjustments

 

0.5

 

 

 

(0.5

)

 

Accrual at March 27, 2004

 

$

0.2

 

$

 

$

 

$

4.0

 

$

4.2

 

 

Note 5 – Shareholders’ Equity

 

Restricted Stock Units

On March 24, 2004, the Company’s Board of Directors approved the grant of 2.4 million restricted stock units to selected members of the Company’s senior management, excluding its Chief Executive Officer (CEO).  These restricted stock units generally vest in two equal installments on the second and fourth anniversaries of the date of grant.  The Company has recorded the $61.2 million value of these restricted stock units as a component of shareholders’ equity and will amortize that amount on a straight-line basis over the 4 year requisite service period. The value of the restricted stock units was based on the closing market price of the Company’s common stock of $25.50 on the date of grant. Quarterly amortization will be approximately $3.8 million, of which approximately $0.5 million will be included in cost of sales; $1.1 million will be included in research and development expense; and the

 

11



 

remaining $2.2 million will be included in selling, general and administrative expense. The restricted stock units will be included in the calculation of diluted earnings per share utilizing the treasury stock method.

 

CEO Restricted Stock Award

On March 19, 2003, the Company entered into an Option Cancellation and Restricted Stock Award Agreement (the Agreement) with Mr. Steven P. Jobs, its CEO.  The Agreement cancelled stock option awards for the purchase of 27.5 million shares of the Company’s common stock previously granted to Mr. Jobs in 2000 and 2001. Mr. Jobs retained options to purchase 60,000 shares of the Company’s common stock granted in August of 1997 in his capacity as a member of the Company’s Board of Directors, prior to becoming the Company’s CEO.  The Agreement replaced the cancelled options with a restricted stock award of 5 million shares of the Company’s common stock.  The restricted stock award generally vests three years from date of grant. Vesting of some or all of the restricted shares will be accelerated in the event Mr. Jobs is terminated without cause, dies, or has his management role reduced following a change in control of the Company.

 

The Company has recorded the value of the restricted stock award of $74.75 million as a component of shareholders’ equity and is amortizing that amount on a straight-line basis over the 3 year service/vesting period.  The value of the restricted stock award was based on the closing market price of the Company’s common stock of $14.95 on the date of the award. Amortization expense for this award, which amounts to approximately $6.2 million per quarter, has been included in selling, general, and administrative expense beginning in March 2003 and will continue to be included through March 2006.  The 5 million restricted shares have been included in the calculation of diluted earnings per share utilizing the treasury stock method.

 

Comprehensive Income

Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under generally accepted accounting principles are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges.

 

The following table summarizes components of total comprehensive income, net of taxes, during the three and six month periods ended March 27, 2004, and March 29, 2003 (in millions):

 

 

 

Three
Months Ended

 

Six
Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

46

 

$

14

 

$

109

 

$

6

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Net change in unrealized derivative gains/losses

 

22

 

5

 

14

 

10

 

Change in foreign currency translation

 

(2

)

6

 

12

 

14

 

Net change in unrealized investment gains/losses

 

1

 

 

2

 

3

 

Reclassification adjustment for investment gains included in net income

 

 

(7

)

(3

)

(14

)

 

 

 

 

 

 

 

 

 

 

Total comprehensive income

 

$

67

 

$

18

 

$

134

 

$

19

 

 

The following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company during the three and six month periods ended March 27, 2004, and March 29, 2003 (in millions):

 

 

 

Three
Months Ended

 

Six
Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

 

 

 

 

 

 

 

 

 

 

Change in fair value of derivatives

 

$

1

 

$

 

$

(17

)

$

(4

)

Adjustment for net losses realized and included in net income

 

21

 

5

 

31

 

14

 

Change in unrealized derivative gains/losses

 

$

22

 

$

5

 

$

14

 

$

10

 

 

12



 

The following table summarizes the components of accumulated other comprehensive income (loss), net of taxes (in millions):

 

 

 

As of
3/27/04

 

As of
9/27/03

 

 

 

 

 

 

 

Unrealized gains on available-for-sale securities

 

$

 

$

1

 

Unrealized losses on derivative investments

 

(2

)

(16

)

Cumulative foreign currency translation

 

(8

)

(20

)

Accumulated other comprehensive income (loss)

 

$

(10

)

$

(35

)

 

Note 6 – Employee Benefit Plans

 

2003 Employee Stock Option Plan

At the Annual Meeting of Shareholders held on April 24, 2003, the shareholders approved an amendment to the 1998 Executive Officer Stock Plan to change the name of the plan to the 2003 Employee Stock Option Plan (the 2003 Plan), to provide for broad-based grants to all employees in addition to executive officers and other key employees and to prohibit future “repricings” of employee stock options, including 6-months-plus-1-day option exchange programs, without shareholder approval. Based on the terms of individual option grants, options granted under the 2003 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of 4 years, based on continued employment, with either annual or quarterly vesting. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, restricted stock units, stock appreciation rights, and stock purchase rights.

 

1997 Employee Stock Option Plan

In August 1997, the Company’s Board of Directors approved the 1997 Employee Stock Option Plan (the 1997 Plan), a non-shareholder approved plan for grants of stock options to employees who are not officers of the Company. Based on the terms of individual option grants, options granted under the 1997 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of 4 years, based on continued employment, with either annual or quarterly vesting. As a result of shareholder approval of amendments to the 1998 Executive Officer Stock Plan in April 2003, the Company terminated the 1997 Employee Stock Option Plan and cancelled all remaining unissued shares totaling 14,295,351 following the completion of an employee stock option exchange program in October 2003.

 

Employee Stock Option Exchange Program

On March 20, 2003, the Company announced a voluntary employee stock option exchange program (the Exchange Program) whereby eligible employees, other than executive officers and members of the Board of Directors, had an opportunity to exchange outstanding options with exercise prices at or above $25.00 per share for a predetermined smaller number of new stock options issued with exercise prices equal to the fair market value of one share of the Company’s common stock on the day the new awards are issued, which will be at least six months plus one day after the exchange options are cancelled.  On April 17, 2003, in accordance with the Exchange Program, the Company cancelled options to purchase 16,569,193 shares of its common stock. On October 22, 2003, new stock options totaling 6,697,368 shares were issued to employees at an exercise price of $22.76 per share, which is equivalent to the closing price of the Company’s stock on that date. No financial or accounting impact to the Company’s financial position, results of operations or cash flow was associated with this transaction.

 

1997 Director Stock Option Plan

In August 1997, the Company’s Board of Directors adopted a shareholder approved Director Stock Option Plan (DSOP) for non-employee directors of the Company. Initial grants of 30,000 options under the DSOP vest in three equal installments on each of the first through third anniversaries of the date of grant, and subsequent annual grants of 10,000 options are fully vested at grant.

 

13



 

Rule 10b5-1 Trading Plans

Certain of the Company’s executive officers, including Mr. Fred D. Anderson, Mr. Timothy D. Cook, Mr. Jonathan Rubinstein, and Mr. 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 Company’s stock including the exercise and sale of employee stock options and shares acquired pursuant to the Company’s employee stock purchase plan.

 

Employee Stock Purchase Plan

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 employee’s compensation, up to a maximum of $25,000 in any calendar year. As of March 27, 2004, approximately 3 million shares were reserved for future issuance under the Purchase Plan. The number of shares authorized for issuance is limited to a total of 1 million shares per offering period.

 

Stock Option Plan Activity

A summary of the Company’s stock option plan activity and related information for the three and six month periods ended March 27, 2004 and March 29, 2003 follows (share amounts are presented in thousands):

 

 

 

 

 

Outstanding Options

 

 

 

Shares
Available
For Grant

 

Number of
Shares

 

Weighted
Average
Exercise Price

 

 

 

 

 

 

 

 

 

Balance at 9/27/03

 

45,830

 

63,012

 

$

19.08

 

Options Granted

 

(16,248

)

16,248

 

$

22.14

 

Restricted Stock Units Granted

 

(2,400

)

 

 

Options Cancelled

 

1,676

 

(1,676

)

$

20.48

 

Options Exercised

 

 

(5,128

)

$

17.67

 

Plan Shares Expired

 

(15,376

)

 

 

Balance at 3/27/04

 

13,482

 

72,456

 

$

19.84

 

 

 

 

 

 

 

 

 

Balance at 9/28/02

 

6,571

 

109,430

 

$

28.17

 

Options Granted

 

(2,278

)

2,278

 

$

14.93

 

Restricted Stock Granted

 

(5,000

)

 

 

Options Cancelled

 

29,990

 

(29,990

)

$

35.83

 

Options Exercised

 

 

(303

)

$

9.32

 

Plan Shares Expired

 

(1

)

 

 

Balance at 3/29/03

 

29,282

 

81,415

 

$

25.05

 

 

The options outstanding as of March 27, 2004 have been segregated into six ranges for additional disclosure as follows (option amounts are presented in thousands):

 

 

 

Options Outstanding

 

Options Exercisable

 

Range of
Exercise Prices

 

Options
Outstanding
as of
3/27/04

 

Weighted-
Average
Remaining
Contractual Life
in Years

 

Weighted
Average
Exercise Price

 

Options
Exercisable
as of
3/27/04

 

Weighted
Average
Exercise
Price

 

 

 

 

 

 

 

 

 

 

 

 

 

$0.83 - $15.59

 

9,728

 

4.92

 

$

11.69

 

7,721

 

$

10.96

 

$15.60 - $17.31

 

11,626

 

5.91

 

$

17.00

 

9,650

 

$

17.07

 

$17.32 - $18.50

 

15,476

 

6.55

 

$

18.43

 

11,951

 

$

18.44

 

$18.51 - $20.86

 

12,913

 

7.37

 

$

20.26

 

6,825

 

$

20.24

 

$20.87 - $22.76

 

15,796

 

6.74

 

$

22.21

 

570

 

$

21.93

 

$22.77 - $69.78

 

6,917

 

6.57

 

$

32.98

 

5,108

 

$

35.93

 

$0.83 - $69.78

 

72,456

 

6.42

 

$

19.84

 

41,825

 

$

19.22

 

 

14



 

The Company had 2.4 million restricted stock units outstanding as of March 27, 2004, which were excluded from the options outstanding balances in the preceding tables.  None of these restricted stock units were vested as of March 27, 2004. The grant of these restricted stock units has been deducted from the shares available for grant under the Company’s stock option plans.

 

Note 7 – Stock-Based Compensation

 

The Company has provided pro forma disclosures in Note 1 of these Notes to Condensed Consolidated Financial Statements of the effect on net income and earnings per share as if the fair value method of accounting for stock compensation had been used for its employee stock option grants and employee stock purchase plan purchases. These pro forma effects have been estimated at the date of grant and beginning of the period, respectively, using the Black-Scholes option pricing model.

 

For purposes of the pro forma disclosures provided pursuant to SFAS No. 123, the option awards issued in October 2003 and the awards cancelled as part of the Employee Stock Option Exchange Program have been accounted for using modification accounting.  In accordance with SFAS No. 123, the grant date of the awards issued is the date of acceptance of the exchange offer by participating employees. The cancellation of certain of the Company’s Chief Executive Officer’s options and replacement with restricted shares in March 2003 is also being accounted for using modification accounting for purposes of the pro forma disclosures provided pursuant to SFAS No. 123.

 

The assumptions used for the three and six month periods ended March 27, 2004 and March 29, 2003, and the resulting estimates of weighted-average fair value per share of options granted and for stock purchases during those periods are as follows:

 

 

 

Three
Months Ended

 

Six
Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

 

 

 

 

 

 

 

 

 

 

Expected life of stock options

 

3.5 years

 

4 years

 

3.5 years

 

4 years

 

Expected life of stock purchases

 

6 months

 

N/A

 

6 months

 

6 months

 

Interest rate - stock options

 

2.33

%

2.43

%

2.33% - 2.35

%

2.44

%

Interest rate - stock purchases

 

0.96

%

N/A

 

0.96% - 1.10

%

1.75

%

Volatility - stock options

 

40

%

62

%

40

%

63

%

Volatility - stock purchases

 

34

%

N/A

 

34% - 44

%

44

%

Dividend yields

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average fair value of options granted during the period

 

$

7.00

 

$

7.12

 

$

6.96

 

$

7.38

 

Weighted-average fair value of employee stock purchases during the period

 

$

4.93

 

N/A

 

$

4.91

 

$

4.67

 

 

Note 8 – Commitments and Contingencies

 

Lease Commitments

The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off-balance-sheet financing arrangements. The major facility leases are for terms of 5 to 10 years and generally provide renewal options for terms of 3 to 5 additional years. Leases for retail space are for terms of 5 to 15 years and often contain multi-year renewal options. As of September 27, 2003, the Company’s total future minimum lease payments under noncancelable operating leases were $600 million, of which $354 million related to leases for retail space.  As of March 27, 2004, total future minimum lease payments related to leases for retail space increased to $376 million.

 

Accrued Warranty and Indemnifications

The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end-user. The Company also offers a 90-day

 

15



 

basic warranty for Apple software and for Apple service parts used to repair Apple hardware products. The Company provides currently for the estimated cost that may be incurred under its basic limited product warranties at the time related revenue is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its preexisting warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future expectations.

 

The following table reconciles changes in the Company’s accrued warranties and related costs for the three and six month periods ended March 27, 2004 and March 29, 2003 (in millions):

 

 

 

Three
Months Ended

 

Six
Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

 

 

 

 

 

 

 

 

 

 

Beginning accrued warranty and related costs

 

$

80

 

$

70

 

$

67

 

$

69

 

Cost of warranty claims

 

(27

)

(17

)

(48

)

(35

)

Accruals for product warranties

 

27

 

15

 

61

 

34

 

Ending accrued warranty and related costs

 

$

80

 

$

68

 

$

80

 

$

68

 

 

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 licensing 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 March 27, 2004 or September 27, 2003.

 

Contingencies

Beginning on September 27, 2001, three shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and its Chief Executive Officer. These lawsuits are substantially identical, and purport to bring suit on behalf of persons who purchased the Company’s publicly traded common stock between July 19, 2000, and September 28, 2000. The complaints allege violations of the 1934 Securities Exchange Act and seek unspecified compensatory damages and other relief. The Company believes these claims are without merit and intends to defend them vigorously. The Company filed a motion to dismiss on June 4, 2002, which was heard by the Court on September 13, 2002. On December 11, 2002, the Court granted the Company’s motion to dismiss for failure to state a cause of action, with leave to Plaintiffs to amend their complaint within thirty days. Plaintiffs filed their amended complaint on January 31, 2003, and on March 17, 2003, the Company filed a motion to dismiss the amended complaint. The Court heard the Company’s motion on July 11, 2003 and dismissed Plaintiff’s claims with prejudice on August 12, 2003.  Plaintiffs have appealed the ruling.

 

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 Company’s results of operations and financial position.

 

16



 

Note 9 - Segment Information and Geographic Data

 

In accordance with SFAS No 131, Disclosures about Segments of an Enterprise and Related Information, the Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments.

 

The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments are comprised of the Americas, Europe, Japan, and Retail. The Americas segment includes both North and South America, except for the activities of the Company’s Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. The Japan segment includes only Japan, except for the activities of the Company’s Retail segment. The Retail segment currently operates Apple-owned retail stores in the United States and Japan. Other operating segments include Asia-Pacific, which includes Australia and Asia except for Japan, and the Company’s subsidiary, FileMaker, Inc. Each reportable geographic operating segment provides similar hardware and software products and similar services, and the accounting policies of the various segments are the same as those described in the Company’s 2003 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 segment’s performance is also evaluated based on operating income. Net sales for geographic segments are based on the location of the customers. Operating income for each segment includes net sales to third parties, related cost of sales, and operating expenses directly attributable to the segment. Operating income for each segment excludes other income and expense and certain expenses that are managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses, manufacturing costs not included in standard costs, income taxes, and various nonrecurring charges. Corporate expenses include research and development, corporate marketing expenses, 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 $20 million and $24 million during the second quarters of 2004 and 2003, respectively, and $48 million and $30 million during the first six months of 2004 and 2003, respectively.

 

Operating income for all segments, except Retail, includes cost of sales at manufacturing standard cost, other cost of sales, related sales and marketing costs, and certain general and administrative costs. This measure of operating income, which includes manufacturing profit, provides a comparable basis for comparison between the Company’s various geographic segments.  Certain manufacturing expenses and related adjustments not included in segment cost of sales, including variances between standard and actual manufacturing costs and the mark-up above standard cost for product supplied to the Retail segment, are included in corporate expenses.

 

Management assesses the operating performance of the Retail segment differently than it assesses the operating performance of the Company’s geographic segments. The Retail segment revenue and operating income is intended to depict a comparable measure to that of the Company’s major channel partners in the United States operating retail stores so the Company can evaluate the Retail segment performance as if it were a channel partner. Therefore, the Company makes three significant adjustments to the Retail segment for management reporting purposes that are not included in the results of the Company’s other segments.

 

First, the Retail segment’s operating income includes cost of sales for Apple products at an amount normally charged to major channel partners in the United States operating retail stores, less the cost of sales programs and incentives provided to those channel partners and the Company’s cost to support those partners. For the second quarter of 2004 and 2003, 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 $45 million and $23 million, respectively. For the first six months of 2004 and 2003, 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 $97 million and $46 million, respectively.

 

17



 

Second, the Company’s extended warranty, support and service contracts are transferred to the Retail segment at the same cost as that charged to the Company’s major retail channel partners in the United States, resulting in a comparable measure of revenue and gross margin between the Company’s Retail stores and those retail channel partners.  The Retail segment recognizes the full amount of revenue and cost of sales at the time of sale of the Company’s extended warranty, support and service contracts. Because the Company has not yet earned the revenue or incurred the costs associated with the sale of these contracts, an offset to these amounts is recognized in other operating segments’ net sales and cost of sales. For the second quarter of 2004, this resulted in the recognition of net sales and cost of sales by the Retail segment, with corresponding offsets in other operating segments, of $12 million and $8 million, respectively. For the second quarter of 2003, the net sales and cost of sales recognized by the Retail segment for sales of extended warranty, support and service contracts were $6 million and $4 million, respectively. For the first six months of 2004, this resulted in the recognition of additional net sales and cost of sales by the Retail segment, with corresponding offsets in other operating segments, of $24 million and $16 million, respectively. This compares to similar adjustments to net sales and cost of sales during the first six months of 2003 of $12 million and $9 million, respectively.

 

Third, the Company has opened five high profile stores in New York, Los Angeles, Chicago, San Francisco and Tokyo, Japan as of March 27, 2004 and has two additional stores under development in Osaka, Japan, and London, England, which are expected to open by the end of calendar year 2004.  These high profile stores are larger than the Company’s typical retail stores and were designed to further promote brand awareness and provide a venue for certain corporate sales and marketing activities, including corporate briefings.  As such, the Company allocates certain operating expenses associated with these stores to corporate marketing expense to reflect the estimated benefit realized Company-wide. The allocation of these operating costs is based on the excess amount incurred for a high profile store to that of a more typical Company retail location. Expenses allocated to corporate marketing resulting from the operations of these stores were $4.0 million and $1.1 million in the second quarters of 2004 and 2003, respectively, and $6.2 million and $2.2 million for the first six months of 2004 and 2003, respectively.

 

Summary information by operating segment follows (in millions):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

Americas:

 

 

 

 

 

 

 

 

 

Net sales

 

$

881

 

$

684

 

$

1,805

 

$

1,422

 

Operating income

 

$

91

 

$

49

 

$

205

 

$

90

 

 

 

 

 

 

 

 

 

 

 

Europe:

 

 

 

 

 

 

 

 

 

Net sales

 

$

449

 

$

338

 

$

968

 

$

689

 

Operating income

 

$

72

 

$

43

 

$

169

 

$

69

 

 

 

 

 

 

 

 

 

 

 

Japan:

 

 

 

 

 

 

 

 

 

Net sales

 

$

173

 

$

220

 

$

330

 

$

359

 

Operating income

 

$

27

 

$

45

 

$

48

 

$

58

 

 

 

 

 

 

 

 

 

 

 

Retail:

 

 

 

 

 

 

 

 

 

Net sales

 

$

266

 

$

135

 

$

539

 

$

283

 

Operating income (loss)

 

$

5

 

$

(3

)

$

14

 

$

(4

)

 

 

 

 

 

 

 

 

 

 

Other Segments (a):

 

 

 

 

 

 

 

 

 

Net sales

 

$

140

 

$

98

 

$

273

 

$

194

 

Operating income

 

$

24

 

$

14

 

$

42

 

$

27

 

 


(a)     Other Segments consists of Asia-Pacific and FileMaker.

 

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A reconciliation of the Company’s segment operating income to the consolidated financial statements follows (in millions):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

 

 

 

 

 

 

 

 

 

 

Segment operating income

 

$

219

 

$

148

 

$

478

 

$

240

 

Corporate expenses, net

 

(157

)

(149

)

(342

)

(255

)

Restructuring costs

 

(10

)

(3

)

(10

)

(26

)

Total operating income (loss)

 

$

52

 

$

(4

)

$

126

 

$

(41

)

 

Note 10 – Related Party Transactions and Certain Other Transactions

 

In March 2002, the Company entered into a Reimbursement Agreement with its Chief Executive Officer, Mr. Steven P. Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the operation of his private plane when used for Apple business.  The Reimbursement Agreement became effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of the plane in May 2001. The Company recognized a total of $40,000 and $77,000 in expenses pursuant to the Reimbursement Agreement during the second quarters of 2004 and 2003, respectively, and $322,000 and $161,000 in expenses for the first six months of 2004 and 2003. All expenses recognized pursuant to the Reimbursement Agreement have been included in selling, general, and administrative expenses in the condensed consolidated statements of operations.

 

In connection with a relocation assistance package, the Company in May 2000 loaned Mr. Ronald B. Johnson, Senior Vice President, Retail, $1.5 million for the purchase of his principal residence. The loan was secured by a deed of trust and was due and payable in May 2004. Under the terms of the loan, Mr. Johnson agreed that should he exercise any of his stock options prior to the due date of the loan, he would pay the Company an amount equal to the lesser of (1) an amount equal to 50% of the total net gain realized from the exercise of the options; or (2) $375,000 multiplied by the number of years between the exercise date and the date of the loan. Mr. Johnson repaid $750,000 of this loan in fiscal 2003 and repaid the remaining balance of $750,000 in April 2004.

 

Mr. Jerome York, a member of the Board of Directors of the Company, is a member of an investment group that purchased MicroWarehouse, Inc. (MicroWarehouse) in January 2000. Until September 7, 2003, he also served as its Chairman, President and Chief Executive Officer. MicroWarehouse is a reseller of computer hardware, software and peripheral products, including products made by the Company. On September 8, 2003, CDW Corporation (CDW), acquired selected North American assets of MicroWarehouse. MicroWarehouse subsequently filed for Chapter 11 bankruptcy protection in the United States. MicroWarehouse accounted for 0.3% and 0.4% of the Company’s net sales for the three and six month periods ended March 27, 2004, respectively; and 2.8% and 3.0% of the Company’s net sales for the three and six month periods ended March 29, 2003, respectively. Trade receivables from MicroWarehouse were $9.3 million and $9.9 million as of March 27, 2004 and September 27, 2003, respectively. The Company has provided what it believes to be an adequate allowance on the outstanding receivable based on the Company’s secured interest position in selected MicroWarehouse assets and the expected payments to unsecured creditors. Sales to MicroWarehouse and related trade receivables were generally subject to the same terms and conditions as those with the Company’s other resellers. In addition, the Company has purchased miscellaneous equipment and supplies from MicroWarehouse. Total purchases amounted to approximately $385,000 and $1.2 million for the three and six month periods ended March 29, 2003. No purchases were made in the three or six months ended March 27, 2004.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This section and other parts of this Form 10-Q contain forward-looking statements that involve risks and uncertainties.  Forward-looking statements can be identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements.  Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled “Factors That May Affect Future Results and Financial Condition” below. The following discussion should be read in conjunction with the 2003 Form 10-K and the condensed consolidated financial statements and notes thereto included elsewhere in this Form 10-Q. All information is based on the Company’s fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law.

 

Available Information

The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available on its website at www.apple.com/investor when such reports are available on the Securities and Exchange Commission (SEC) website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549.  The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.  The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov.  The contents of these websites are not incorporated into this filing.  Further, the Company’s references to the URLs for these websites are intended to be inactive textual references only.

 

Executive Overview

Apple designs, manufactures and markets personal computers and related software and services, peripherals and personal computing and communicating solutions. The Company sells its products worldwide through its online stores, direct sales force, third-party wholesalers and resellers, and its own retail stores. The Company’s products and services include the Macintosh line of desktop and notebook computers, the Mac OS X operating system, the iPod digital music player, the iTunes Music Store and digital music management software, and a portfolio of other software products, peripherals and services for education, creative, consumer and business customers.  A further description of the Company’s products may be found below and in Part I, Item 1 of the 2003 Form 10-K under the heading “Business.”

 

The Company competes in several highly competitive markets including the personal computer industry with its Macintosh line of computers and related software, the consumer electronics industry with products such as the iPod, and digital music distribution through its iTunes Music Store. The Company continually faces both aggressive pricing practices as well as the emergence of new competitors in these markets.  In an effort to remain competitive in these markets, the Company intends to continue focusing on creating innovative products and services aligned with its digital hub strategy, whereby the Macintosh functions as the digital hub for digital devices including the iPod, personal digital assistants, cellular phones, digital video and still cameras, and other electronic devices.  The Company is also concentrating on expanding and improving its distribution capabilities by opening its own retail stores, both domestically and internationally, in high traffic quality shopping venues; staffing selected resellers’ stores with Company employees; entering into strategic alliances with other companies to brand and sell the Company’s products and services; increasing the accessibility of iPods through various resellers that do not currently sell Macintosh systems; and increasing the reach of its online stores.

 

Critical Accounting Estimates

The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Company’s discussion and analysis of its financial condition and results of operations requires the Company’s management to make judgments, assumptions, and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2003 Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of

 

20



 

which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates.

 

Management believes the Company’s critical accounting estimates are those related to revenue recognition, allowance for doubtful accounts, inventory valuation and exposures related to inventory purchase commitments, valuation of long-lived assets including acquired intangibles, warranty costs, and income taxes. Management believes these policies to be critical because they are both important to the portrayal of the Company’s financial condition and results, and they require management to make judgments and estimates about matters that are inherently uncertain.

 

Revenue Recognition

Net sales consist primarily of revenue from the sale of products (i.e., hardware, software, and peripherals), and extended warranty and support contracts. The Company recognizes revenue pursuant to applicable accounting standards, including Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition.

 

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped, and title and risk of loss have been transferred.  For most of the Company’s product sales, these criteria are met at the time the product is shipped.  For online sales to individuals, for some sales to education customers in the United States, and for certain other sales, the Company defers revenue until the customer receives the product because the Company legally retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed to not be, fixed and determinable, revenue is deferred and subsequently recognized as amounts become due and payable.

 

The Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives.  The estimated cost of these programs is accrued as a reduction to revenue in the period the Company has sold the product and committed to a plan.  The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs and incur incremental price protection obligations that could result in additional reductions of revenue at the time such programs are offered. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company would be required to record additional reductions to revenue, which could have a material adverse impact on the Company’s results of operations.

 

Allowance for Doubtful Accounts

The Company distributes its products through third-party resellers and directly to certain education, consumer, and commercial customers. The Company generally does not require collateral from its customers. However, when possible the Company does attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe and Asia and by arranging with third-party financing companies to provide flooring arrangements and other loan and lease programs to the Company’s direct customers. These credit-financing arrangements are directly between the third-party financing company and the end customer.  As such, the Company does not assume any recourse or credit risk sharing related to any of these arrangements. However, considerable trade receivables that are not covered by collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company’s distribution and retail channel partners.

 

The allowance for doubtful accounts is based on management’s assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition of those specific customers. The Company records an allowance to reduce the specific receivables to the amount that is reasonably believed to be collectible.  The Company also records an allowance for all other trade receivables based on multiple factors including historical experience with bad debts, the general economic environment, the financial condition of the Company’s distribution channels, and the aging of such receivables. If there is a deterioration of a major customer’s financial condition, if the Company becomes aware of additional information related to the credit worthiness of a major customer, or if future actual default rates on trade receivables in general differ from those currently

 

21



 

anticipated, the Company may have to adjust its allowance for doubtful accounts, which would affect earnings in the period the adjustments are made.

 

Inventory Valuation and Inventory Purchase Commitments

The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory each period that considers multiple factors including demand forecasts, product lifecycle status, product development plans, current sales levels, and component cost trends. The personal computer industry is subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the Company’s products are less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, the Company may be required to record additional write-downs which would negatively affect gross margins in the period when the write-downs are recorded.

 

The Company accrues necessary reserves for cancellation fees related to component orders that have been cancelled. Consistent with industry practice, the Company acquires components through a combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company’s requirements for periods ranging from 30 to 130 days. If there is an abrupt and substantial decline in demand for one or more of the Company’s products or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record additional reserves for cancellation fees that would negatively affect gross margins in the period when the cancellation fees are identified.

 

Valuation of Long-Lived Assets Including Acquired Intangibles

The Company reviews property, plant, and equipment and certain identifiable intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate. If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their fair market value. Although the Company has recognized no material impairment adjustments related to its property, plant, and equipment or identifiable intangibles during the past three fiscal years, except those made in conjunction with restructuring actions, deterioration in the Company’s business in a geographic region or business segment in the future, including deterioration in the performance of individual retail stores, could lead to such impairment adjustments in future periods in which such business issues are identified.

 

In accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, the Company no longer amortizes goodwill but instead performs a review of goodwill for impairment annually, or earlier if indicators of potential impairment exist. The review of goodwill for potential impairment is highly subjective and requires that: (1) goodwill be allocated to various reporting units of the Company’s business to which it relates; (2) the Company estimate the fair value of those reporting units to which the goodwill relates; and (3) the Company determine the book value of those reporting units. If the estimated fair value of reporting units with allocated goodwill is determined to be less than their book value, the Company is required to estimate the fair value of all identifiable assets and liabilities of those reporting units in a manner similar to a purchase price allocation for an acquired business. This requires independent valuation of certain internally developed and unrecognized assets including in-process research and development and developed technology. Once this process is complete, the amount of goodwill impairment, if any, can be determined.

 

Based on the Company’s estimates as of March 27, 2004, there was no impairment of goodwill. However, changes in various circumstances including changes in the Company’s market capitalization, changes in the Company’s forecasts, and changes in the Company’s internal business structure could cause one or more of the Company’s reporting units to be valued differently thereby causing an impairment of goodwill. Additionally, in response to changes in the personal computer industry and changes in global or regional economic conditions, the Company may strategically realign its resources and consider restructuring, disposing, or otherwise exiting businesses, which could result in an impairment of property, plant, and equipment, identifiable intangibles, or goodwill.

 

Warranty Costs

The Company provides currently for the estimated cost for product warranties at the time the related revenue is recognized based on the size of the installed base of products subject to warranty protection, historical and projected

 

22



 

warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates its estimates to assess the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.  If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liability would be required and could negatively affect the Company’s results of operations.

 

Income Taxes

The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with SFAS No. 109, Accounting for Income Taxes, the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards.  Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized.

 

Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if the Company subsequently realizes deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in a positive adjustment to earnings or a decrease in goodwill in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws.  Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s results of operations and financial position.

 

Hardware Products Update

The Company offers a range of personal computing products including desktop and notebook personal computers, related devices and peripherals, networking and connectivity products, and various third-party hardware products. All of the Company’s Macintosh® products utilize PowerPC® RISC-based microprocessors. The Company’s entire line of Macintosh systems, excluding servers, features the Company’s suite of software for digital photography, music, and movies. A discussion of the Company’s products may be found in the 2003 Form 10-K. Certain newly introduced products and/or upgrades to existing products are discussed below.

 

PowerBook® G4

In April 2004, the Company updated its PowerBook® G4 notebooks with faster PowerPC G4 processors. Both the 15-inch and 17-inch PowerBook G4 now offer up to a 1.5 GHz PowerPC G4 processor and graphics performance with the ATI Mobility Radeon 9700 graphics processor. The new 12-inch PowerBook G4 features a 1.33 GHz PowerPC processor, NVIDIA GeForce FX Go5200 graphics with 64MB of dedicated video memory and a larger 60GB Ultra ATA hard drive.  Every new PowerBook G4 notebook comes with built-in AirPort® Extreme wireless networking and an internal Bluetooth module for wireless connectivity.

 

iBook® G4

In April 2004, the Company updated its iBook G4 lineup for consumers and education customers with faster PowerPC G4 processors running at up to 1.2 GHz and an optional SuperDriveÔ.  The new 12-inch and 14-inch iBooks include support for wireless connectivity with AirPort Extreme® 54 Mbps 802.11g wireless networking and Bluetooth, and a slot-load Combo drive. Each iBook offers ATI Mobility Radeon 9200 graphics with 32MB of dedicated DDR memory and AGP 4X support. All iBook models also offer input/output (I/O) ports, including FireWire® 400, USB 2.0 and a built-in 56K v.92 modem and Ethernet (10/100BASE-T).

 

eMacÔ

In April 2004, the Company updated its eMac, which now has a suggested retail price starting at $799 and is available with a SuperDrive for a suggested retail price starting at $999. The new eMac offers faster PowerPC G4 processors running at up to 1.25 GHz, 333 MHz DDR memory, faster ATI Radeon graphics and USB 2.0 connectivity to peripherals.

 

23



 

Xserve® and Xserve RAID

Xserve, the Company’s first rack-mount server product, was designed for simple setup and remote management of intensive I/O applications such as digital video, high-resolution digital imagery, and large databases. In January 2004, the Company announced Xserve G5, which is available with either a single or dual 2.0 GHz PowerPC G5 processor, and began shipments in March 2004 of the single processor model. Xserve G5 includes a new system controller with up to 8GB of PC3200 error correcting code (ECC) memory; three hot-plug Serial Advanced Technology Architecture (ATA) drive modules that deliver up to 750GB of storage; and dual on-board Gigabit Ethernet for high-performance networking. At the same time, the Company also introduced its new Xserve RAID storage system along with support for Windows and Linux-based computing environments. Designed with 14 independent ATA/100 drive channels and an industry standard 2GB Fibre Channel, Xserve RAID provides up to 3.5 terabytes of storage capacity and up to 336 MBps throughput.

 

Peripheral Products Update

The Company sells certain associated Apple-branded computer hardware peripherals, including iPod® digital music players, iSight™ digital video cameras, and a range of high quality flat panel TFT active-matrix digital color displays. The Company also sells a variety of third-party Macintosh compatible hardware products directly to end users through both its retail and online stores, including computer printers and printing supplies, storage devices, computer memory, digital video and still cameras, personal digital assistants, and various other computing products and supplies. A discussion of the Company’s products may be found in the 2003 Form 10-K. Certain newly introduced products and/or upgrades to existing products are discussed below.

 

iPod®

In January 2004, the Company announced the availability of a new 15GB iPod model and also introduced a new form factor with the iPod mini.  Smaller and lighter than the original iPod model, the new iPod mini has storage capacity of 4GB and holds up to 1,000 songs, features a patent pending, touch sensitive Click Wheel for one-handed navigation, and is encased in an anodized aluminum case available in a selection of five colors, including silver, gold, pink, blue or green.  The new iPod mini retains the same user interface as the original model and works seamlessly with the Company’s iTunes Music Store® and the iTunes® digital music management software for buying, managing and listening to digital music on either a Mac or Windows-based platform. The Company has also entered into a strategic alliance with Hewlett-Packard Company (HP), which provides for an HP-branded digital music player based on the iPod, the preinstallation of iTunes digital music management software on HP’s consumer PCs and notebooks and access to the iTunes music store.

 

Software Products and Computer Technologies Update

The Company offers a range of software products for education, creative, consumer and business customers, including Mac OS® X, the Company’s proprietary operating system software for the Macintosh; server software and related solutions; professional application software; and consumer, education and business oriented application software. A discussion of the Company’s products may be found in the 2003 Form 10-K. Certain newly introduced products and/or upgrades to existing products are discussed below.

 

FileMaker®

FileMaker Corporation, a wholly owned subsidiary of the Company, develops, publishes, and distributes desktop-based database management application software for Mac OS and Windows-based operating systems.  The FileMaker® Pro database software and related products offer relational databases and desktop-to-web publishing capabilities. In March 2004, the Company introduced FileMaker Pro 7 for Mac OS X and Windows with new architecture and enhancements in ease-of-use, customizability and developer productivity. FileMaker Pro 7 has been redesigned using a modern, streamlined relational architecture, which enables users to simplify information management by storing multiple tables within a single file. The new relationships graph presents a visual “map” of the database and lets users create and modify relationships with a simple click and drag tool. FileMaker Pro 7 has also expanded its data capacity to 8 terabytes per file or 4,000 times the former limit.

 

XsanÔ

Xsan, the Company’s new enterprise-class Storage Area Network (SAN) file system was introduced as a beta version in April 2004 and is expected to be available for general release in the Fall of 2004. Xsan is a 64-bit cluster file system for Mac OS X that enables organizations to consolidate storage resources and provide multiple computers with concurrent file-level read/write access to shared volumes over Fibre Channel. Advanced features such as metadata controller failover and Fibre Channel multipathing ensure high availability; file-level locking allows

 

24



 

multiple systems to read and write concurrently to the same volume which is ideal for complex workflows; bandwidth reservation provides for effective ingestion of bandwidth-intensive data streams, such as high resolution video; and flexible volume management results in more efficient use of storage resources. Since Xsan is interoperable with ADIC’s StorNext File System, it can be used in heterogeneous environments that include Windows, UNIX and Linux server operating system platforms.

 

Motion

In April 2004, the Company announced Motion, a new motion graphic design and production application that is expected to be available in the Summer of 2004. Motion features interactive animation of text, graphics and video, with real-time previewing of multiple filters and particle effects. Motion introduces “Behaviors,” a new procedural animation technology that allows for the adding of natural looking movement to type and graphics, such as gravity and wind, without the use of complex keyframes. Motion’s “Interactive Dashboards” give users contextual, semi-transparent floating palettes that provide the tools and slider parameters for objects being animated on screen and utilizing “Project Pane” users can view and manage all layers, filters, behaviors, masks and objects within a project at once.

 

Shake® 3.5

Shake® 3.5, an upgrade of the Company’s compositing and visual effects software designed for large format film and video productions was introduced in April 2004. Shake 3.5 features new shape-based morphing and warping tools for advanced compositing and new “shape shifting” special effects. Morphing and warping further enhance Shake’s visual effects tools, including layering, tracking, rotoscoping, painting and color correction. Shake 3.5 also improves upon the Shake Qmaster network render manager that can now handle distributed rendering tasks for both Shake and Alias’ Maya, allowing for distribution of rendering tasks across a cluster of servers or computers.

 

DVD Studio Pro® 3

In April 2004, the Company announced DVD Studio Pro® 3, the latest version of the Company’s professional DVD authoring application which is expected to be available in May 2004. DVD Studio Pro 3 features new Alpha Transitions, which are QuickTime® based movie transitions that may be added to DVDs, and a new Graphical View for easy visualization of a project’s entire flow in a storyboard environment. Graphical View makes it easy to see the relationships between menus, tracks, slideshows, stories and scripts. DVD Studio Pro 3 also includes Compressor 1.2, the latest version of the Company’s digital media encoding and compression tool that provides high-quality HD to MPEG-2 encoding. In addition to DV and SD, DVD Studio Pro 3 now provides the ability to scale HD and encode directly to MPEG-2 all in one step.

 

Logic® Pro 6 and Logic Express 6

Logic Pro 6, introduced by the Company in January 2004, includes Logic Platinum, an audio recording and sequencer application, and the entire line of 53 audio digital signal processing (DSP) plug-ins and professional-quality software instruments. Logic Pro 6 allows professional musicians and audio engineers to compose, record, edit and mix music, including professional software instruments, multitrack recorders, mixing desks and sound effect processors. Logic Pro 6 also includes the ability to create 5.1 and 7.1 surround sound, support for up to 128 audio tracks, virtually unlimited input channels and a sample rate of up to 192k.

 

Based on Logic Pro 6, Logic Express 6 is a computer music production application designed to fit the needs of students and educators with a basic set of professional tools to compose and produce music with sophisticated results. Logic Express 6 features audio production tools, including over 28 effect plug-ins and sample-based software instruments. Logic Express 6 also includes support for up to 48 audio tracks, 12 input channels and a sample rate of up to 96k.

 

Final Cut Pro® HD

Final Cut Pro® HD, the latest version of the Company’s video editing software was introduced in April 2004 and features real-time performance of high-quality native DVCPRO HD in addition to real-time support for digital video (DV) and standard definition (SD) formats. This product is expected to be generally available in May 2004. Final Cut Pro HD supports native DVCPRO HD editing with no recompression or image degradation and enables HD preview monitoring. Final Cut Pro HD’s support of native DVCPRO HD makes media conversion unnecessary, preserving the full quality of the camera original. Final Cut Pro HD includes precision, non-modal editing and trimming tools; powerful interface customization features; advanced real-time color correction and image control; and enhanced audio editing capabilities with multi-track audio mixing and multi-channel audio output.

 

25



 

Final Cut® Express

Final Cut Express, based on Final Cut Pro, enables small business users, educators, students and advanced hobbyists to perform professional-quality digital video editing. In January 2004, the Company introduced Final Cut® Express 2 which features RT Extreme for real-time compositing and effects, an enhanced user interface, real-time color correction tools and enhanced audio editing capabilities.

 

iLife®

In January 2004, the Company introduced iLife ‘04, the next generation suite of its digital lifestyle applications, which features new versions of iPhoto™, iMovie® and iDVD™ and introduces GarageBand™, a new music creation software application. iLife ‘04 also features the iTunes digital music management software.

 

iPhoto 4 has new features that allow users to scroll through and resize photos in seconds to easily find a particular photo; Smart Albums which automatically organizes photos based on date, keyword or the user’s own rating; new transitions and controls for rotating, rating and deleting photos.

 

iMovie 4 features improved rendering and editing performance, including the ability to edit and trim audio and video clips in the enhanced timeline with click-and-drag editing.  Users may also select and edit multiple clips simultaneously.  With graphical audio waveforms and live audio scrubbing, users can locate specific edit points in audio tracks, and alignment guides make it easy to precisely sync video and audio.

 

iDVD 4 includes new themes and professional effects that allow users to use photos and movies as buttons, backgrounds and menus.  Movies from iMovie, photos from iPhoto and music from either iTunes or GarageBand can be added directly to a DVD via the media browser, and enhanced photo slideshows can include cinematic transitions and iTunes playlists.  The DVD Map provides an overview of an entire DVD project and instant accessibility to all project elements.

 

GarageBand, the Company’s new consumer oriented music creation software, allows users to play, record and create music using a simple interface.  With GarageBand, recorded performances, digital audio and looping tracks can be arranged and edited to create songs.  GarageBand comes with more than 50 software instruments, pre-recorded audio loops for making complete songs or backing tracks, pro-quality effects presets for mixing, and vintage amplifier sounds for the guitar.  The Company also introduced Jam Pack, which provides additional features that enhance the use of GarageBand to create and record music.

 

Internet Software, Integration, and Services

Apple’s Internet strategy is focused on delivering seamless integration with and access to the Internet throughout the Company’s product lines.  The Company’s Internet products provide an optimized user experience by adherence to many industry standards. An easy Internet Setup Assistant is included with the Mac OS. A discussion of the Company’s services may be found in the 2003 Form 10-K.  Certain newly introduced services and/or upgrades to existing services are discussed below.

 

iTunes® 4.5 and iTunes Music Store®

In April 2004, the Company introduced iTunes 4.5 and the third generation of its iTunes Music Store. New features include  “iMix,” a new way for users to publish playlists for other users to preview, rate and purchase; “Party Shuffle,” a new playlist that automatically chooses songs from a user’s music library, displays just-played and upcoming songs, and allows users to easily add, delete and rearrange the upcoming songs like a professional DJ; and “Radio Charts” a feature that allows users to search and buy the top songs played on local radio stations in major US markets.

 

26



 

Net Sales

Net sales and Macintosh unit sales by operating segment and net sales and unit sales by product follow (net sales in millions and unit sales in thousands):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

3/27/04

 

3/29/03

 

Change

 

3/27/04

 

3/29/03

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Sales by Operating Segment:

 

 

 

 

 

 

 

 

 

 

 

 

 

Americas net sales

 

$

881

 

$

684

 

29

%

$

1,805

 

$

1,422

 

27

%

Europe net sales

 

449

 

338

 

33

%

968

 

689

 

40

%

Japan net sales

 

173

 

220

 

(21

)%

330

 

359

 

(8

)%

Retail net sales

 

266

 

135

 

97

%

539

 

283

 

90

%

Other segments net sales

 

140

 

98

 

43

%

273

 

194

 

41

%

Total net sales

 

$

1,909

 

$

1,475

 

29

%

$

3,915

 

$

2,947

 

33

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unit Sales by Operating Segment:

 

 

 

 

 

 

 

 

 

 

 

 

 

Americas Macintosh unit sales

 

361

 

338

 

7

%

739

 

715

 

3

%

Europe Macintosh unit sales

 

187

 

180

 

4

%

427

 

382

 

12

%

Japan Macintosh unit sales

 

76

 

107

 

(29

)%

153

 

178

 

(14

)%

Retail Macintosh unit sales

 

70

 

42

 

67

%

143

 

88

 

63

%

Other segments Macintosh unit sales (a)

 

55

 

44

 

25

%

116

 

91

 

27

%

Total Macintosh unit sales

 

749

 

711

 

5

%

1,578

 

1,454

 

9

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Sales by Product:

 

 

 

 

 

 

 

 

 

 

 

 

 

Power Macintosh net sales (b)

 

$

349

 

$

293

 

19

%

$

747

 

$

585

 

28

%

PowerBook net sales

 

336

 

353

 

(5

)%

735

 

588

 

25

%

iMac net sales

 

252

 

302

 

(17

)%

503

 

658

 

(24

)%

iBook net sales

 

223

 

151

 

48

%

444

 

367

 

21

%

Total Macintosh net sales

 

1,160

 

1,099

 

6

%

2,429

 

2,198

 

11

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Peripherals and other hardware (c)

 

536

 

216

 

148

%

1,035

 

434

 

138

%

Software (d)

 

127

 

95

 

34

%

276

 

183

 

51

%

Service and other sales (e)

 

86

 

65

 

32

%

175

 

132

 

33

%

Total net sales

 

$

1,909

 

$

1,475

 

29

%

$

3,915

 

$

2,947

 

33

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unit Sales by Product:

 

 

 

 

 

 

 

 

 

 

 

 

 

Power Macintosh unit sales

 

174

 

156

 

12

%

380

 

314

 

21

%

PowerBook unit sales

 

157

 

166

 

(5

)%

352

 

267

 

32

%

iMac unit sales

 

217

 

256

 

(15

)%

444

 

554

 

(20

)%

iBook unit sales

 

201

 

133

 

51

%

402

 

319

 

26

%

Total Macintosh unit sales

 

749

 

711

 

5

%

1,578

 

1,454

 

9

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales per Macintosh unit sold (f)

 

$

1,549

 

$

1,546

 

0

%

$

1,539

 

$

1,512

 

2

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

iPod unit sales

 

807

 

80

 

909

%

1,540

 

299

 

415

%

iPod net sales

 

$

264

 

$

31

 

752

%

$

520

 

$

112

 

364

%

 

Notes:

 


(a)          Other Segments consists of Asia Pacific and FileMaker.

(b)         Power Macintosh figures include server sales.

(c)          Net sales of peripherals and other hardware include sales of iPod, Apple-branded and third-party displays, and other hardware accessories.

(d)         Net sales of software include sales of Apple-branded operating system and application software and sales of third-party software.

(e)          Service and other sales primarily include sales of AppleCare and Internet services.

(f)            Net sales per Macintosh unit sold are derived by dividing total Macintosh net sales by total Macintosh unit sales.

 

27



 

Net sales during the second quarter of 2004 increased 29% or $434 million from the same quarter in 2003, and were up 33% or $968 million for the first six months of fiscal 2004 compared to the same period of fiscal 2003.  Several factors contributed to these increases including:

 

                  Net sales of peripherals and other hardware rose $320 million or 148% during the second quarter of 2004 compared to the same quarter in 2003, and increased $601 million or 138% in the first half of 2004. These increases in the second quarter of 2004 result primarily from the significant year-over-year increase in iPod net sales and unit sales of 752% and 909%, respectively, in the second quarter of 2004 compared to the same quarter in the prior year.  Strong iPod sales were experienced in all of the Company’s operating segments during the second quarter of 2004 with unit sales of 807,000, surpassing record units sales in the prior holiday quarter by 10%. In addition, iPod sales during the current year were favorably affected by several factors including shipment of the iPod mini which began in the second quarter of 2004; the introduction of Macintosh and Windows compatible models; the Company’s introduction of a new version of the iTunes Music Store in the U.S. for both Macintosh and Windows users in October 2003; and expansion of the Company’s iPod distribution network. Net sales of peripherals and other hardware was also favorably affected by an increase in net sales of displays and other computer accessories, which rose by 47% and 60% for the three and six months ended March 27, 2004, compared to the same periods in 2003, respectively.  Net sales of other computer accessories include, AirPort cards and base stations, iSight digital video cameras, third party hardware products, and a number of iPod related accessories.  The increase in total net sales of peripherals and other hardware were experienced predominantly by the Company’s Americas, Europe, and Retail segments.

 

                  Total Macintosh net sales increased by 6% and 11% during the second quarter and first six months of 2004 compared with the same periods in 2003.  Unit sales during these same periods also reflected similar increases of 5% and 9%, respectively, compared to the same period in the prior year. Unit sales of the Company’s professional desktop and portable systems for the first half of 2004 compared to the same period in 2003 increased 21% and 32%, respectively. The increase in year-to-date Power Macintosh sales is due primarily to the introduction of the Power Mac G5, which did not begin shipping until the end of fiscal 2003. In addition, iBook unit sales increased 26% in the first half of 2004 compared to the same period in the prior year. Unit sales of portable systems, consisting of the PowerBook and iBook, represented 48% of all Macintosh systems sold during the three and six months ended March 27, 2004 and increased by 20% and 29% during the second quarter and first half of the prior year, respectively, which reflects an overall trend in the industry towards portable systems. Net sales per Macintosh unit sold during the second quarter of 2004 remained relatively flat compared to the same quarter in 2003, but increased 2% to $1,539 during the first six months of 2004 from $1,512 in 2003.  The year to date increase was the result of various changes in overall unit mix towards relatively higher-priced Power Macintosh and PowerBook systems and an increase in direct sales primarily from the Company’s retail and online stores. The impact of these factors was somewhat offset by lower year-over-year pricing for the first half of 2004 on comparable Macintosh systems for some of the Company’s Macintosh product lines in response to industry pricing pressure.

 

                  The Retail segment’s net sales grew 97% to $266 million during the second quarter of 2004 and grew by 90% to $539 million in the first half of the year compared to the same periods in the prior year.  These increases are largely attributable to the increase in total stores from 53 at the end of the second quarter of 2003 to 78 as of March 27, 2004, as well as a 35% year-over-year increase in average revenue per store. While the Company’s customers in areas where the Retail segment has opened stores may elect to purchase from the Retail segment stores rather than the Company’s preexisting sales channels in the United States and Japan, the Company believes that a substantial portion of the Retail segment’s net sales is incremental to the Company’s total net sales. See additional comments below related to the Retail segment under the heading “Segment Operating Performance.”

 

                  Net sales of software rose $32 million or 34% during the second quarter of 2004 compared to the same quarter in 2003, and increased $93 million or 51% for the first six months of 2004 compared to the same period in the prior year. These increases reflect higher net sales of Apple-branded software including iLife, which was introduced in January 2004, and Mac OS X version 10.3 “Panther,” which was released in October 2003 and accounted for approximately $13 million and $65 million of the increase in software net sales for the three and six month periods ended March 27, 2004, respectively.

 

28



 

                  The Company’s U.S. education channel experienced year-over-year growth in net sales of approximately 18% during both the second quarter and first half of 2004.  Also, unit sales increased by 10% and 9% for the three and six month periods ended March 27, 2004 compared to the same periods in the prior year. While the K-12 market has remained relatively flat in net sales and unit sales year-over-year, the Company’s higher education market has continued to perform well driving the Company’s overall growth in U.S. education. Sales of iBook also increased year-over-year in the second quarter of 2004 due in part to increases in the number of one-to-one (1:1) learning solutions whereby every student and teacher receive a computer.

 

                  Service and other sales rose over 30% during the second quarter and for the first six months of 2004 compared to the same periods in 2003.  These increases are the result of significant year-over-year increases in net sales associated with AppleCare Protection Plan (APP) extended maintenance and support services, as well as increases in net sales associated with Internet services. Increased net sales associated with APP are primarily the result of higher attach rates on APP over the last several years. Increased net sales associated with Internet services are due primarily to the introduction of the iTunes Music Store, introduced for the Macintosh in April of 2003 and updated in October 2003 for both Windows and Macintosh users, and increased net sales of the Company’s .Mac Internet service.

 

Offsetting the favorable factors discussed above, the Company’s net sales during the second quarter and first half of 2004 were negatively impacted by the following:

 

                  Net sales and unit sales of iMac systems were down 17% and 15%, respectively, during the second quarter of 2004 versus the same quarter in 2003.  This same pattern of decline was also experienced in the first six months of 2004 with decreases of 24% and 20% in net sales and unit sales, respectively.  Sales of flat panel iMac systems, which have a suggested retail price starting at $1,299, have been negatively affected by a shift in consumer preference to portable systems and competitor desktop models with price points below $1,000.  The Company introduced a new version of the eMac in April 2004 with a suggested retail price starting at $799 aimed at the price sensitive customer. Also, the current flat panel iMac and eMac form factors are approximately 2 years old, which continue to contribute to declining net sales.

 

                  Net sales and unit sales in the Company’s Japan segment declined during both the second quarter and first half of 2004 compared to the same periods of 2003.  These declines are believed to be attributable to the continued weakness in consumer PC shipments throughout Japan, the Company’s belief that its professional and creative customers have delayed computer upgrades pending the release in Japan of certain Mac OS X native applications, such as Quark Xpress 6, and a shift in sales from the Japan Segment to the Retail segment as a result of the opening of the Tokyo store in the first quarter of 2004. See additional comments below related to the Japan segment under the heading “Segment Operating Performance.”

 

Segment Operating Performance

The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments are comprised of the Americas, Europe, Japan, and Retail. The Americas segment includes both North and South America, except for the activities of the Company’s Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. The Japan segment includes only Japan, except for the activities of the Company’s Retail segment.  The Retail segment currently operates Apple-owned retail stores in the United States and opened its first international store in Tokyo, Japan in the first quarter of 2004. Each reportable geographic operating segment provides similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Part I, Item 1 of this Form 10-Q in the Notes to Condensed Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data.”

 

Americas

Net sales in the Americas segment grew 29% or $197 million in the second quarter of 2004 compared with the same quarter in 2003.  For the first six months of 2004, net sales grew $383 million, a 27% increase, compared to the same period of 2003.  The increase in net sales was primarily attributable to the significant year-over-year increase in iPod sales as well as from strong sales of peripherals, software, and services.  Macintosh unit sales also increased by 7% and 3%, respectively, for the three and six month periods ended March 27, 2004 driven primarily from strong sales of portable and Power Macintosh systems, partially offset by continued weakness in iMac sales.

 

29



 

As noted above, the Company experienced an increase of approximately 18% in U.S. education channel net sales for both the quarter and six month periods of 2004 compared to the same periods in the prior year. Strong U.S. education net sales in the second quarter and first half of the year relate primarily to strength in higher education net sales that drove year-over-year growth of over 40% for both the three and six months periods ended March 27, 2004. The Company’s K-12 net sales were relatively flat year-over-year, despite the challenges in the K-12 market from continued budget constraints and increased competition.

 

Europe

Net sales in Europe increased $111 million or 33% during the second quarter of 2004 as compared to the same quarter in 2003, and increased $279 million or 40% for the first six months of 2004 compared to the same period in 2003. Total Macintosh unit sales in Europe were up 4% and 12% in the second quarter and first half of 2004 compared to the same periods in 2003, respectively.  Consistent with the Americas segment, Europe experienced strong net sales across all product lines, except for the iMac, in the three and six month periods ended March 27, 2004. Demand in Europe during these periods was particularly strong for the Company’s professional Macintosh systems, iPods, peripherals and software.

 

Japan

Japan’s net sales decreased $47 million or 21% during the second quarter of 2004 compared to the same quarter in 2003, and decreased $29 million or 8% for the first six months of 2004 compared to the same period in 2003.  Unit sales in Japan were down 29% and 14% for the second quarter and first half of 2004, respectively, compared to the same periods in the prior year. These decreases in net sales and unit sales are believed to be attributable in part to negative growth in consumer PC shipments that continues to be experienced throughout Japan, which has contributed to the decrease in net sales of the Company’s Macintosh systems. The Company also believes that some professional and creative customers have delayed upgrades to their systems in anticipation of certain software vendors porting their applications to Mac OS X in Japan, including Quark XPress 6, which is expected to occur later in fiscal year 2004.  In addition, such decreases may also be the result of a shift in sales from the Japan segment to the Retail segment as a result of the opening of the Tokyo store in the first quarter of 2004. The decrease in net sales was partially offset by strong iPod and iBook sales during the three and six month periods ended March 27, 2004. Japan’s net sales and Macintosh unit sales continue to remain significantly below their historic levels.

 

Retail

The Company opened five new retail stores during the second quarter, including its newest high profile store in San Francisco.  At the end of the second quarter of 2004, the Company had 78 retail stores open as compared to 53 open stores at the end of the second quarter of 2003.  The Retail segment’s second quarter 2004 net sales grew by $131 million or 97% from the same quarter in 2003.  Net sales for the first six months of 2004 grew to $539 million from $283 million during the same period of 2003, a 90% increase.

 

With an average of 75 stores open during the quarter, average quarterly revenue per store increased to $3.5 million, up from $2.6 million in the year-ago quarter. The Retail segment has contributed strongly to the increase in net sales of peripherals and software experienced by the Company during 2004. During the first half of 2004, approximately 54% of the Retail segment’s net sales came from the sale of iPods, other Apple-branded and third-party peripherals, software and services. This compares to 42% for the Retail segment during the first half of 2003 and 38% for the Company as a whole during the first half of 2004.

 

In accordance with the Company’s operating segment reporting, as further discussed in Part I, Item 1 of this Form 10-Q in the Notes to Condensed Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data,” the Retail segment reported profit of $5 million and $14 million during the second quarter and first six months of 2004 as compared to losses of $3 million and $4 million during the second quarter and first six months of 2003. This improvement is primarily attributable to the segment’s year-over-year increase in average quarterly revenue per store and the impact of opening 25 new stores.

 

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 $290 million through the end of fiscal 2003, and totaled $48 million during the first six months of 2004. As of March 27, 2004, the Retail segment had approximately 1,660 employees and had outstanding operating lease commitments associated with retail store space and related facilities of approximately $376 million. The Company would incur substantial costs should it choose to terminate its Retail

 

30



 

segment or close individual stores. Such costs could adversely affect the Company’s results of operations and financial condition. Investment in a new business model such as the Retail segment is inherently risky, particularly in light of the significant investment involved, overall economic uncertainties, and the fixed nature of a substantial portion of the Retail segment’s operating expenses.

 

Gross Margin

Gross margin for the three and six months ended March 27, 2004 and March 29, 2003 was as follows (in millions, except gross margin percentages):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

1,909

 

$

1,475

 

$

3,915

 

$

2,947

 

Cost of sales

 

1,379

 

1,057

 

2,849

 

2,123

 

Gross margin

 

$

530

 

$

418

 

$

1,066

 

$

824

 

Gross margin percentage

 

27.8

%

28.3

%

27.2

%

28.0

%

 

Gross margin of 27.8% and 27.2% for the three and six months ended March 27, 2004, respectively, declined from 28.3% and 28.0% for the same periods in 2003. The year-over-year declines in quarterly and year-to-date gross margins were primarily due to the increase in mix towards more lower margin iPod and 1:1 iBook sales, pricing actions on certain Power Macintosh G5 models that were transitioned during 2004, purchase order cancellation costs associated with these G5 product transitions, and higher freight and duty costs in the current year. Also contributing to the reduction in gross margin were higher warranty costs on certain portable Macintosh products.

 

Operating Expenses

Operating expenses for the three and six months ended March 27, 2004 and March 29, 2003 were as follows (in millions, except for percentages):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

3/27/04

 

3/29/03

 

3/27/04

 

3/29/03