UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

(Mark One)

 

 

Commission file number 0-10030

 

 

APPLE COMPUTER, INC.

(Exact name of Registrant as specified in its charter)

 

 

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

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common Stock, no par value

Common Share Purchase Rights

(Titles of classes)

 

 

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 Exchange Act Rule 12b-2).

 

Yes   ý   No   o

 

365,611,414 shares of Common Stock Issued and Outstanding as of May 2, 2003

 

 

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 29, 2003			March 30, 2002			March 29, 2003			March 30, 2002
Net sales		$	1,475		$	1,495		$	2,947		$	2,870
Cost of sales		1,057			1,086			2,123			2,039
Gross margin		418			409			824			831
Operating expenses:
Research and development		119			111			240			224
Selling, general, and administrative		300			270			599			559
Restructuring costs		3			—			26			24
Total operating expenses		422			381			865			807
Operating income (loss)		(4		)	28			(41		)	24
Gains on non-current investments, net		—			—			—			23
Interest and other income, net		23			27			52			61
Total interest and other income, net		23			27			52			84
Income before provision for income taxes		19			55			11			108
Provision for income taxes		5			15			3			30
Income before accounting change		14			40			8			78
Cumulative effect of accounting change, net of income taxes of $1		—			—			(2		)	—
Net income		$	14		$	40		$	6		$	78
Earnings per common share before accounting change:
Basic		$	0.04		$	0.11		$	0.02		$	0.22
Diluted		$	0.04		$	0.11		$	0.02		$	0.22
Earnings per common share after accounting change:
Basic		$	0.04		$	0.11		$	0.02		$	0.22
Diluted		$	0.04		$	0.11		$	0.02		$	0.22
Shares used in computing earnings per share (in thousands):
Basic		360,490			353,480			359,774			352,405
Diluted		362,243			365,969			361,591			361,622

 

See accompanying notes to condensed consolidated financial statements.

 

2

 

APPLE COMPUTER, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(in millions, except share amounts)

 

		March 29, 2003			September 28, 2002
ASSETS:
Current assets:
Cash and cash equivalents		$	3,410		$	2,252
Short-term investments		1,116			2,085
Accounts receivable, less allowances of $48 and $51, respectively		492			565
Inventories		41			45
Deferred tax assets		168			166
Other current assets		241			275
Total current assets		5,468			5,388
Property, plant and equipment, net		619			621
Goodwill		85			85
Acquired intangible assets		29			34
Other assets		160			170
Total assets		$	6,361		$	6,298
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Current liabilities:
Accounts payable		$	921		$	911
Accrued expenses		776			747
Current debt		310			—
Total current liabilities		2,007			1,658
Long-term debt		—			316
Deferred tax liabilities and other non-current liabilitiesand other non-current liabilities		215			229
Total liabilities		2,222			2,203
Commitments and contingencies
Shareholders’ equity:
Common stock, no par value; 900,000,000 shares authorized; 365,545,268 and 358,958,989 shares issued and outstanding, respectively		1,919			1,826
Deferred stock compensation		(75		)	(7		)
Retained earnings		2,331			2,325
Accumulated other comprehensive income (loss)		(36		)	(49		)
Total shareholders’ equity		4,139			4,095
Total liabilities and shareholders’ equity		$	6,361		$	6,298

 

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 29, 2003			March 30, 2002
Cash and cash equivalents, beginning of the period		$	2,252		$	2,310
Operating Activities:
Net income		6			78
Cumulative effect of accounting change, net of taxes		2			—
Adjustments to reconcile net income to cash generated by operating activities:
Depreciation, amortization and accretion		62			57
Non-cash restructuring		12			4
Provision for (benefit from) deferred income taxes		(12		)	30
Loss on disposition of property, plant, and equipment		2			4
Gains on sales of short-term investments, net		(18		)	(3		)
Gains on sales of non-current investments, net		—			(23		)
Changes in operating assets and liabilities:
Accounts receivable		73			(178		)
Inventories		4			(15		)
Other current assets		34			(91		)
Other assets		(14		)	(11		)
Accounts payable		10			186
Other current liabilities		47			6
Cash generated by operating activities		208			44
Investing Activities:
Purchase of short-term investments		(1,097		)	(2,897		)
Proceeds from maturities of short-term investments		1,214			1,422
Proceeds from sale of short-term investments		849			319
Proceeds from sale of non-current investments		13			25
Purchases of property, plant, and equipment		(60		)	(79		)
Other		15			(32		)
Cash generated by (used for) investing activities		934			(1,242		)
Financing Activities:
Proceeds from issuance of common stock		16			47
Cash generated by financing activities		16			47
Increase  (decrease) in cash and cash equivalents		1,158			(1,151		)
Cash and cash equivalents, end of the period		$	3,410		$	1,159
Supplemental cash flow disclosures:
Cash paid for interest		$	10		$	10
Cash paid for income taxes, net		$	25		$	7

 

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 personal computing and communicating solutions for sale primarily to education, creative, consumer, and business customers.

 

Basis of Presentation and Preparation

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

 

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 28, 2002, included in its Annual Report on Form 10-K for the year ended September 28, 2002 (the 2002 Form 10-K).

 

Accounting for Asset Retirement Obligations

On September 29, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 143, Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs.  The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made.  The fair value of the liability is added to the carrying amount of the associated asset and this additional carrying amount is depreciated over the life of the asset. All of the Company’s existing asset retirement obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. The Company estimated that as of September 29, 2002, gross expected future cash flows of $9.5 million would be required to fulfill these obligations.

 

As of the date of adoption, the Company recorded a $6 million long-term asset retirement liability and a corresponding increase in leasehold improvements. This amount represents the present value of expected future cash flows associated with returning certain of the Company’s leased properties to original condition. The difference between the gross expected future cash flow of $9.5 million and its present value at September 29, 2002, of $6 million will be accreted over the life of the related leases as an operating expense.  Net of the related income tax effect of approximately $1 million, adoption of SFAS No. 143 resulted in an unfavorable cumulative-effect type adjustment to net income during the first quarter of 2003 of approximately $2 million. This adjustment represents cumulative depreciation and accretion that would have been recognized through the date of adoption of SFAS No. 143 had the statement been applied to the Company’s existing asset retirement obligations at the time they were initially incurred.

 

The following table reconciles changes in the Company’s asset retirement liability for the first six months of 2003 (in millions):

 

Asset retirement liability recorded at 9/29/02		$	5.5
Additional asset retirement obligations recognized		0.3
Accretion recognized		0.9
Asset retirement liability as of 3/29/03		$	6.7

 

5

 

Accounting for Restructuring Charges

In June 2002, the Financial Accounting Standards Board issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs To Exit an Activity (Including Certain Costs Associated with a Restructuring) and requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, as opposed to when management is committed to an exit plan.  SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. This Statement was effective for exit or disposal activities initiated after December 31, 2002. The provisions of SFAS No. 146 were required to be applied prospectively after the adoption date to newly initiated exit activities.

 

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 25, Accounting for Stock Issued to Employees, and has provided pro forma disclosures of the effect on net income and earnings per share as if the fair value-based method had been applied in measuring compensation expense. The Company has elected to follow APB No. 25 because, as discussed below, the alternative fair value accounting provided for under SFAS No. 123, Accounting for Stock-Based Compensation, 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 No. 25, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized.

 

As required under SFAS No. 123, the pro forma effects of stock-based compensation on net income and earnings per common share for employee stock options granted and employee stock purchase plan 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.

 

For purposes of the pro forma disclosures provided pursuant to SFAS No. 123, the expected volatility assumptions used by the Company have been based solely on historical volatility rates of the Company’s common stock. The Company has made no adjustments to its expected volatility assumptions based on current market conditions, current market trends, or expected volatility implicit in market traded options on the Company’s stock. The Company will continue to monitor the propriety of this approach to developing its expected volatility assumption and could determine for future periods that adjustments to historical volatility and/or use of a methodology that is based on the expected volatility implicit in market traded options on the Company’s common stock are more appropriate based on the facts and circumstances existing in future periods.

 

6

 

For purposes of pro forma disclosures, the estimated fair value of the options and shares is amortized to pro forma net income over the options’ vesting period and the shares’ plan period. The Company’s pro forma information for the three and six-month periods ended March 29, 2003 and March 30, 2002 follows (in millions, except per share amounts):

 

		Three Months Ended						Six Months Ended
		3/29/03			3/30/02			3/29/03			3/30/02
Net income  - as reported		$	14		$	40		$	6		$	78
Stock-based employee compensation expense determined under the fair value based method for all awards, net of tax		(50		)	(57		)	(103		)	(113		)
Net loss - pro forma		$	(36	)	$	(17	)	$	(97	)	$	(35	)
Net income per common share - as reported
Basic		$	0.04		$	0.11		$	0.02		$	0.22
Diluted		$	0.04		$	0.11		$	0.02		$	0.22
Net loss per common share - pro forma
Basic		$	(0.10	)	$	(0.05	)	$	(0.27	)	$	(0.10	)
Diluted		$	(0.10	)	$	(0.05	)	$	(0.27	)	$	(0.10	)

 

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 29, 2003, and September 28, 2002 (in millions):

 

		As of 3/29/03			As of 9/28/02
Cash		$	165		$	161
U.S. Treasury and Agency securities		47			47
U.S. corporate securities		2,327			1,952
Foreign securities		871			92
Total cash equivalents		3,245			2,091
U.S. Treasury and Agency securities		699			681
U.S. corporate securities		379			988
Foreign securities		38			416
Total short-term investments		1,116			2,085
Total cash, cash equivalents, and short-term investments		$	4,526		$	4,337

 

The Company’s short-term investment portfolio consists of investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities. The Company’s U.S. corporate securities consist primarily of commercial paper, certificates of deposit, time deposits, and corporate debt securities. Foreign securities consist primarily of foreign commercial paper, certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. dollars. The Company had net unrealized gains on its investment portfolio of $20 million as of September 28, 2002, and net unrealized losses of $1 million as of March 29, 2003. The Company occasionally sells short-term investments prior to their stated maturities. As a result of such sales, the Company recognized gains of $9 million during the second quarter of 2003 and $18 million and $3 million during the first six months of 2003 and 2002, respectively. These gains were included in interest and other income, net.

 

7

 

As of March 29, 2003, and September 28, 2002, $385 million and $1.087 billion, 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 of 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 consolidated balance sheets 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.  The combined fair value of these investments held by the Company was $28 million and $39 million as of March 29, 2003, and September 28, 2002, respectively.

 

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. During the first quarter of 2002, the Company sold 4.7 million shares of ARM stock for both net proceeds and a gain before taxes of $21 million. During the first quarter of 2002, the Company also sold 250,000 shares of Akamai and 117,000 shares of EarthLink stock for net proceeds of approximately $2 million each and a gain before taxes of $710,000 and $223,000, respectively.  No sales of the Company’s non-current debt and equity investments were made in the second quarter of 2003.

 

Debt

The Company currently has debt outstanding in the form of $300 million of aggregate principal amount 6.5% unsecured notes that was originally issued in 1994. The notes, which pay interest semiannually, were sold at 99.925% of par, for an effective yield to maturity of 6.51%. The notes, along with approximately $10 million of related unamortized deferred gains on closed interest rate swaps, are due in February of 2004 and therefore have been classified as current debt as of March 29, 2003.

 

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 revenues 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 2003, 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 2002.

 

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 sometimes enters 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 its long-term debt, and/or 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.

 

8

 

Accounting for Derivative Financial Instruments

On October 1, 2000, the Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 established accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. SFAS No. 133 requires that all derivatives be recognized as either assets or liabilities at fair value. Derivatives that are not hedges must be 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 29, 2003, the Company had a net deferred loss associated with cash flow hedges of approximately $700,000 net of taxes, substantially all of which is expected to be reclassified to earnings by the end of the fourth quarter of fiscal 2003.

 

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

 

Inventories

 

		3/29/03			9/28/02
Purchased parts		$	1		$	9
Work in process		1			—
Finished goods		39			36
Total inventories		$	41		$	45

 

Other Current Assets

 

		3/29/03			9/28/02
Vendor non-trade receivables		$	129		$	142
Other current assets		112			133
Total other current assets		$	241		$	275

 

Property, Plant, and Equipment

 

		3/29/03			9/28/02
Land and buildings		$	346		$	342
Machinery, equipment, and internal-use software		348			367
Office furniture and equipment		70			67
Leasehold improvements		312			281
		1,076			1,057
Accumulated depreciation and amortization		(457		)	(436		)
Total net property, plant, and equipment		$	619		$	621

 

Other Assets

 

		3/29/03			9/28/02
Non-current deferred tax assets		$	62		$	70
Non-current debt and equity investments		28			39
Capitalized software development costs, net		16			19
Other assets		54			42
Total other assets		$	160		$	170

 

9

 

Accrued Expenses

 

		3/29/03			9/28/02
Deferred revenue		$	294		$	253
Accrued marketing and distribution		131			136
Accrued compensation and employee benefits		95			93
Accrued warranty and related costs		68			69
Other current liabilities		188			196
Total accrued expenses		$	776		$	747

 

Interest and Other Income, Net

 

		Three Months Ended						Six Months Ended
		3/29/03			3/30/02			3/29/03			3/30/02
Interest income		$	18		$	29		$	41		$	63
Interest expense		(2		)	(3		)	(4		)	(6		)
Gain on sales of short term investments		9			—			18			3
Other income (expense), net		(2		)	1			(3		)	1
Total interest and other income, net		$	23		$	27		$	52		$	61

 

Inventory Prepayment

In April 2002, the Company made a $100 million prepayment to an Asian supplier for the purchase of components over the following nine months. In return for this deposit, the supplier agreed to supply the Company with a specified level of components during the three consecutive fiscal quarters ending December 28, 2002. Approximately $53 million of this deposit remained unused as of September 28, 2002 and was reflected in the condensed consolidated balance sheets in other current assets. During the first six months of 2003, the remainder of the deposit balance was fully utilized for the purchase of components. The deposit was unsecured and had no stated interest component. The Company imputed an amount to cost of sales and interest income during each period the deposit was outstanding at an appropriate market interest rate to reflect the economics of this transaction.

 

Goodwill and Other Intangible Assets

The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 3 to 7 years. The Company ceased amortization of goodwill at the beginning of fiscal 2002 when it adopted SFAS No. 142, Goodwill and Other Intangible Assets.

 

The following table summarizes the components of gross and net intangible asset balances  (in millions):

 

		As of 3/29/03									As of 9/28/02
		Gross Carrying Amount			Accumulated Amortization			Net Carrying Amount			Gross Carrying Amount			Accumulated Amortization			Net Carrying Amount
Goodwill (a)		$	85		$	—		$	85		$	85		$	—		$	85
Other intangible assets		5			(5		)	—			5			(5		)	—
Acquired technology		42			(13		)	29			42			(8		)	34
Total acquired intangible assets		$	132		$	(18	)	$	114		$	132		$	(13	)	$	119

 

(a)               Accumulated amortization related to goodwill of $55 million arising prior to the adoption of SFAS No. 142 has been reflected in the gross carrying amount of goodwill as of March 29, 2003, and September 28, 2002.

 

Amortization associated with acquired technology for the three and six-month periods ended March 29, 2003 and March 30, 2002 follows (in millions):

 

		Three Months Ended						Six Months Ended
		3/29/03			3/30/02			3/29/03			3/30/02
Acquired technology amortization		$	2		$	1		$	5		$	2

 

10

 

Accrued Warranty and Related Costs

The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end user. The Company also offers a 90-day basic warranty for Apple 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 warranty claim rates, historical 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 six-month periods ended March 29, 2003 and March 30, 2002 (in millions):

 

		Six Months Ended
		3/29/03			3/30/02
Beginning accrued warranty and related costs		$	69		$	87
Cost of warranty claims		(35		)	(42		)
Accruals for product warranties		34			31
Ending accrued warranty and related costs		$	68		$	76

 

Note 4 – Restructuring Actions

 

Fiscal 2003 Restructuring Actions

 

Q2’03 Restructuring Actions

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. The primary focus of 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. The second quarter actions resulted in recognition of severance costs of $2.4 million for termination of 93 employees, 79 of who were terminated prior to the end of the second quarter at a cost of $1.6 million. During the second quarter, an additional $400,000 was accrued for asset write-offs and lease payments on an abandoned facility in the Americas operating segment. Except for certain costs associated with operating leases on the abandoned facility, the Company currently anticipates that substantially all of the remaining accrual will be spent by the end of the third quarter of fiscal 2003.

 

The following table summarizes activity associated with restructuring actions initiated during the second quarter of 2003 (in millions):

 

		Employee Severance Benefits			Asset Impairments			Lease and Contract Cancellations			Totals
Q2’03 Charge		$	2.4		$	0.1		$	0.3		$	2.8
Q2’03 Spending		(1.6		)	—			—			(1.6		)
Q2’03 Non-Cash Charges		—			(0.1		)	—			(0.1		)
3/29/03 Accrual Balance		$	0.8		$	0.0		$	0.3		$	1.1

 

11

 

Q1’03 Restructuring Actions

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 operations at the Company-owned manufacturing 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 will ultimately result in the elimination of 260 positions worldwide, 197 of which were eliminated by the end of the first quarter of 2003.

 

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. 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.

 

During the second quarter of 2003, the Company identified and reversed approximately $150,000 of severance  costs accrued as part of the first quarter 2003 restructuring actions when it was determined the accrual would not be used. As of March 29, 2003, approximately $4 million of the original $5 million accrual for severance had been utilized and a total of 242 positions had been eliminated. Except for certain costs associated with operating leases on closed facilities, the Company currently anticipates that substantially all of the remaining accrual for severance will be spent to eliminate 14 additional positions by the end of the third quarter of fiscal 2003.

 

The following table summarizes activity associated with restructuring actions initiated during the first quarter of 2003 (in millions):

 

		Employee Severance Benefits			Deferred Compensation Write-off			Asset Impairments			Lease Cancellations			Totals
Q1’03 Charge		$	5		$	5		$	7		$	7		$	24
Q1’03 Spending		(3		)	—			—			—			(3		)
Q1’03 Non-Cash Charges		—			(5		)	(7		)	—			(12		)
12/28/02 Accrual Balance		2			—			—			7			9
Q2’03 Spending		(1		)	—			—			(1		)	(2		)
3/29/03 Accrual Balance		$	1		$	0		$	0		$	6		$	7

 

Fiscal 2002 Restructuring Actions

During fiscal 2002, the Company recorded total restructuring charges of approximately $30 million related to actions intended to eliminate certain activities and better align the Company’s operating expenses with existing general economic conditions and to partially offset the cost of continuing investments in new product development and investments in the Company’s Retail operating segment.

 

Q4’02 Restructuring Actions

During the fourth quarter of 2002, the Company’s management approved and initiated restructuring actions with a total cost of approximately $6 million designed to reduce headcount costs in corporate operations and sales and to adjust its PowerSchool product strategy. These restructuring actions resulted in the elimination of approximately 180 positions worldwide at a cost of $1.8 million, 162 of which were eliminated by December 28, 2002. Eliminated positions were primarily in corporate operations, sales, and PowerSchool related research and development in the Americas operating segment. The shift in product strategy at PowerSchool included discontinuing development and marketing of PowerSchool’s PSE product. This shift resulted in the impairment of previously capitalized development costs associated with the PSE product in the amount of $4.5 million. As of March 29, 2003, substantially all of the $2 million severance accrual had been utilized, except for insignificant severance and related costs associated with 12 remaining positions.

 

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The following table summarizes activity associated with restructuring actions initiated during the fourth quarter of 2002 (in millions):

 

		Employee Severance Benefits			Asset Impairments			Totals
Q4’02 Charge		$	2		$	4		$	6
Q4’02 Spending		(2		)	—			(2		)
Q4’02 Non-Cash Charges		—			(4		)	(4		)
9/28/02 Accrual Balance		$	0		$	0		$	0

 

Q1’02 Restructuring Actions

During the first quarter of 2002, the Company’s management approved and initiated restructuring actions with a total cost of approximately $24 million. These restructuring actions resulted in the elimination of approximately 425 positions worldwide at a cost of $8 million. Positions were eliminated primarily in the Company’s operations, information systems, and administrative functions. In addition, these restructuring actions also included significant changes in the Company’s information systems strategy resulting in termination of equipment leases and cancellation of existing projects and activities.  The Company ceased using the assets associated with first quarter 2002 restructuring actions during that same quarter. Related lease and contract cancellation charges totaled $12 million, and charges for asset impairments totaled $4 million. The first quarter 2002 restructuring actions were primarily related to corporate activity not allocated to operating segments. During the first quarter of 2003, the Company reversed the remaining unused accrual of $600,000.

 

The following table summarizes activity associated with restructuring actions initiated during the first quarter of 2002 (in millions):

 

		Employee Severance Benefits			Asset Impairments			Lease and Contract Cancellations			Totals
Q1’02 Charge		$	8		$	4		$	12		$	24
Q1’02 Spending		(5		)	—			—			(5		)
Q1’02 Non-Cash Charges		—			(4		)	—			(4		)
12/29/01 Accrual Balance		$	3		$	0		$	12		$	15
Q2’02 Spending		(1		)	—			(11		)	(12		)
3/30/02 Accrual Balance		$	2		$	0		$	1		$	3
Q3’02 Spending		(1		)	—			—			(1		)
6/26/02 Accrual Balance		$	1		$	0		$	1		$	2
Q4’02 Spending		(1		)	—			—			(1		)
9/28/02 Accrual Balance		$	0		$	0		$	1		$	1
Q1’03 Reversal		—			—			(1		)	(1		)
12/28/02 Accrual Balance		$	0		$	0		$	0		$	0

 

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Note 5 – Shareholders’ Equity

 

CEO Restricted Stock Award

On March 19, 2003, the Company entered into an Option Cancellation and Restricted Stock Award Agreement (the Agreement) with Steven P. Jobs, its Chief Executive Officer.  The Agreement cancelled stock option awards previously granted to Mr. Jobs  in 2000 and 2001 for the purchase of 27.5 million common shares of the Company’s common stock.  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.  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 will amortize 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 on the date of the award.  Quarterly amortization will be approximately $6.3 million and will be recognized as an operating expense.  The 5 million restricted shares will be included in the calculation of diluted earnings per share utilizing the treasury stock method.

 

Stock Repurchase Plan

In July 1999, the Company’s Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock.  This repurchase plan does not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. Since inception of the stock repurchase plan through the end of fiscal 2000, the Company had repurchased a total of 5.05 million shares at a cost of $191 million. No shares have been repurchased since the end of fiscal 2000. During the fourth quarter of 2001, the Company entered into a forward purchase agreement to acquire 1.5 million shares of its common stock in September of 2003 at an average price of $16.64 per share for a total cost of $25.5 million.  The total cost to acquire the same number of shares at the closing price of the Company's common stock on March 29, 2003, would be approximately $22.3 million.

 

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 is comprised of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, from unrealized gains and losses on marketable securities categorized as available-for-sale, and from 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 29, 2003, and March 30, 2002 (in millions):

 

		Three Months Ended						Six Months Ended
		3/29/03			3/30/02			3/29/03			3/30/02
Net income		$	14		$	40		$	6		$	78
Other comprehensive income:
Net change in unrealized derivative gains/losses		5			(12		)	10			13
Change in accumulated translation adjustment		6			(1		)	14			(4		)
Net change in unrealized investment gains losses		—			(21		)	3			(32		)
Reclassification adjustment for investment gains included in net income		(7		)	—			(14		)	(17		)
Total comprehensive income		$	18		$	6		$	19		$	38

 

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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 ending March 29, 2003 and March 30, 2002 (in millions):

 

		Three Months Ended						Six Months Ended
		3/29/03			3/30/02			3/29/03			3/30/02
Change in fair value of derivatives		$	—		$	4		$	(4	)	$	30
Adjustment for net losses (gains) realized and included in net income		5			(16		)	14			(17		)
Change in unrealized gain on derivative instruments		5			(12		)	10			13

 

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

 

		As of 3/29/03			As of 9/28/02
Unrealized gains on available-for-sale securities		$	2		$	13
Unrealized losses on derivative investments		(1		)	(11		)
Cumulative translation adjustments		(37		)	(51		)
Accumulated other comprehensive income (loss)		$	(36	)	$	(49	)

 

Note 6 – Employee Benefit Plans

 

1998 Executive Officer Stock Plan

The 1998 Executive Officer Stock Plan (the 1998 Plan) is a shareholder approved plan which replaced the 1990 Stock Option Plan terminated in April 1998, the 1981 Stock Option Plan terminated in October 1990, and the 1987 Executive Long Term Stock Option Plan terminated in July 1995. Options granted before these plans’ termination dates remain outstanding in accordance with their terms. Options may be granted under the 1998 Plan to the Chairman of the Board of Directors, executive officers of the Company at the level of Senior Vice President and above, and other key employees. These options generally become exercisable over a period of 4 years, based on continued employment, and generally expire 10 years after the grant date. The 1998 Plan permits the granting of incentive stock options, nonstatutory stock options, 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. Options may be granted under the 1997 Plan to employees at not less than the fair market value on the date of grant. These options generally become exercisable over a period of 4 years, based on continued employment, and generally expire 10 years after the grant date.

 

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.

 

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 29, 2003, approximately 1 million shares were reserved for issuance under the Purchase Plan.

 

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Subsequent Event – Employee Stock Plans

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, to provide for broad-based grants to all employees in addition to executive officers and other key employees and to prohibit “repricings” including 6-months-plus-1-day option exchange programs without shareholder approval.  Since the amendment was approved, the Company will terminate the 1997 Employee Stock Option Plan and cancel all remaining unissued shares, following the completion of the employee stock option exchange program.  In addition, shareholders also approved an amendment to the Employee Stock Purchase Plan to increase the number of shares authorized for issuance by 4 million shares.

 

Stock Option Activity

 

A summary of the Company’s stock option activity and related information for the six month periods ended March 29, 2003, and March 30, 2002 follows (option amounts are presented in thousands):

 

				Outstanding Options
		Shares Available For Grant		Number of Shares		Weighted Average Exercise Price
Balance at 9/28/02		6,571		109,430		$	28.17
Options Granted		(2,278	)	2,278		$	14.93
Restricted Share Grant		(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
Balance at 9/29/01		10,075		97,179		$	29.25
Additional Options Authorized		10,000		—
Options Granted		(20,461	)	20,461		$	19.83
Options Cancelled		2,376		(2,376	)	$	32.15
Options Exercised		—		(2,375	)	$	13.61
Plan Shares Expired		(2	)	—
Balance at 3/30/02		1,988		112,889		$	27.81

 

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The options outstanding as of March 29, 2003, have been segregated into five ranges for additional disclosure as follows (option amounts are presented in thousands):

 

		Options Outstanding							Options Exercisable
		Options Outstanding as of March 29, 2003		Weighted- Average Remaining Contractual Life in Years		Weighted Average Exercise Price			Options Exercisable as of March 29, 2003		Weighted Average Exercise Price
$  0.83 - $17.09		19,263		6.49		$	13.70		13,218		$	12.76
$17.10 - $18.50		23,039		7.25		$	18.22		13,187		$	18.18
$18.51 - $25.45		19,318		8.36		$	21.19		7,042		$	20.96
$25.46 - $47.44		13,703		6.74		$	45.15		9,760		$	45.36
$47.45 - $69.78		6,092		7.17		$	53.84		3,207		$	54.03
$  0.83 - $69.78		81,415		7.24		$	25.05		46,414		$	25.25

 

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, have 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 that will be granted at the fair market value on the day of the new grant, 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 accepted and cancelled options to purchase 16,569,193 shares of its common stock and issued a promise to grant approximately 6,892,309 new options to participating employees. Options cancelled pursuant to the Exchange Program are reflected as outstanding as of March 29, 2003, in the preceding tables. The new stock options will be granted on October 20, 2003, which is the first business day that is six months and one day after cancellation of the exchanged options. No financial or accounting impact to the Company’s financial position, results of operations or cash flow for the three months ended March 29, 2003, was associated with this transaction.

 

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 a Black-Scholes option pricing model.

 

The assumptions used for the three and six-month periods ended March 29, 2003, and March 30, 2002, 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
		3/29/03			3/30/02			3/29/03			3/30/02
Expected life of stock options		4 years			4 years			4 years			4 years
Expected life of stock purchases		N/A			N/A			6 months			6 months
Interest rate - stock options		2.43		%	4.46		%	2.44		%	3.94		%
Interest rate - stock purchases		N/A			N/A			1.75		%	3.61		%
Volatility - stock options		62		%	64		%	63		%	64		%
Volatility - stock purchases		N/A			N/A			44		%	50		%
Dividend yields		—			—			—			—
Weighted-average fair value of options granted during the period		$	7.12		$	12.39		$	7.38		$	10.17
Weighted-average fair value of employee stock purchases during the period		N/A			N/A			$	4.67		$	7.01

 

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Note 8 – 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 12 years and often contain multi-year renewal options. As of September 28, 2002, the Company’s total future minimum lease payments under noncancelable operating leases were $464 million, of which $209 million related to leases for retail space.  As of March 29, 2003, total future minimum lease payments related to leases for retail space increased to $305 million.

 

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. Plaintiffs filed their amended complaint on January 31, 2003, and on March 17, 2003, the Company filed a motion to dismiss the amended complaint. A hearing on the Company’s motion is currently scheduled for July 2003.

 

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 have a material adverse effect on its financial condition, liquidity or results of operations. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected.

 

The parliament of the European Union has finalized the Waste Electrical and Electronic Equipment Directive (the Directive). The Directive makes producers of electrical goods, including personal computers, financially responsible for the collection, recycling, and safe disposal of past and future products. The Directive must now be approved and implemented by individual European Union governments by August 13, 2004, while the producers’ financial obligations are scheduled to start August 13, 2005. The Company’s potential liability resulting from the Directive related to past sales of its products and expenses associated with future sales of its product may be substantial. However, because it is likely that specific laws, regulations, and enforcement policies will vary significantly between individual European member states, it is not currently possible to estimate the Company’s existing liability or future expenses resulting from the Directive. As the European Union and its individual member states clarify specific requirements and policies with respect to the Directive, the Company will continue to assess its potential financial impact. Similar legislation may be enacted in other geographies, including federal and state legislation in the United States, the cumulative impact of which could be significant.

 

Note 9 - Segment Information and Geographic Data

 

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. The Retail segment operates Apple-owned retail stores in the United States. 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

 

18

 

accounting policies of the various segments are the same as those described in the Summary of Significant Accounting Policies in Note 1, 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 revenue from third parties, 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 $30 million and $24 million during the first six months of 2003 and during the second quarter of 2003, respectively.

 

Operating income for all segments, except Retail, includes cost of sales at standard cost. 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.

 

To assess the operating performance of the Retail segment several significant items are included in its results for internal management reporting that are not included in results of the Company’s other segments. First, cost of sales for the Retail segment includes a mark-up above the Company’s standard cost to approximate the price normally charged to the Company’s resellers operating retail stores in the United States. For the second quarter of 2003 and the second quarter of 2002, 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 $23 million and $21 million, respectively. For the first six months of 2003 and the first six months of 2002, 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 $46 million and $30 million, respectively.

 

Second, the Retail segment includes in its net sales proceeds from sales of the Company’s extended warranty and support contracts and also recognizes related cost of sales based on the amount such contracts are normally sold to the Company’s resellers operating retail stores in the United States. This treatment is consistent with how the Company’s major resellers account for the sales and cost of the Company’s extended warranty and support 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 the Americas segment’s net sales and cost of sales. For the second quarter of 2003, this resulted in the recognition of additional net sales and cost of sales by the Retail segment, with corresponding offsets in the Americas segment, of $6.3 million and $4.3 million, respectively. For the second quarter of 2002, the net sales and cost of sales recognized by the Retail segment for sales of extended warranty and support contracts were $1.9 million and $1.4 million, respectively. For the first six months of 2003, this resulted in the recognition of additional net sales and cost of sales by the Retail segment, with corresponding offsets in the Americas segment, of $12.2 million and $8.5 million, respectively. This compares to similar adjustments to net sales and cost of sales during the first six months of 2002 of $3.0 million and $2.1 million, respectively.

 

Third, a portion of the operating expenses associated with certain high profile retail stores is allocated from the Retail segment to corporate marketing expense. Allocation of these expenses reflects the unique nature of these stores which, given their larger size and extraordinary design elements, function as vehicles for general corporate marketing, corporate sales and marketing events, and brand awareness.  Allocated operating costs are those in excess of operating costs incurred by one of the Company’s more typical retail locations. Stores were open in two such high profile locations in New York and Los Angeles as of March 29, 2003, both of which were opened in fiscal 2002. Expenses allocated to corporate marketing resulting from the operations of these two stores were $1.1 million in the second quarter of 2003 and $2.2 million for the six-months ended March 29, 2003. These costs were not significant during the first half of 2002.

 

19

 

Summary information by operating segment follows (in millions):

 

 

(a)                                  Other Segments consists of Asia-Pacific and FileMaker. Certain amounts in 2002 fiscal periods related to recent acquisitions and Internet services have been reclassified from Other Segments to the Americas segment to conform to the  2003 presentation.

 

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

 

 

Note 10 - 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 and restricted stock is reflected in diluted earnings per share by application of the treasury stock method.

 

20

 

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

 

 

Options to purchase approximately 74 and 44 million shares of common stock that were outstanding at March 29, 2003 and March 30, 2002, respectively, were not included in the computation of diluted earnings per share for the quarters then ended because the options’ exercise price was greater than the average market price of the Company’s common stock during those quarters and therefore, their effect would have been antidilutive. Additionally, 5 million shares of restricted stock were not included in the computation of diluted earnings per share for the second quarter of 2003 because their effect would have been antidilutive.

 

Note 11 – 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 is 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 $77,000 in expenses pursuant to this reimbursement agreement during the second quarter of 2003, and $161,000 in expenses for the six-months ended March 29, 2003. For fiscal 2002, the Company recognized a total of $1,168,000 in expenses pursuant to this reimbursement agreement related to expenses incurred by Mr. Jobs during 2001 and 2002.

 

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. He also serves as its Chairman, President and Chief Executive Officer. MicroWarehouse is a multi-billion dollar specialty catalogue and online retailer and direct marketer of computer products, including products made by the Company, through its MacWarehouse catalogue.  MicroWarehouse accounted for 2.8% and 3.0% of the Company’s net sales for the three and six-month periods ended March 29, 2003, respectively, and 3.3% of the Company’s net sales in fiscal 2002. Trade receivables from MicroWarehouse were $20.2 million and $20.9 million as of March 29, 2003, and September 28, 2002, respectively. Sales to MicroWarehouse and related trade receivables are generally subject to the same terms and conditions as those with the Company’s other resellers. In addition, the Company purchases 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, respectively, and $2.9 million in fiscal 2002.

 

21

 

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. 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 2002 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.

 

Available Information

Beginning in fiscal 2003, 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 our website at www.apple.com/investor when such reports are available on the Securities and Exchange Commission website. The contents of this website are not incorporated into this filing.  Further, our reference to the URL for this website is intended to be an inactive textual reference only.

 

Critical Accounting Policies

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 2002 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 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 policies 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, and valuation of non-current debt and equity investments. 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. Additional information about these critical accounting policies may by found in the Company’s 2002 Form 10-K in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under the heading “Critical Accounting Policies.”

 

Accounting for Stock-Based Compensation

The Company currently measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees and provides pro forma disclosures of the effect on net income and earnings per share as if the fair value-based method had been applied in measuring compensation expense. The Company has elected to follow APB No. 25 because, as discussed in Note 1 of the Notes to Condensed Consolidated Financial Statements provided in this Form 10-Q, the alternative fair value accounting provided for under SFAS No. 123, Accounting for Stock-Based Compensation, 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 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.

 

The Financial Accounting Standards Board (FASB) decided on April 22, 2003, to require all companies to expense the value of employee stock options. Companies will be required to measure the cost of employee stock options according to their fair value. The FASB has indicated that later this year it plans to issue an exposure draft of a new accounting standard addressing this matter. This new accounting standard  could become effective as early as 2004. Prior to issuance of this exposure draft, the FASB has indicated it will be addressing several significant technical issues. Among other things, the FASB must determine the extent to which the new accounting standard will permit adjustments to recognized expense for actual option forfeitures and actual performance outcomes. This determination will affect the amount of compensation cost recognized. Also, a method to determine the fair value of employee stock options must be established. Current accounting standards require use of an option-pricing model,

 

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such as the Black-Scholes model, to determine fair value and provide guidance on adjusting some of the input factors used in the model. This valuation approach has received significant criticism and may be subject to changes that could have a significant impact on the calculated fair value of employee stock options under the new standard.

 

The Company has provided formal input to both the FASB and the International Accounting Standards Board  (IASB) regarding the IASB’s exposure draft on stock-based compensation and the FASB’s efforts to achieve maximum convergence on accounting for stock-based compensation between U.S. and international accounting standards. The Company believes it is important to be involved in the development of accounting standards and plans on continuing its involvement in the process of developing new U.S. and international accounting standards regarding the accounting for employee stock options.

 

At the Company’s annual shareholder’s meeting on April 24, 2003, shareholders approved a proposal requesting that the Company’s Board of Directors (the Board) establish a policy of expensing the value of all future employee stock options issued by the Company. The Board and management appreciates and takes seriously the views expressed by the Company’s shareholders. However, in light of the FASB’s announced intention to soon require all companies to expense the value of employee stock options and the FASB’s near-term review of technical issues that will play a significant role in determining the value of and accounting for employee stock options, the Company does not currently intend to expense the value of employee stock options until the FASB finalizes its new accounting standard on the matter.

 

Internet Services Update

In April 2003, the Company launched the iTunes® Music Store, an online music store that allows customers to  find, purchase, and download music for 99 cents per song. Requiring no subscription fee, the iTunes Music Store offers customers a broad range of personal rights to the songs they purchase including playing songs on up to three Macintosh® computers, burning songs onto an unlimited number of CD’s for personal use, playing songs on an unlimited number of iPod™ portable digital music players, and using songs in any application on their Macintosh system including iPhoto™, iMovie™, and iDVD™. The iTunes Music Store currently features over 200,000 songs.

 

Users can easily search the contents of the entire music store to locate songs by title, artist, or album, or browse the entire contents of the music store by genre and artist. Users can also listen to a free 30-second preview of any song in the store. The iTunes Music Store is fully integrated into the latest version of iTunes, allowing customers to purchase, download, organize, share, and listen to their digital music using a single application.

 

Hardware Products Update

 

iPod™

The Company introduced new iPod models in April 2003. The new iPod is smaller and lighter and is available in three models with storage capacity of either 10GB, 15GB, or 30GB; the latter holding up to 7,500 songs. In addition to MP3, iPod now supports the AAC audio format. The new iPod also features solid-state interfaces and is available with a new dock that facilitates fast and easy connection to a computer or stereo.

 

Xserve® and Xserve RAID Storage System

In February 2003, the Company upgraded its Xserve 1U rack servers with more powerful processors, more storage capacity, and a FireWire® 800 interface. At the same time, the Company introduced the Xserve RAID Storage System, a rack storage system that holds up to 14 hot-swapable drive modules capable of holding up to 2.5 terabytes of data. Xserve RAID architecture combines affordable, high-capacity ATA/100 drive technology with a Fibre channel interface for reliable and fast data access. Xserve RAID provides RAID level 5 throughput that supports affordable real-time HD 1080i video editing.

 

PowerBook®

In January 2003, the Company introduced two new PowerBook models. The 17-inch PowerBook G4 features a 17-inch active-matrix display, is encased in a durable aluminum alloy enclosure, is 1-inch thick, and weighs as little as 6.8 pounds. The new 17-inch PowerBook G4 also features built-in support for AirPort® Extreme 54 Mbps 802.11g wireless networking, new high-speed FireWire 800, a backlit keyboard with ambient light sensors, and built-in Bluetooth for wireless connection to cell phones and other Bluetooth equipped peripherals. The 12-inch PowerBook G4 features a 12-inch, active-matrix display housed in a lightweight, durable aluminum alloy enclosure weighing

 

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approximately 4.6 pounds. The 12-inch PowerBook G4 features a high-speed PowerPC G4 processor, NVIDIA graphics, built-in Bluetooth wireless networking, and battery life of up to five hours on a single charge.

 

Power Mac®

In January 2003, the Company announced a refresh of its Power Macintosh® line of professional desktop systems. The new line is priced significantly lower than the models it replaces and features faster processors, FireWire 800, and internal support for 54Mbps AirPort Extreme and Bluetooth wireless networking.

 

Peripheral Products Update

In January 2003, the Company introduced the 20-inch Apple Cinema Display® and instituted significant price reductions on its 23-inch Cinema HD Display and its 17-inch Apple Studio Display®. The new 20-inch Apple Cinema Display features an active-matrix, liquid crystal display that incorporates a digital interface.

 

Software Products and Computer Technologies Update

 

Final Cut Pro® 4

Final Cut Pro 4, a major upgrade to the Company’s professional editing software for film and video, was announced in April 2003. Final Cut Pro 4 introduces RT Extreme for real-time compositing and effects, new interface customization tools, new high-quality 8- and 10-bit uncompressed formats, and for the first time in an editing system costing less than $100,000, full 32-bit floating point per channel video processing. Final Cut Pro 4 also includes three completely new integrated applications – Live Type for advanced titling, Soundtrack for music creation, and Compressor for full featured batch transcoding.

 

DVD Studio Pro® 2

The Company announced DVD Studio Pro 2 in April 2003. It is a completely new DVD authoring product, rebuilt from the ground up with a new user interface, professionally designed and fully customizable templates, an innovative new menu editor, timeline-based track editing and a new software-based MPEG-2 encoder.

 

Shake® 3

The Company announced Shake 3 in April 2003, an upgrade of its compositing and visual effects software. Shake 3 includes new Mac® OS X only features such as the Shake Qmaster network render management software and unlimited network rendering licenses which allow visual effects artists to easily distribute rendering tasks across a cluster of Apple’s Xserve rack servers or desktop Power Mac G4 computers for maximum performance and efficiency. Shake 3 also includes new visual effects features available to Mac OS X, Linux and IRIX customers including motion-tracking and real-time broadcast preview.

 

Final Cut® Express

Final Cut Express is a new product based on Apple’s award-winning Final Cut Pro®. Final Cut Express enables small business users, educators, students and advanced hobbyists to perform professional-quality digital video editing. Final Cut Express includes key features used by video editors such as the same interface and workflow as Final Cut Pro, powerful video editing tools, hundreds of special effects, and easy delivery of output to DVD, the Internet, or tape.

 

Keynote™

Keynote is the Company’s new presentation software that gives users the ability to create high-quality presentations. Designed to be easy to use, Keynote includes professionally designed themes, advanced typography, professional-quality image resizing, animated charts and tables that can be created quickly, and cinematic-quality transitions.  Keynote imports and exports PowerPoint, QuickTime®, and PDF files to simplify the creation and sharing of presentations.

 

iLife™

Introduced in January 2003, iLife is the Company’s integrated suite of four digital lifestyle applications that features the Company’s iTunes®, iPhoto™, iMovie™, and iDVD™ software applications. These applications are integrated to allow users to easily access their digital music, photos and movies from within each application.

 

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Safari™ Public Beta

Safari is the Company’s new Mac OS® X compatible web browser that is capable of loading web pages more quickly than any other Macintosh-based web browser. Safari uses the advanced interface technologies underlying Mac OS X.

 

Airport® Extreme

AirPort Extreme is the Company’s next generation of Wi-Fi wireless networking technology based on the new ultra-fast 802.11g standard. With speeds up to 54 Mbps, AirPort Extreme delivers almost five times the data rate of today’s 802.11b based products, yet is fully compatible with the millions of 802.11b Wi-Fi devices around the world.  The new AirPort Extreme Base Stations offer 54 Mbps data rates for up to 50 users, wireless bridging to extend the range beyond just one base station, and USB printer sharing to allow multiple users to wirelessly share USB printers connected directly to the base station.

 

Business Outlook

For the third quarter of 2003, the Company expects net sales, gross margin, and total operating expenses to be relatively flat as compared to the second quarter of 2003. The Company expects third quarter interest and other income, net to decline significantly to approximately $15 million. As a result, the Company currently expects to report a slight profit for the third quarter of 2003.

 

The foregoing statements concerning the Company’s anticipated net sales, gross margin, operating expenses, interest and other income, net, and earnings for the third quarter of 2003 are forward-looking. The Company’s actual results could differ. The Company’s future operating results and financial condition are dependent upon general economic conditions, market conditions within the PC industry, and the Company’s ability to successfully develop, manufacture, and market technologically innovative products in order to meet the dynamic conditions within the highly competitive market for personal computers. Some of the potential risks and uncertainties that could affect the Company’s future operating results and financial condition are discussed throughout this Item 2, including the discussion under the heading below “Factors That May Affect Future Results and Financial Condition,” and in the 2002 Form 10-K.

 

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Net Sales

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

 

		Three Months Ended									Six Months Ended
		3/29/03			3/30/02			Change			3/29/03			3/30/02			Change
Net Sales by Operating Segment:
Americas net sales (a)		$	684		$	736		(7	)%		$	1,422		$	1,439		(1	)%
Europe net sales		338			365			(7	)%		689			728			(5	)%
Japan net sales		220			227			(3	)%		359			410			(12	)%
Retail net sales		135			70			93	%		283			118			140	%
Other segments net sales (a)		98			97			1	%		194			175			11	%
Total net sales		$	1,475		$	1,495		(1	)%		$	2,947		$	2,870		3	%
Unit Sales by Operating Segment:
Americas Macintosh unit sales		338			401			(16	)%		715			783			(9	)%
Europe Macintosh unit sales		180			211			(15	)%		382			426			(10	)%
Japan Macintosh unit sales		107			131			(18	)%		178			228			(22	)%
Retail Macintosh unit sales		42			24			75	%		88			38			132	%
Other segments Macintosh unit sales (a)		44			46			(4	)%		91			84			8	%
Total Macintosh unit sales		711			813			(13	)%		1,454			1,559			(7	)%
Net Sales by Product:
Power Macintosh net sales (b)		$	293		$	383		(23	)%		$	585		$	749		(22	)%
PowerBook net sales		353			198			78	%		588			455			29	%
iMac net sales		302			448			(33	)%		658			652			1	%
iBook net sales		151			180			(16	)%		367			424			(13	)%
Total Macintosh net sales		1,099			1,209			(9	)%		2,198			2,280			(4	)%
Peripherals and other hardware (c)		216			153			41	%		434			333			30	%
Software (d)		95			72			32	%		183			135			36	%
Service and other sales		65			61			7	%		132			122			8	%
Total other net sales		376			286			31	%		749			590			27	%
Total net sales