UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-Q


(Mark One)

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

 

For the quarterly period ended June 30, 2007

 

or

 

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

 

For the transition period from                to                 .

 

Commission File Number: 000-10030


APPLE INC.

(Exact name of registrant as specified in its charter)


CALIFORNIA

 

942404110

(State or other jurisdiction

 

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

of incorporation or organization)

 

 

 

 

 

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 x    No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o    No  x

869,640,955 shares of common stock issued and outstanding as of July 25, 2007

 




PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

APPLE INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(in millions, except share and per share amounts)

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

June 30, 
2007

 

July 1, 
2006

 

June 30, 
2007

 

July 1, 
2006

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

5,410

 

$

4,370

 

$

17,789

 

$

14,478

 

Cost of sales (1)

 

3,415

 

3,045

 

11,725

 

10,292

 

Gross margin

 

1,995

 

1,325

 

6,064

 

4,186

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development (1)

 

208

 

175

 

575

 

533

 

Selling, general, and administrative (1)

 

746

 

584

 

2,140

 

1,808

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

954

 

759

 

2,715

 

2,341

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

1,041

 

566

 

3,349

 

1,845

 

 

 

 

 

 

 

 

 

 

 

Other income and expense

 

155

 

95

 

429

 

252

 

 

 

 

 

 

 

 

 

 

 

Income before provision for income taxes

 

1,196

 

661

 

3,778

 

2,097

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

378

 

189

 

1,186

 

650

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

818

 

$

472

 

$

2,592

 

$

1,447

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.94

 

$

0.55

 

$

3.01

 

$

1.72

 

Diluted

 

$

0.92

 

$

0.54

 

$

2.92

 

$

1.65

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

Basic

 

866,806

 

851,375

 

862,500

 

840,759

 

Diluted

 

890,671

 

876,368

 

887,095

 

876,971

 

 

(1) Stock-based compensation expense was allocated as follows:

 

 

 

 

 

 

 

 

 

Cost of sales

 

$

10

 

$

6

 

$

25

 

$

16

 

Research and development

 

$

20

 

$

12

 

$

56

 

$

40

 

Selling, general, and administrative

 

$

35

 

$

19

 

$

93

 

$

67

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

2




APPLE INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
(in millions, except share amounts)

 

 

June 30, 2007

 

September 30, 2006

 

ASSETS:

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

7,118

 

$

6,392

 

Short-term investments

 

6,649

 

3,718

 

Accounts receivable, less allowances of $47 and $52, respectively

 

1,410

 

1,252

 

Inventories

 

251

 

270

 

Deferred tax assets

 

687

 

607

 

Other current assets

 

2,630

 

2,270

 

Total current assets

 

18,745

 

14,509

 

 

 

 

 

 

 

Property, plant and equipment, net

 

1,626

 

1,281

 

Goodwill

 

38

 

38

 

Acquired intangible assets, net

 

237

 

139

 

Other assets

 

1,001

 

1,238

 

 

 

 

 

 

 

Total assets

 

$

21,647

 

$

17,205

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY:

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

3,660

 

$

3,390

 

Accrued expenses

 

3,332

 

3,053

 

Total current liabilities

 

6,992

 

6,443

 

Non-current liabilities

 

1,251

 

778

 

Total liabilities

 

8,243

 

7,221

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Common stock, no par value; 1,800,000,000 shares authorized; 869,161,821 and 855,262,568 shares issued and outstanding, respectively

 

5,149

 

4,355

 

Retained earnings

 

8,199

 

5,607

 

Accumulated other comprehensive income

 

56

 

22

 

Total shareholders’ equity

 

13,404

 

9,984

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

21,647

 

$

17,205

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

3




APPLE INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(in millions)

 

 

Nine Months Ended

 

 

 

June 30, 2007

 

July 1, 2006

 

Cash and cash equivalents, beginning of the period

 

$

6,392

 

$

3,491

 

Operating Activities:

 

 

 

 

 

Net income

 

2,592

 

1,447

 

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

 

 

 

 

 

Depreciation, amortization, and accretion

 

224

 

159

 

Stock-based compensation expense

 

174

 

123

 

Provision for deferred income taxes

 

206

 

201

 

Gain on sale of PowerSchool net assets

 

 

(4

)

Loss on disposition of property, plant, and equipment

 

7

 

5

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(158

)

(194

)

Inventories

 

19

 

(48

)

Other current assets

 

(363

)

(880

)

Other assets

 

254

 

(1,113

)

Accounts payable

 

270

 

734

 

Other liabilities

 

549

 

735

 

Cash generated by operating activities

 

3,774

 

1,165

 

Investing Activities:

 

 

 

 

 

Purchases of short-term investments

 

(9,587

)

(4,393

)

Proceeds from maturities of short-term investments

 

4,246

 

7,827

 

Proceeds from sales of short-term investments

 

2,420

 

175

 

Purchases of long-term investments

 

(6

)

(12

)

Proceeds from sale of PowerSchool net assets

 

 

40

 

Purchases of property, plant, and equipment

 

(530

)

(512

)

Payment for acquisition of intangible assets

 

(222

)

 

Other

 

34

 

(39

)

Cash (used for) generated by investing activities

 

(3,645

)

3,086

 

Financing Activities:

 

 

 

 

 

Proceeds from issuance of common stock

 

294

 

286

 

Excess tax benefits from stock-based compensation

 

303

 

339

 

Repurchases of common stock

 

 

(354

)

Cash generated by financing activities

 

597

 

271

 

Increase in cash and cash equivalents

 

726

 

4,522

 

Cash and cash equivalents, end of the period

 

$

7,118

 

$

8,013

 

 

 

 

 

 

 

Supplemental cash flow disclosure:

 

 

 

 

 

 

 

 

 

 

 

Cash paid for income taxes, net

 

$

688

 

$

108

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

4




APPLE INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1 - Summary of Significant Accounting Policies

Apple Inc. and its wholly-owned subsidiaries (“Apple” or the “Company”) designs, manufactures, and markets personal computers, portable digital music players, and mobile phones and sells a variety of related software, services, peripherals, and networking solutions. The Company sells its products worldwide through its online stores, its retail stores, its direct sales force, and third-party wholesalers, resellers, and value-added resellers. In addition, the Company sells a variety of third-party Macintosh, iPod and iPhone compatible products including application software, printers, storage devices, speakers, headphones, and various other accessories and supplies through its online and retail stores. The Company sells to education, consumer, creative professional, business, and government customers.

Basis of Presentation and Preparation

The accompanying condensed consolidated financial statements include the accounts of the Company.  Intercompany accounts and transactions have been eliminated. The preparation of these condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior year amounts in the condensed consolidated financial statements and notes thereto have been reclassified to conform to the current year presentation.

These condensed consolidated financial statements and accompanying notes should be read in conjunction with the Company’s annual consolidated financial statements and the notes thereto for the fiscal year ended September 30, 2006, included in its Annual Report on Form 10-K for the year ended September 30, 2006 (the “2006 Form 10-K”).

The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company’s first quarter of fiscal year 2007 contained 13 weeks and the first quarter of fiscal year 2006 contained 14 weeks. The Company’s fiscal year 2007 will end on September 29, 2007 and include 52 weeks while fiscal year 2006 included 53 weeks. Unless otherwise stated, references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years.

Revenue Recognition

In March 2007, the Company began shipping Apple TV and in June 2007 began shipping iPhone.  For Apple TV and iPhone, the Company indicated it may provide future unspecified features and additional software products free of charge to customers.  Accordingly, Apple TV and iPhone handsets sales are accounted for under subscription accounting in accordance with the American Institute of Certified Public Accountants Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition.  As such, the Company defers the associated revenue and cost of goods sold at the time of sale, and recognizes both on a straight-line basis over the currently estimated 24-month economic life of these products.  Costs incurred by the Company for engineering, sales, and marketing are expensed as incurred.

The Company records revenue net of taxes collected from customers that are remitted to governmental authorities. These taxes are recorded as current liabilities until remitted to the relevant government authority.

Software Development Costs

Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a 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 most software development costs have been expensed.

5




In the second quarter of 2007, the Company determined that both Mac OS X version 10.5 Leopard (“Leopard”) and iPhone achieved technological feasibility. During the second and third quarters of 2007, the Company capitalized approximately $27 million and $26 million, respectively, of costs associated with the development of Leopard and iPhone. In accordance with SFAS No. 86, the capitalized costs related to Leopard and iPhone are amortized to cost of sales commencing when each respective product begins shipping and are recognized on a straight-line basis over a 3 year estimated useful life of the underlying technology.

Earnings Per Share

Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of outstanding options, shares to be purchased under the employee stock purchase plan, unvested restricted stock and restricted stock units (“RSUs”) is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from outstanding options, restricted stock, and RSUs.  Additionally, the exercise of employee stock options and the vesting of restricted stock and RSUs can result in a greater dilutive effect on earnings per share.

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

 

Three
Months Ended

 

Nine
Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

Numerator (in millions):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

818

 

$

472

 

$

2,592

 

$

1,447

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding, excluding unvested restricted stock

 

866,806

 

851,375

 

862,500

 

840,759

 

Effect of dilutive securities

 

23,865

 

24,993

 

24,595

 

36,212

 

 

 

 

 

 

 

 

 

 

 

Denominator for diluted earnings per share

 

890,671

 

876,368

 

887,095

 

876,971

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.94

 

$

0.55

 

$

3.01

 

$

1.72

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.92

 

$

0.54

 

$

2.92

 

$

1.65

 

 

Potentially dilutive securities representing approximately 12.0 million and 3.0 million shares of common stock for the quarters ended June 30, 2007 and July 1, 2006, respectively, and 13.2 million and 3.3 million shares of common stock for the nine months ended June 30, 2007 and July 1, 2006, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive. Potentially dilutive securities include stock options, shares to be purchased under the employee stock purchase plan, and RSUs.

6




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 June 30, 2007, and September 30, 2006 (in millions):

 

6/30/07

 

9/30/06

 

Cash

 

$

184

 

$

200

 

 

 

 

 

 

 

U.S. Treasury and Agency securities

 

 

52

 

U.S. Corporate Securities

 

5,169

 

4,309

 

Foreign Securities

 

1,765

 

1,831

 

Total cash equivalents

 

6,934

 

6,192

 

 

 

 

 

 

 

U.S. Treasury and Agency securities

 

368

 

447

 

U.S. Corporate Securities

 

5,192

 

2,701

 

Foreign Securities

 

1,089

 

570

 

Total short-term investments

 

6,649

 

3,718

 

 

 

 

 

 

 

Total cash, cash equivalents, and short-term investments

 

$

13,767

 

$

10,110

 

 

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 issued by foreign companies, and certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. dollars. As of June 30, 2007 and September 30, 2006, approximately $2.1 billion and $921 million, respectively, of the Company’s short-term investments had underlying maturities ranging from one to five years.  The remaining short-term investments had maturities less than 12 months.

The gross and net unrealized losses on the Company’s investment portfolio were not significant as of June 30, 2007 and September 30, 2006. The unrealized losses on the Company’s investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities were caused primarily by changes in interest rates.  The Company typically invests in highly rated securities with low probabilities of default.  The Company’s investment policy requires investments to be rated single-A or better. Therefore, the Company considers the declines to be temporary in nature. As of June 30, 2007, the Company does not consider the investments to be other-than-temporarily impaired.

Market values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and the Company’s ability and intent to hold the investment for a period of time, which may be sufficient for anticipated recovery in market value.

Derivative Financial Instruments

The Company uses derivatives to partially offset its business exposure to foreign exchange risk. Foreign currency forward and option contracts are used to offset the foreign exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales. Generally, the 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. 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. Derivatives that are not designated as hedges and the ineffective portions of cash flow hedges are adjusted to fair value through earnings. The effective portions of cash flow hedges are recorded in other comprehensive income until the hedged item is recognized in earnings. Changes in value of fair value hedges are offset against the changes in fair value of the hedged assets, liabilities, or firm commitments through earnings. As of June 30, 2007, the Company had a net deferred loss associated with cash flow hedges of approximately $2.7 million, net of taxes, all of which is expected to be reclassified to earnings by the end of the first quarter of 2008.  As of the end of the third quarter of 2007, the general nature of the 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 2006.

7




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

Other Current Assets

 

6/30/07

 

9/30/06

 

Vendor non-trade receivables

 

$

1,491

 

$

1,593

 

NAND flash memory prepayments

 

441

 

208

 

Other current assets

 

698

 

469

 

 

 

 

 

 

 

Total other current assets

 

$

2,630

 

$

2,270

 

 

Property, Plant and Equipment, Net

 

6/30/07

 

9/30/06

 

Land and buildings

 

$

727

 

$

626

 

Machinery, equipment, and internal-use software

 

826

 

595

 

Office furniture and equipment

 

102

 

94

 

Leasehold improvements

 

907

 

760

 

 

 

2,562

 

2,075

 

Accumulated depreciation and amortization

 

(936

)

(794

)

 

 

 

 

 

 

Net property, plant and equipment

 

$

1,626

 

$

1,281

 

 

Other Assets

 

6/30/07

 

9/30/06

 

Long-term NAND flash memory prepayments

 

$

667

 

$

1,042

 

Non-current deferred tax assets

 

29

 

 

Capitalized software development costs, net

 

64

 

21

 

Other assets

 

241

 

175

 

 

 

 

 

 

 

Total other assets

 

$

1,001

 

$

1,238

 

 

Accrued Expenses

 

6/30/07

 

9/30/06

 

Deferred revenue-current

 

$

1,063

 

$

718

 

Deferred margin on component sales

 

451

 

324

 

Accrued warranty and related costs

 

253

 

284

 

Accrued marketing and distribution

 

234

 

298

 

Accrued compensation and employee benefits

 

203

 

221

 

Other accrued tax liabilities

 

462

 

388

 

Other current liabilities

 

666

 

820

 

 

 

 

 

 

 

Total accrued expenses

 

$

3,332

 

$

3,053

 

 

Non-Current Liabilities

 

6/30/07

 

9/30/06

 

Deferred tax liabilities

 

673

 

$

381

 

Deferred revenue-non-current

 

561

 

383

 

Other non-current liabilities

 

17

 

14

 

 

 

 

 

 

 

Total non-current liabilities

 

$

1,251

 

$

778

 

 

8




Other Income and Expense

 

Three Months Ended

 

Nine Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

Interest income

 

$

168

 

$

99

 

$

459

 

$

274

 

Other expense, net

 

(13

)

(4

)

(30

)

(22

)

 

 

 

 

 

 

 

 

 

 

Other income and expense

 

$

155

 

$

95

 

$

429

 

$

252

 

 

Note 4 – Goodwill and Other Intangible Assets

The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 3 to 10 years.

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

 

 

June 30, 2007

 

September 30, 2006

 

 

 

Gross 
Carrying
Amount

 


Accumulated
 Amortization

 

Net 
Carrying 
Amount

 

Gross 
Carrying 
Amount

 


Accumulated 
Amortization

 

Net 
Carrying 
Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Definite lived and amortizable acquired technology

 

$

203

 

$

(66

)

$

137

 

$

181

 

$

(42

)

$

139

 

Indefinite lived and unamortizable trademarks

 

100

 

 

100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total acquired intangible assets

 

$

303

 

$

(66

)

$

237

 

$

181

 

$

(42

)

$

139

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Goodwill

 

$

38

 

$

 

$

38

 

$

38

 

$

 

$

38

 

 

Note 5 – Shareholders’ Equity

Preferred Stock

The Company has five million shares of authorized preferred stock, none of which is issued or outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors is authorized to determine or alter the rights, preferences, privileges and restrictions of the Company’s authorized but unissued shares of preferred stock.

Restricted Stock Units

The Company’s Board of Directors has granted RSUs to members of the Company’s senior management team, excluding its CEO. These RSUs generally vest over four years either at the end of the four-year service period, in two equal installments on the second and fourth anniversaries of the date of grant, or in equal installments on each of the first through fourth anniversaries of the grant date.  Upon vesting, the RSUs will convert into an equivalent number of shares of common stock. The compensation expense incurred by the Company for RSUs is based on the closing market price of the Company’s common stock on the date of grant and is amortized on a straight-line basis over the requisite service period. The RSUs have been reflected in the calculation of diluted earnings per share utilizing the treasury stock method.

Comprehensive Income

Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that under U.S. generally accepted accounting principles are recorded as an element of shareholders’ equity but are excluded from net income. The 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.

9




The following table summarizes components of total comprehensive income, net of taxes, during the three and nine-month periods ended June 30, 2007 and July 1, 2006 (in millions):

 

 Three
Months Ended

 

 Nine
Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

818

 

$

472

 

$

2,592

 

$

1,447

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Net change in unrealized derivative gains/losses

 

3

 

1

 

 

(2

)

Change in foreign currency translation

 

22

 

19

 

35

 

16

 

Net change in unrealized investment gains/losses

 

(1

)

1

 

(1

)

2

 

Total comprehensive income

 

$

842

 

$

493

 

$

2,626

 

$

1,463

 

 

The following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company during the three and nine-month periods ended June 30, 2007 and July 1, 2006 (in millions):

 

Three
Months Ended

 

Nine
Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

 

 

 

 

 

 

 

 

 

 

Change in fair value of derivatives

 

 

$

2

 

$

1

 

$

9

 

Adjustment for net gain (losses) realized and included in net income

 

3

 

(1

)

(1

)

(11

)

Change in unrealized gain/losses on derivative instruments

 

$

3

 

$

1

 

$

 

$

(2

)

 

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

 

 

 

 

 

As of
6/30/07

 

As of
9/30/06

 

 

 

 

 

 

 

 

 

 

 

Unrealized losses on investments

 

 

 

 

 

$

(1

)

$

 

Unrealized gains on derivative investments

 

 

 

 

 

3

 

3

 

Cumulative foreign currency translation

 

 

 

 

 

54

 

19

 

Accumulated other comprehensive income

 

 

 

 

 

$

56

 

$

22

 

 

Employee Benefit Plans

2003 Employee Stock Plan

The 2003 Employee Stock Plan (the “2003 Plan”) is a shareholder approved plan that provides for broad-based grants to employees, including executive officers. Based on the terms of individual option grants, options granted under the 2003 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of four years, based on continued employment, with either annual or quarterly vesting. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock purchase rights and performance-based awards.  In the third quarter of 2007, the Company’s shareholders approved an amendment to the 2003 Employee Stock Plan to increase the number of shares authorized for issuance by 28 million shares.

1997 Employee Stock Option Plan

In August 1997, the 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 four years, based on continued employment, with either annual or quarterly vesting. In October 2003, the Company terminated the 1997 Plan and no new options can be granted from this plan.

10




1997 Director Stock Option Plan

In August 1997, the Company’s Board of Directors adopted a Director Stock Option Plan (“Director Plan”) for non-employee directors of the Company, which was approved by shareholders in 1998. Pursuant to the Director Plan, the Company’s non-employee directors are granted an option to acquire 30,000 shares of common stock upon their initial election to the Board (“Initial Options). The Initial Options vest and become exercisable in three equal annual installments on each of the first through third anniversaries of the grant date. On the fourth anniversary of a non-employee director’s initial election to the Board and on each subsequent anniversary thereafter, the director will be entitled to receive an option to acquire 10,000 shares of common stock (“Annual Options”). Annual Options are fully vested and immediately exercisable on their date of grant.

Rule 10b5-1 Trading Plans

Certain of the Company’s executive officers, including Mr. Timothy D. Cook, Mr. Peter Oppenheimer, Mr. Philip W. Schiller, and Dr. Bertrand Serlet, have entered into trading plans pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of 1934, as amended. A trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock including the exercise and sale of employee stock options and shares acquired pursuant to the Company’s employee stock purchase plan and upon vesting of RSUs.

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. In the third quarter of 2007, the Company’s shareholders approved an amendment to the Employee Stock Purchase Plan to increase the number of shares authorized for issuance by 6 million shares and limit the number of shares that may be purchased in any calendar year to 3 million shares.  As of June 30, 2007, approximately 7.0 million shares were reserved for future issuance under the Purchase Plan.

Stock Award Activity

A summary of the Company’s stock award activity and related information for the nine months ended June 30, 2007 is set forth in the following table (stock award amounts and aggregate intrinsic value are presented in thousands):

 

 

 

 

Outstanding Options

 

 

 

Shares 
Available
for Grant

 

Number of
Shares

 

Weighted- 
Average
Exercise Price

 

Weighted-Average
Remaining
Contractual Term
(Years)

 

Aggregate
Intrinsic Value

 

Balance at September 30, 2006

 

54,994

 

52,982

 

$

23.23

 

 

 

 

 

Additional Shares Authorized

 

28,000

 

 

 

 

 

 

 

RSUs Granted

 

(2,540

)

 

 

 

 

 

 

Options Granted

 

(12,815

)

12,815

 

$

91.14

 

 

 

 

 

Options Cancelled

 

1,205

 

(1,205

)

$

51.48

 

 

 

 

 

RSUs Cancelled

 

20

 

 

 

 

 

 

 

Options Exercised

 

 

(12,628

)

$

17.29

 

 

 

 

 

Plan Shares Expired

 

(1

)

 

 

 

 

 

 

Balance at June 30, 2007

 

68,863

 

51,964

 

$

40.77

 

4.70

 

$

4,227,002

 

Exercisable at June 30, 2007

 

 

 

27,432

 

$

20.81

 

3.92

 

$

2,778,430

 

Expected to Vest after June 30, 2007

 

 

 

24,532

 

$

62.99

 

5.57

 

$

1,448,572

 

 

Beginning in April 2005, each RSU granted under the 2003 Plan has reduced the number of shares available for grant under that plan by two shares.

11




Aggregate intrinsic value represents the value of the Company’s closing stock price on the last trading day of the fiscal period in excess of the weighted-average exercise price multiplied by the number of shares underlying the outstanding options. Total intrinsic value of options at time of exercise was $349 million and $961 million for the three and nine-month periods ended June 30, 2007, respectively, and $171 million and $1.1 billion for the three and nine-month periods ended July 1, 2006, respectively.

The income tax benefit related to stock-based compensation expense was $21 million and $49 million for the three and nine-month periods ended June 30, 2007, respectively, and $10 million and $36 million for the three and nine-month periods ended July 1, 2006.  As of June 30, 2007, $675 million of total unrecognized compensation cost related to stock options and RSUs is expected to be recognized over a weighted-average period of 3.03 years.

As of June 30, 2007, the Company had 4.67 million RSUs outstanding with a total grant-date fair value of $245 million, which were excluded from the options outstanding balances in the preceding table.  No RSUs were granted or vested during the third quarter of 2007.  The weighted-average grant date fair value of RSUs granted during the first nine months of 2007 was $86.67.  Aggregate intrinsic value of RSUs at June 30, 2007 was $570 million.

There were no grants or forfeitures of restricted stock during the three or nine-month periods ended June 30, 2007.  There was no outstanding restricted stock as of June 30, 2007.

The Company uses the Black-Scholes-Merton (“BSM”) option-pricing model to calculate the fair value of stock-based awards.  The BSM incorporates various assumptions including volatility, expected life, and interest rates.  The expected volatility is based on the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options and other relevant factors including implied volatility in market traded options on the Company’s common stock. The Company bases its expected life assumption on its historical experience and on the terms and conditions of the stock awards it grants to employees.

The assumptions used for the three and nine-month periods ended June 30, 2007 and July 1, 2006 and the resulting estimates of weighted-average fair value per share of options granted and for stock purchases during those periods are as follows:

 

Three
Months Ended

 

Nine
Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

Expected life of stock options

 

3.46 years

 

3.54 years

 

3.46 years

 

3.56 years

 

Expected life of stock purchases

 

6 months

 

6 months

 

6 months

 

6 months

 

Interest rate - stock options

 

4.74

%

4.87

%

4.63

%

4.52

%

Interest rate - stock purchases

 

5.09

%

4.46

%

5.17

%

3.93

%

Volatility - stock options

 

37.40

%

39.50

%

37.74

%

40.27

%

Volatility - stock purchases

 

41.34

%

31.39

%

41.10

%

39.14

%

Expected dividend yields

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average fair value of options granted during the period

 

$

36.64

 

$

23.16

 

$

30.42

 

$

23.39

 

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

 

$

21.94

 

$

16.82

 

$

19.21

 

$

13.75

 

 

Note 6 – 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 15 years and generally provide renewal options for terms of 3 to 5 additional years. Leases for retail space are for terms of 5 to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options.  As of September 30, 2006, the Company’s total future minimum lease payments under noncancelable operating leases were $1.2 billion, of which $887 million related to leases for retail space.  As of June 30, 2007, total future minimum lease payments related to leases for retail space increased $113 million to $1.0 billion.

12




Accrued Warranty and Indemnifications

The following table reconciles changes in the Company’s accrued warranties and related costs for the three and nine-month periods ended June 30, 2007 and July 1, 2006 (in millions):

 

Three
Months Ended

 

Nine
Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

 

 

 

 

 

 

 

 

 

 

Beginning accrued warranty and related costs

 

$

271

 

$

255

 

$

284

 

$

188

 

Cost of warranty claims

 

(76

)

(64

)

(207

)

(215

)

Accruals for product warranties

 

58

 

96

 

176

 

314

 

Ending accrued warranty and related costs

 

$

253

 

$

287

 

$

253

 

$

287

 

 

The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against itself or an indemnified third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims subject to indemnification that would have a material adverse effect on its financial condition, liquidity or results of operations.  Therefore, the Company did not record a liability for infringement costs as of either June 30, 2007 or September 30, 2006.

Concentrations in the Available Sources of Supply of Materials and Product

Certain key components including, but not limited to, microprocessors, enclosures, certain LCDs, certain optical drives, and application-specific integrated circuits (“ASICs”) are currently obtained by the Company from single or limited sources which subjects the Company to supply and pricing risks. Many of these and other key components that are available from multiple sources including, but not limited to, NAND flash memory, DRAM memory, and certain LCDs, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. In addition, the Company has entered into certain agreements for the supply of critical components at favorable pricing, and there is no guarantee that the Company will be able to extend or renew these agreements when they expire. Therefore, the Company remains subject to significant risks of supply shortages and/or price increases that can adversely affect gross margins and operating margins. In addition, the Company uses some components that are not common to the rest of the global personal computer and consumer electronics industries, and new products introduced by the Company often utilize custom components obtained from only one source until the Company has evaluated whether there is a need for and subsequently qualifies additional suppliers.  If the supply of a key single-sourced component to the Company were to be delayed or curtailed, or in the event a key manufacturing vendor delays shipments of completed products to the Company, the Company’s ability to ship related products in desired quantities and in a timely manner could be adversely affected. The Company’s business and financial performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components may be affected if producers were to decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. Finally, significant portions of the Company’s CPUs, iPods, iPhones, logic boards, and other assembled products are now manufactured by outsourcing partners, primarily in various parts of Asia. A significant concentration of this outsourced manufacturing is currently performed by only a few of the Company’s outsourcing partners, often in single locations. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments.

Long-Term Supply Agreements

During the first quarter of 2006, the Company entered into long-term supply agreements with Hynix Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND flash memory through calendar year 2010.  As part of these agreements, the Company prepaid $1.25 billion for flash memory components during 2006, which will be applied to certain inventory purchases made over the life of each respective agreement. Approximately $142 million of the prepayment had been utilized by the Company as of June 30, 2007.

13




Contingencies

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 financial condition, liquidity, or results of operations.

Note 7 - Segment Information and Geographic Data

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

The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its operating segments, which are generally based on the nature and location of its customers, to be the Americas, Europe, Japan, Asia-Pacific, Retail, and FileMaker operations. The Company’s four geographical segments, together with the Retail segment, all sell the same products to the same types of customers. The Company’s reportable operating segments are comprised of the Americas, Europe, Japan, and Retail operations. The Americas, Europe, and Japan reportable segments exclude activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the U.S., Canada, Japan, the U.K., and Italy. Other operating segments include Asia-Pacific, which includes Australia and Asia except for Japan, and the Company’s subsidiary, FileMaker, Inc.  Each reportable geographic operating segment provides similar hardware and software products and similar services, and as of June 30, 2007 the accounting policies of the various segments are the same as those described in the Company’s 2006 Form 10-K in Note 1, “Summary of Significant Accounting Policies.”

The Company evaluates the performance of its operating segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of the customers, and net sales for the Retail segment are based on sales from the Company’s retail stores. Operating income for each segment includes net sales to third parties, related cost of sales, and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses such as manufacturing costs and variances not included in standard costs, research and development, corporate marketing expenses, stock-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. Segment assets exclude corporate assets such as cash, short-term and long-term investments, manufacturing facilities, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets, and retail store construction-in-progress not subject to depreciation. Except for the Retail segment, capital expenditures for long-lived assets are not reported to management by segment. Capital expenditures by the Retail segment were $88 million and $54 million during the third quarters of 2007 and 2006, respectively, and $164 million and $136 million during the first nine months of 2007 and 2006, respectively.

14




From the establishment of the Retail segment in fiscal 2001 through the quarter ended March 31, 2007, Company management assessed the segment’s operating performance differently from the Company’s other operating segments. Because the Company’s Retail initiative was an unproven concept at inception, management chose to measure the Retail segment’s performance in a manner that would allow comparability to the Company’s major channel partners operating retail stores in the U.S. There were three significant differences in the measurement of the Retail segment’s results relative to the Company’s other operating segments. First, the Retail segment’s operating income reflected cost of sales for Apple products at amounts normally charged to Apple’s major U.S. channel partners for the same products, less the cost of the Company’s sales programs and other costs to support those partners. Second, the cost of sales of the Company’s service and support contracts, including the AppleCare Protection Plan (“APP”) and .Mac, were reflected in the Retail segment’s results at the costs charged to major channel partners for such contracts, and all associated revenue was reflected in the Retail segment’s results at the time of sale rather than being amortized over the lives of the respective agreements. Because the Company had not yet earned the revenue or incurred the cost associated with the sale of such contracts, an offset to these amounts was recognized in other segments’ net sales and cost of sales. Third, the Company allocated certain expenses related to the operation of its high-profile stores to corporate marketing expense.

Having operated the Company’s Retail stores successfully for more than six years, management believes its Retail initiative is a proven concept that will continue to be an integral element of the Company’s distribution and marketing strategies. Additionally, the Company expects sales of iPhone by the Company’s geographic operating segments to generate significant levels of deferred revenue and deferred cost of sales over time. In consideration of these factors, management has determined that beginning with the quarter ended June 30, 2007, aligning measurements for the performance of the Retail segment with those used for the Company’s other operating segments provides the most meaningful information. Accordingly, management has begun to measure the Retail segment’s operating performance in a manner generally consistent with the Company’s other operating segments. The cost of sales of the Company’s products sold through the Retail segment is now reflected at amounts similar to the cost of sales of the same products reflected in the Company’s other operating segments. Revenue from APP and .Mac contracts sold through the Retail segment is now being recognized over the lives of the respective service agreements. Additionally, the Retail segment is applying the same subscription accounting to iPhone net sales and cost of sales that the Company’s other operating segments apply. Management believes aligning measurements for the performance of the Retail segment with those used for the Company’s other operating segments will provide greater comparability with the rest of the Company’s segments and allow for more meaningful assessment of the Retail segment’s operating results. The Company has reclassified prior period operating segment results to reflect these changes in the measurement of the operating results for the Retail segment, along with the corresponding offsetting impact to the Company’s other operating segments.

The Company will continue to allocate certain operating expenses associated with its high-profile stores to corporate marketing expense to reflect the estimated Company-wide benefit. These high-profile stores are larger than the 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. The allocation of these operating costs to corporate expense is based on the amount incurred for a high-profile store in excess of that incurred by a more typical Company retail location. The Company had opened a total of eight high-profile stores as of June 30, 2007. Expenses allocated to corporate marketing resulting from the operations of high-profile stores were $10 million and $9 million in the third quarters of 2007 and 2006, respectively, and $30 million and $24 million for the first nine months of 2007 and 2006, respectively.

15




Summary information by reportable segment, revised for all periods presented to reflect the Company’s third quarter 2007 change in measurement of its Retail segment’s operating results along with the corresponding offsetting impact in the Company’s other operating segments, is as follows (in millions):

 

Three Months Ended

 

Nine Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

Americas:

 

 

 

 

 

 

 

 

 

Net sales

 

$

2,680

 

$

2,213

 

$

8,668

 

$

7,067

 

Operating income

 

$

711

 

$

486

 

$

2,274

 

$

1,421

 

 

 

 

 

 

 

 

 

 

 

Europe:

 

 

 

 

 

 

 

 

 

Net sales

 

$

1,160

 

$

900

 

$

4,121

 

$

3,108

 

Operating income

 

$

308

 

$

162

 

$

996

 

$

473

 

 

 

 

 

 

 

 

 

 

 

Japan:

 

 

 

 

 

 

 

 

 

Net sales

 

$

258

 

$

259

 

$

827

 

$

925

 

Operating income

 

$

59

 

$

47

 

$

169

 

$

161

 

 

 

 

 

 

 

 

 

 

 

Retail:

 

 

 

 

 

 

 

 

 

Net sales

 

$

915

 

$

688

 

$

2,864

 

$

2,362

 

Operating income

 

$

184

 

$

122

 

$

607

 

$

444

 

 

 

 

 

 

 

 

 

 

 

Other Segments (a):

 

 

 

 

 

 

 

 

 

Net sales

 

$

397

 

$

310

 

$

1,309

 

$

1,016

 

Operating income

 

$

94

 

$

62

 

$

286

 

$

189

 

 


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

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

 

Three Months Ended

 

Nine Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

 

 

 

 

 

 

 

 

 

 

Segment operating income

 

$

1,356

 

$

879

 

$

4,332

 

$

2,688

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation expense

 

(65

)

(37

)

(174

)

(123

)

Other corporate expenses, net (a)

 

(250

)

(276

)

(809

)

(720

)

Total operating income

 

$

1,041

 

$

566

 

$

3,349

 

$

1,845

 

 


(a)                                  Other corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard costs, and other separately managed general and administrative expenses including certain corporate expenses associated with support of the Retail segment.

Note 8 – Related Party Transactions and Certain Other Transactions

The Company entered into a Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the operation of his private plane when used for Apple business. The Company recognized a total of $10,000 and $573,000 in expenses pursuant to the Reimbursement Agreement during the three and nine-month periods ended June 30, 2007, respectively. The Company recognized a total of $112,000 in expenses pursuant to the Reimbursement Agreement during the three and nine months ended July 1, 2006.  All expenses recognized pursuant to the Reimbursement Agreement have been included in selling, general, and administrative expenses in the Condensed Consolidated Statements of Operations.

16




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 Part II, Item 1A., “Risk Factors.”  The following discussion should be read in conjunction with the 2006 Form 10-K filed with the SEC (the “2006 Form 10-K”) and the condensed consolidated financial statements and notes thereto included elsewhere in this Form 10-Q. All information is based on the Company’s fiscal year. 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 the Company’s website at http://www.apple.com/investor when such reports are available on the Securities and Exchange Commission (“SEC”) website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549.  The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-202-551-8090.  The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov.  The contents of these websites are not incorporated into this filing.  Further, the Company’s references to the URLs for these websites are intended to be inactive textual references only.

Executive Overview

The Company designs, manufactures, and markets personal computers, portable digital music players, and mobile phones and sells a variety of related software, services, peripherals, and networking solutions. The Company’s products and services include the Macintosh® line of desktop and portable computers, the iPod line of portable digital music players, iPhone, Apple TV, Xserve®, and Xserve RAID, a portfolio of consumer and professional software applications, the Mac OS® X operating system, third-party digital content through the iTunes Store™, and a variety of accessory, service and support offerings. The Company sells its products worldwide through its online stores, its retail stores, its direct sales force, and third-party wholesalers, resellers, and value-added resellers. In addition, the Company sells a variety of third-party Macintosh, iPod and iPhone compatible products including application software, printers, storage devices, speakers, headphones, and various other accessories and supplies through its online and retail stores. The Company sells to education, consumer, creative professional, business, and government customers. Further discussion of the Company’s products may be found below under the heading “Products” and Part II, Item 1A., “Risk Factors,” as well as in Part I, Item 1., “Business” of the Company’s 2006 Form 10-K.

The Company believes that for both consumers and professionals the personal computer has become the center of an evolving digital lifestyle by integrating and enhancing the utility of advanced digital devices such as the Company’s iPods, iPhones, digital video and still cameras, televisions, CD and DVD players, and other consumer electronic devices. The attributes of the personal computer that enable this functionality include a high-quality user interface, easy access to relatively inexpensive data storage, the ability to run complex applications, and the ability to connect easily to a wide variety of other digital devices and to the Internet. The Company is the only participant in the personal computer industry that controls the design and development of the entire personal computer – from the hardware and operating system to sophisticated applications. This, along with its products’ innovative industrial designs, intuitive ease-of-use, built-in graphics, multimedia and networking capabilities, uniquely positions the Company to offer innovative integrated digital lifestyle solutions.

The Company’s business strategy leverages its ability, through the design and development of its own operating system, hardware, and many software applications and technologies, to bring to its customers around the world compelling new products and solutions with superior ease-of-use, seamless integration, and innovative industrial design.

17




The Company participates in several highly competitive markets, including personal computers with its Macintosh line of computers, consumer electronics with its iPod product family of portable digital music players, and distribution of third-party digital content through its online iTunes Store. With the introduction of iPhone, the Company has also begun to compete with mobile communication device companies that have substantial experience and technological and financial resources.  While the Company is widely recognized as a leading innovator in the personal computer and consumer electronics markets as well as a leader in the emerging market for distribution of digital content, these markets are highly competitive and subject to aggressive pricing. To remain competitive, the Company believes that increased investment in research and development (“R&D”) and marketing and advertising is necessary to maintain or expand its position in the markets where it competes.  The Company’s R&D spending is focused on further developing its existing line of personal computers, operating systems, software applications, and portable digital music players; developing new digital lifestyle consumer and professional software applications; and investing in new product areas such as iPhone and wireless technologies.  The Company also believes increased investment in marketing and advertising programs is critical to increasing product and brand awareness.

The Company utilizes a variety of direct and indirect distribution channels.  The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware, software, and peripheral integration, demonstrate the unique digital lifestyle solutions that are available only on Macintosh computers, and demonstrate the compatibility of the Macintosh with the Windows platform and networks.  The Company further believes that providing a high-quality sales and after-sales support experience is critical to attracting and retaining customers.  To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company has expanded and improved its distribution capabilities by opening its own retail stores in the U.S. and internationally.  The Company had 185 stores open as of June 30, 2007.

The Company also staffs selected third-party stores with the Company’s own employees to improve the buying experience through reseller channels.  The Company has deployed Apple employees and contractors in reseller locations around the world including the U.S., Canada, Europe, Japan, Asia and Australia. The Company also sells to customers directly through its online stores around the world.

To improve access to the iPod product family, the Company has significantly expanded the number of distribution points where iPods are sold. iPods can be purchased in certain department stores, member-only warehouse stores, large retail chains, and specialty retail stores, as well as through the channels listed above.

iPhone is currently distributed in the United States through the Company’s online and retail stores as well as stores owned and operated by AT&T.

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Company’s discussion and analysis of its financial condition and results of operations require the Company’s management to make judgments, assumptions, and estimates that affect the amounts reported in its condensed consolidated financial statements and accompanying notes. Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2006 Form 10-K and Note 1 of the Notes to Condensed Consolidated Financial Statements in this Form 10-Q describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates and such differences may be material.

Management believes the Company’s critical accounting policies and estimates are those related to revenue recognition, allowance for doubtful accounts, inventory valuation and inventory purchase commitments, warranty costs, stock-based compensation, and income taxes. Management believes these policies to be critical because they are both important to the portrayal of the Company’s financial condition and results, and they require management to make judgments and estimates about matters that are inherently uncertain. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors.

18




Revenue Recognition

Net sales consist primarily of revenue from the sale of hardware, software, peripherals, digital content, and service and support contracts. The Company recognizes revenue for software products (operating system software and applications software), or any product that is considered to be software-related in accordance with the guidance in EITF No. 03-5, Applicability of American Institute of Certified Public Accountants (“AICPA”) Statement of Position 97-2 to Non-software Deliverables in an Arrangement Containing More-Than-Incidental Software, (e.g., Macintosh computers, iPod portable digital music players and iPhone) pursuant to AICPA Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition, as amended.  For products that are not software or software-related, (e.g., digital content sold on the iTunes Store and certain Macintosh and iPod supplies and accessories) the Company recognizes revenue pursuant to SEC Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition.

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

The Company began shipping Apple TV in March 2007 and iPhone in June 2007.  For both Apple TV and iPhone, the Company may provide future unspecified features and additional software products free of charge to customers.  Therefore, sales of Apple TV and iPhone handsets are recognized under subscription accounting in accordance with Statement of Position (“SOP”) No. 97-2.  The Company recognizes the associated revenue and cost of goods sold on a straight-line basis over the currently-estimated 24-month economic lives of these products.  Costs incurred by the Company for engineering, sales, and marketing are expensed as incurred.

The Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives.  For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met.  If refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses.  For customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the 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 to revenue at the time such programs are offered. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company would be required to record additional reductions to revenue, which could have a material adverse impact on the Company’s results of operations.

Allowance for Doubtful Accounts

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

19




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

Inventory Valuation and Inventory Purchase Commitments

The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory each fiscal quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The personal computer and consumer electronics industries are subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the 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 were recorded.

The Company accrues reserves for estimated cancellation fees related to component orders that have been cancelled or are expected to be cancelled. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company’s requirements for periods ranging from 30 to 150 days. If there is an abrupt and substantial decline in demand for one or more of the 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 and recorded.

Warranty Costs

The Company provides for the estimated cost for hardware and software warranties at the time the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates its estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to warranty protection and adjusts the amounts as necessary.  If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liability would be required and could negatively affect the Company’s results of operations.

The Company periodically provides updates to its applications and system software in order to maintain the software’s compliance with specifications. The estimated cost to develop such updates is accounted for as warranty cost that is recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates include the number of units delivered, the number of updates expected to occur, and the historical cost and estimated future cost of the resources necessary to develop these updates.

Stock-Based Compensation

The Company accounts for stock-based compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004) (“SFAS No. 123R”), Share-Based Payment.  Under the provisions of SFAS No. 123R, stock-based compensation cost is estimated at the grant date based on the award’s fair-value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing model and is recognized as expense ratably over the requisite service period.  The BSM model requires various highly judgmental assumptions including volatility, forfeiture rates, and expected option life.  If any of the assumptions used in the BSM model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

20




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. 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.

Products

The Company offers a range of personal computing products including desktop and portable personal computers, related devices and peripherals, and various third-party hardware products.  In addition, the Company offers software products including Mac OS X, the 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. The Company also designs, develops and markets to Macintosh and Windows users its family of iPod digital music players along with related accessories and services including the online distribution of third-party content through the Company’s iTunes Store.

In January 2007, the Company announced iPhone, a handheld device that combines in a single product a mobile phone, a widescreen iPod with touch controls, and an Internet communications device.   iPhone’s user interface is based on the Multi-Touch™ display allowing users to control the device with their fingers.  iPhone lets users make a call by pointing at a name or number in their address book, a favorites list, or a call log as well as select and listen to voicemail messages in whatever order they want.  iPhone also allows users to play their iTunes® content, including movies, television shows, music, photos and podcasts, with the touch of a finger.  iPhone features desktop-class email, web browsing, searching, and maps.  iPhone is compatible with a Mac or PC and automatically syncs content from a user’s iTunes library, as well as contacts, bookmarks, and email accounts. iPhone is a quad-band GSM phone featuring EDGE and Wi-Fi wireless technologies for data networking, Bluetooth 2.0, a built-in 2 megapixel camera, a 3.5-inch touch screen with 480 by 320 resolution at 160 ppi, and providing up to 8 hours of talk time, 6 hours of Internet use, 7 hours of video playback or 24 hours of audio playback. AT&T Mobility LLC (formerly Cingular Wireless LLC) is the exclusive U.S. carrier for iPhone. The Company began shipping iPhone in the U.S. on June 29, 2007.

In January 2007, the Company announced Apple TV, a device that permits users to wirelessly play iTunes content on a widescreen television.  Compatible with a Mac or PC, Apple TV includes either a 40GB or 160GB hard drive capable of storing up to 200 hours of video, 36,000 songs, 25,000 photos, or a combination of each and is capable of displaying content in high definition resolution up to 720p. Apple TV connects to a broad range of widescreen televisions and home theater systems and comes standard with HDMI, component video, and both analog and digital optical audio ports. Using high-speed AirPort® 802.11 wireless networking, Apple TV can auto-sync content from one computer or stream content from up to five additional computers directly to a television.  The Company began shipping Apple TV in March 2007.

A detailed discussion of the Company’s other products may be found in its 2006 Form 10-K.

21




Net Sales

The first nine months of 2007 spanned 39 weeks while the first nine months of 2006 spanned 40 weeks.  This additional week is added to the first fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters.

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

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

6/30/07

 

7/1/06

 

Change

 

6/30/07

 

7/1/06

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Sales by Operating Segment (a):

 

 

 

 

 

 

 

 

 

 

 

 

 

Americas net sales

 

$

2,680

 

$

2,213

 

21

%

$

8,668

 

$

7,067

 

23

%

Europe net sales

 

1,160

 

900

 

29

%

4,121

 

3,108

 

33

%

Japan net sales

 

258

 

259

 

 

827

 

925

 

-11

%

Retail net sales

 

915

 

688

 

33

%

2,864

 

2,362

 

21

%

Other Segments net sales (b)

 

397

 

310

 

28

%

1,309

 

1,016

 

29

%

Total net sales

 

$

5,410

 

$

4,370

 

24

%

$

17,789

 

$

14,478

 

23

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unit Sales by Operating Segment:

 

 

 

 

 

 

 

 

 

 

 

 

 

Americas Macintosh unit sales

 

824

 

642

 

28

%

2,054

 

1,651

 

24

%

Europe Macintosh unit sales

 

393

 

301

 

31

%

1,317

 

1,004

 

31

%

Japan Macintosh unit sales

 

81

 

79

 

3

%

230

 

242

 

-5

%

Retail Macintosh unit sales

 

330

 

216

 

53

%

913

 

563

 

62

%

Other Segments Macintosh unit sales (b)

 

136

 

89

 

53

%

373

 

233

 

60

%

Total Macintosh unit sales

 

1,764

 

1,327

 

33

%

4,887

 

3,693

 

32

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Sales by Product:

 

 

 

 

 

 

 

 

 

 

 

 

 

Desktops (c)

 

$

956

 

$

705

 

36

%

$

2,825

 

$

2,450

 

15

%

Portables (d)

 

1,577

 

1,161

 

36

%

4,386

 

2,712

 

62

%

Total Macintosh net sales

 

2,533

 

1,866

 

36

%

7,211

 

5,162

 

40

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

iPod

 

1,570

 

1,497

 

5

%

6,686

 

6,117

 

9

%

Other music related products and services (e)

 

608

 

457

 

33

%

1,895

 

1,433

 

32

%

iPhone and related products and services (f)

 

5

 

 

NM

 

5

 

 

NM

 

Peripherals and other hardware (g)

 

308

 

236

 

31

%

914

 

803

 

14

%

Software, service, and other sales (h)

 

386

 

314

 

23

%

1,078

 

963

 

12

%

Total net sales

 

$

5,410

 

$

4,370

 

24

%

$

17,789

 

$

14,478

 

23

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unit Sales by Product:

 

 

 

 

 

 

 

 

 

 

 

 

 

Desktops (c)

 

634

 

529

 

20

%

1,897

 

1,810

 

5

%

Portables (d)

 

1,130

 

798

 

42

%

2,990

 

1,883

 

59

%

Total Macintosh unit sales

 

1,764

 

1,327

 

33

%

4,887

 

3,693

 

32

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

iPod unit sales

 

9,815

 

8,111

 

21

%

41,430

 

30,680

 

35

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

iPhone unit sales

 

270

 

 

NM

 

270

 

 

NM

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales per Macintosh unit sold (i)

 

$

1,436

 

$

1,406

 

2

%

$

1,476

 

$

1,398

 

6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales per iPod unit sold (j)

 

$

160

 

$

185

 

-14

%

$

161

 

$

199

 

-19

%

 


Notes:

(a)   In the third quarter of fiscal 2007, the Company revised the way it measures the Retail Segment’s operating results to a manner that is generally consistent with the Company’s other operating segments.  Prior period results have been reclassified to reflect this change to the Retail Segment’s operating results along with the corresponding offsets to the other operating segments. Further information regarding the Company’s operating segments may be found in Part I, Item 1., “Financial Statements” of this Form 10-Q in the Notes to Condensed Consolidated Financial Statements at Note 7, “Segment Information and Geographic Data.”

(b)         Other Segments include Asia Pacific and FileMaker.

(c)   Includes iMac, eMac, Mac mini, Mac Pro, Power Mac, and Xserve product lines.

22




(d)         Includes MacBook, iBook, MacBook Pro, and PowerBook product lines.

(e)          Consists of iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories.

(f)            Consists of iPhones and Apple-branded and third-party iPhone accessories.

(g)         Includes sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories.

(h)         Includes sales of Apple-branded operating system software, application software, third-party software, AppleCare, and Internet services.

(i)             Derived by dividing total Macintosh net sales by total Macintosh unit sales.

(j)             Derived by dividing total iPod net sales by total iPod unit sales.

Net sales during the third quarter of 2007 increased 24% or $1.0 billion from the same period in 2006, and were up 23% or $3.3 billion for the first nine months of 2007 compared to the same period in 2006 even though the first nine months of 2007 spanned 26 weeks while the first nine months of 2006 spanned 27 weeks. Several factors contributed to these increases including the following:

·                  Macintosh net sales increased $667 million or 36% during the third quarter of 2007 and increased $2.0 billion or 40% during the first nine months of 2007 compared to the same periods in 2006.  Macintosh unit sales increased by 437,000 units or 33% during the third quarter of 2007 and increased 1.194 million units or 32% during the first nine months of 2007 compared to the same periods in 2006. The increases in Macintosh net sales and unit sales were driven by higher sales of portable products, especially sales of the MacBook that increased in all of the Company’s operating segments, as well as increased sales of the MacPro and iMac in most operating segments. The Macintosh unit growth rate of 33% in the third quarter of 2007 is higher than the projected PC industry average growth rate for the quarter and reflects strong growth in customer demand for the Company’s Macintosh products. Net sales and unit sales of the Company’s portable products increased 36% and 42%, respectively, during the third quarter of 2007, and increased 62% and 59%, respectively, during the first nine months of 2007 compared to the same periods in 2006. This growth was attributable to increased sales of both the MacBook, which began shipping in May 2006, and the MacBook Pro, which began shipping in February 2006.  Both of these products were updated in the third quarter of 2007.  Macintosh desktop net sales and unit sales increased by 36% and 20%, respectively, during the third quarter of 2007 compared to the same period in 2006 due to strong sales of both the iMac and Mac Pro.  Macintosh desktop net sales and unit sales increased by 15% and 5%, respectively during the first nine months of 2007.   Macintosh desktop net sales grew faster than unit sales during this period due to increased sales of the higher-priced 24-inch iMac and Mac Pro and a shift in product mix away from the lower-priced Mac mini and the discontinued eMac products. Net sales per Macintosh unit sold increased by 2% and 6% for the third quarter and first nine months of 2007, respectively, compared to the same periods in 2006 primarily due to a shift in product mix to higher-priced portable products, the introduction of the Mac Pro in August 2006, and the discontinuation of the lower-priced eMac.

·                  Net sales of iPods increased $73 million or 5% during the third quarter of 2007 and increased  $569 million or 9% during the first nine months of 2007 compared to the same periods in 2006.  Unit sales of iPods increased 21% and 35% during the third quarter and first nine months of 2007, respectively, compared to the same periods in 2006.  Strong sales of iPods during the first nine months of 2007 were driven largely by iPod nano and iPod shuffle that were updated in September 2006. During the third quarter and first nine months of 2007, the net sales per iPod unit sold decreased by 14% and 19%, respectively, compared to the same periods in 2006 primarily due to a shift in product mix towards the lower-priced iPod shuffle and price reductions taken in September 2006 on the Company’s iPod product offerings.

·                  Net sales of iPhone and related products and services were $5 million during the third quarter of 2007. iPhone revenue included in net sales reflects only the portion recognized in accordance with subscription accounting over iPhone’s 24-month estimated economic life.  In the third quarter of 2007, commencing with the June 29 launch, iPhone unit sales were 270,000.

·                  Net sales of other music related products and services increased $151 million or 33% during the third quarter of 2007 and increased $462 million or 32% during the first nine months of 2007 compared to the same periods in 2006 due to increased net sales from the iTunes Store. The Company believes this growth was the result of heightened consumer interest in downloading digital content and the expansion of third-party audio and video content available for sale via the iTunes Store.

23




·                  Net sales of peripherals and other hardware increased $72 million or 31% during the third quarter of 2007 and rose $111 million or 14% during the first nine months of 2007 compared to the same periods in 2006 due to an increase in wireless networking products and other hardware accessories, including printers and scanners, which for the nine months ended June 30, 2007 was partially offset by a decrease in net sales of displays.

·                  Net sales of software, service, and other sales rose $72 million or 23% during the third quarter of 2007 and rose $115 million or 12% during the first nine months of 2007 compared to the same periods in 2006. This growth for the three and nine-month periods was primarily attributable to increased net sales of AppleCare Protection Plan (“APP”) extended service and support contracts and increased sales of Apple branded and third-party developers’ software products.

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, Europe, and Japan reportable segments do not include activities related to the Retail segment.  The Americas segment includes both North and South America. The Europe segment includes European countries as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the U.S., Canada, Japan, the U.K., and Italy. Each reportable geographic operating segment and the Retail operating segment provide similar hardware and software products and similar services. In the third quarter of fiscal 2007, the Company revised the way it measures the Retail Segment’s operating results to a manner that is generally consistent with the Company’s other operating segments.  Prior period results have been reclassified to reflect this change to the Retail Segment’s operating results along with the corresponding offsets to the other operating segments. Further information regarding the Company’s operating segments and the current quarter’s change in measurement of Retail operating results may be found in Part I, Item 1., “Financial Statements” of this Form 10-Q in the Notes to Condensed Consolidated Financial Statements at Note 7, “Segment Information and Geographic Data.”

Americas

Net sales in the Americas segment during the third quarter of 2007 increased $467 million or 21% and Macintosh unit sales increased by 28% compared to the same period in 2006. The increase in net sales during the third quarter of 2007 was primarily due to an increase in sales of Macintosh portable and desktop systems as well as content from the iTunes Store. During the third quarter of 2007, the Americas segment represented approximately 50% of the Company’s total net sales, relatively unchanged from the same period in 2006.

For the first nine months of 2007, net sales in the Americas segment increased $1.6 billion or 23% compared to the same period in 2006, while Americas Macintosh unit sales increased 24% over the same period in 2006. The increase in net sales during the first nine months of 2007 was primarily attributable to the year-over-year increase in sales of the Company’s portable and desktop systems, iPods and content from the iTunes Store. The Americas segment represented approximately 49% of the Company’s total net sales for both the first nine months of 2007 and 2006, respectively.

Europe

Net sales in Europe increased $260 million or 29% during the third quarter of 2007 compared to the same period in 2006.  Macintosh unit sales in Europe increased 31% on a year-over-year basis. These increases were mainly a result of growth in sales of all of the Company’s Macintosh portable and desktop systems, as well as iPods and content from the iTunes Store.

For the first nine months of 2007, net sales in Europe increased by $1.0 billion or 33% compared to the same period in 2006.  Total Macintosh unit sales in Europe increased 31% on a year-over-year basis. These increases were mainly a result of growth in net sales of Macintosh portable systems and iMacs, iPods, and content from the iTunes Store.

24




Japan

Japan’s net sales were essentially flat during the third quarter of 2007 and declined $98 million or 11% during the first nine months of 2007 compared to the same periods in 2006. Total Macintosh unit sales in Japan increased 3% year-over-year during the third quarter of 2007 but decreased by 5% year-over-year for the first nine months of 2007. The decrease in net sales for the first nine months of 2007 was due to a decrease in net sales of Macintosh desktop systems, MacBook Pro, and iPods, partially offset by an increase in net sales of the MacBook.  Although iPod unit sales were relatively flat for the nine months of 2007 compared to the same period in 2006, net sales of iPods decreased due to price reductions in September 2006 on the Company’s iPod product offerings and due to a shift in mix towards lower priced iPod shuffles. The Company is continuing to evaluate ways to improve the future results of its Japan segment.

Retail

During the third quarter of 2007, the Company opened 8 new retail stores.  The Company had 185 retail stores open at the end of the third quarter of 2007 compared to 155 stores at the end of the third quarter of 2006. Retail net sales grew by 33% during the third quarter of 2007 compared to the same period in 2006 due to strong growth in sales of Macintosh products. Macintosh unit sales increased by 53% due to strong demand for the MacBook, MacBook Pro, and iMac. Strong growth in iPod unit sales was offset by lower average selling prices resulting from price reductions in September of 2006. Average quarterly revenue per store increased to $5.1 million in the third quarter of 2007 from $4.7 million in the third quarter of 2006. Retail net sales grew by 21% during the first nine months of 2007 due to an increase in Macintosh unit sales resulting from strong demand for the Company’s MacBook, MacBook Pro, and iMac as well as service and software partially, offset by a decrease in net sales of iPods and music related accessories. Average revenue per store decreased to $16.5 million for the first nine months of 2007, from $17.2 million in the first nine months of 2006 primarily due to lower iPod sales resulting from lower iPod price points and expanded and well-supplied channel distribution. as well as the impact of an additional week included in the first nine months of 2006.

The Retail segment reported a profit of $184 million during the third quarter of 2007 compared to a profit of $122 million during the third quarter of 2006. The segment reported a profit of $607 million during the first nine months of 2007 compared to a profit of $444 million during the first nine months of 2006. The increased profit in the third quarter and first nine months of 2007 was due to the addition of new stores and higher Macintosh net sales, partially offset by increased spending on store remodeling and personnel and a reduction in iPod net sales.

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 $893 million through the end of the third quarter of 2007.

As of June 30, 2007, the Retail segment had approximately 7,300 full-time equivalent employees and had outstanding lease commitments associated with retail space of $1.0 billion.

Gross Margin

Gross margin for the three and nine-month periods ended June 30, 2007 and July 1, 2006 was as follows (in millions, except gross margin percentages):

 

Three Months Ended

 

Nine Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

Net sales

 

$

5,410

 

$

4,370

 

$

17,789

 

$

14,478

 

Cost of sales

 

3,415

 

3,045

 

11,725

 

10,292

 

Gross margin

 

$

1,995

 

$

1,325

 

$

6,064

 

$

4,186

 

Gross margin percentage

 

36.9

%

30.3

%

34.1

%

28.9

%

 

Gross margin percentage for the third quarter and first nine months of 2007 was 36.9% and 34.1%, respectively, compared to 30.3% and 28.9%, for the comparable periods of 2006, respectively. The year-over-year increase in gross margin percentage during the third quarter of 2007 was primarily due to favorable costs of certain commodity components (including LCD flat-panel displays and NAND flash memory), favorable product mix, and higher overall revenue resulting in more effective leverage on fixed production costs.

25




A significant portion of the gross margin improvement in the third quarter of 2007 was due to excess supply in the market for memory and other components. This excess supply in the market has begun to be absorbed and prices of many components have begun to increase. The Company expects this will result in a lower gross margin percentage for the fourth quarter of 2007 as compared to the third quarter of 2007.  The Company also expects gross margin to be negatively impacted in the fourth quarter of 2007 by its back-to-school promotion and product transitions.

Over the longer term, the Company anticipates that its gross margin percentage will be below third quarter 2007 levels due to product sales price competition, changes in product mix and higher component costs across the Company’s product lines.

The foregoing statements regarding the Company’s expected gross margins for the fourth quarter of 2007 and future periods are forward-looking. Gross margin could differ from anticipated levels because of several factors, including certain of those set forth below in Part II, Item 1A., “Risk Factors.” There can be no assurance that the Company will achieve its expected gross margin levels.

Operating Expenses

Operating expenses for the three and nine-month periods ended June 30, 2007 and July 1, 2006 were as follows (in millions, except for percentages):

 

Three Months Ended

 

Nine Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

Research and development

 

$

208

 

$

175

 

$

575

 

$

533

 

Percentage of net sales

 

4

%

4

%

3

%

4

%

Selling, general, and administrative expenses

 

$

746

 

$

584

 

$

2,140

 

$

1,808

 

Percentage of net sales

 

14

%

13

%

12

%

12

%

 

Research and Development (R&D)

Expenditures for R&D increased 19% or $33 million to $208 million in the third quarter of 2007 compared to the same period in 2006, and increased 8% or $42 million to $575 million compared to the first nine months of 2006. R&D expense for the three and nine months ended June 30, 2007 does not include capitalized software development costs of approximately $26 million and $53 million, respectively, related to the development of Mac OS X Leopard and iPhone.  The increases in R&D expense were primarily due to an increase in R&D headcount in the current year to support expanded R&D activities, partially offset by one less week of expenses in the first quarter of 2007 and the capitalized software development costs mentioned above. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the Company’s core business strategy.  As such, the Company expects to increase spending in R&D to remain competitive.

Selling, General, and Administrative Expense (SG&A)

Expenditures for SG&A increased $162 million or 28% and $332 million or 18%, respectively, for the three and nine-month periods ended June 30, 2007, compared to the same periods in 2006.  The increases were primarily due to higher direct and indirect channel variable selling expenses resulting from the significant year-over-year increase in total net sales for both the third quarter and first nine months of 2007, the Company’s continued expansion of its Retail segment in both domestic and international markets, and a current year increase in spending on marketing and advertising, partially offset by one less week of expenses in the first quarter of 2007.

Other Income and Expense

Other income and expense for the three and nine-month periods ended June 30, 2007 and July 1, 2006 were as follows (in millions):

 

Three Months Ended

 

Nine Months Ended

 

 

 

6/30/07

 

7/1/06

 

6/30/07

 

7/1/06

 

Interest income

 

$

168

 

$

99

 

$

459

 

$

274

 

Other income (expense), net

 

(13

)

(4

)

(30

)

(22

)

 

 

 

 

 

 

 

 

 

 

Other income and expense

 

$

155

 

$

95

 

$

429

 

$

252

 

 

Total other income and expense increased $60 million or 63% during the third quarter of 2007 compared to the same period in 2006, and increased $177 million or 70% during the first nine months of 2007 compared to the same period in 2006.  The increases were attributable primarily to higher cash and short-term investment balances and increased investment yields resulting from higher market interest rates. The weighted-average interest rate earned by the Company on its cash, cash equivalents and short-term investments increased to 5.27% in the third quarter of 2007 from 4.77% in the third quarter of 2006.

26




Provision for Income Taxes

The Company’s effective tax rate for the three and nine months ended June 30, 2007 was approximately 32% and 31%, respectively, compared with approximately 29% and 31% for the three and nine months ended July 1, 2006.  The Company’s effective rate for both periods differs from the statutory federal income tax rate of 35% primarily due to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S.  The tax rate for the three months ended June 30, 2007, differs from the same period in 2006 due to a net tax benefit recorded in the third quarter of 2006 resulting from the repatriation of foreign earnings under the American Jobs Creation Act and the implementation of certain tax planning strategies associated with the repatriation.

The Internal Revenue Service (“IRS”) has substantially completed its field audit of the Company’s federal income tax returns for the years 2002 through 2003 and proposed certain adjustments.  The Company intends to contest certain of these adjustments through the IRS Appeals Office.  Substantially all IRS audit issues for years prior to 2002 have been resolved.  In addition, the Company is subject to audits by state, local, and foreign tax authorities.  Management believes that adequate provision has been made for any adjustments that may result from tax examinations.  However, the outcome of tax audits cannot be predicted with certainty.  Should any issues addressed in the Company’s tax audits be resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income tax in the period such resolution occurs.

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS No. 159”), including an amendment of FASB Statement No. 115. SFAS No. 159 allows companies to choose to elect to measure eligible financial instruments and certain other items at fair value that are not required to be measured at fair value. SFAS No. 159 requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company beginning in the first quarter of fiscal 2009.  Although the Company will continue to evaluate the application of SFAS No. 159, management does not currently believe adoption will have a material impact on the Company’s results of operations or financial position.

In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.  SAB No. 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated.  SAB No. 108 is effective for fiscal years ending after November 15, 2006 and is required to be adopted by the Company in the fourth quarter of fiscal 2007.  Although the Company will continue to evaluate the application of SAB No. 108, management does not currently believe adoption will have a material impact on the Company’s results of operations or financial position.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, provides a framework for measuring fair value, and expands the disclosures required for fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require fair value measurements; it does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company beginning in the first quarter of fiscal 2009. Although the Company will continue to evaluate the application of SFAS No. 157, management does not currently believe adoption will have a material impact on the Company’s results of operations or financial position.

In June 2006, the FASB issued FASB Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes by creating a framework for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions that they have taken or expect to take in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by the Company beginning in the first quarter of fiscal 2008. Although the Company will continue to evaluate the application of FIN 48, management does not currently believe adoption will have a material impact on the Company’s results of operations or financial position.

27




Liquidity and Capital Resources

As of June 30, 2007, the Company had $13.8 billion in cash, cash equivalents, and short-term investments, an increase of $3.7 billion over the same balance at the end of September 30, 2006. The principal components of this net increase were cash generated by operating activities of $3.8 billion, proceeds from the issuance of common stock under stock plans of $294 million, and excess tax benefits from stock-based compensation of $303 million.  These increases were partially offset by purchases of property, plant, and equipment of $530 million and payments for acquisitions of intangible assets of $222 million. The Company’s short-term investment portfolio is primarily invested in high credit quality, liquid investments. Additionally, the Company’s working capital was $11.8 billion as of June 30, 2007 compared to $8.0 billion as of September 30, 2006.

The Company believes its existing balances of cash, cash equivalents, and short-term investments will be sufficient to satisfy its working capital needs, capital expenditures, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months.

Capital Expenditures

The Company’s total capital expenditures were $530 million during the first nine months of 2007, consisting of $164 million for retail store facilities and $366 million for real estate acquisitions and corporate infrastructure including information systems enhancements.  The Company currently anticipates it will utilize approximately $850 million for capital expenditures during 2007, including approximately $315 million for expansion of the Company’s Retail segment, and approximately $535 million is projected to support normal replacement of existing capital assets, enhancements to general information technology infrastructure, and to be used for real estate acquisitions including purchases related to the Company’s second corporate campus.

Off-Balance Sheet Arrangements and Contractual Obligations

The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company.

Lease Commitments

As of September 30, 2006, the Company had total outstanding commitments on noncancelable operating leases of approximately $1.2 billion, $887 million of which related to leases of retail space and related facilities. The major facility leases are for terms of 5 to 15 years and generally provide renewal options for terms of 3 to 5 additional years. Leases for retail space are for terms of 5 to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. Total outstanding commitments on noncancelable operating leases related to the lease of retail space increased to $1.0 billion as of June 30, 2007.

Purchase Commitments with Contract Manufacturers and Component Suppliers

The Company utilizes several contract manufacturers to manufacture sub-assemblies for the Company’s products and to perform final assembly and test of finished products. These contract manufacturers acquire components and build product based on demand information supplied by the Company, which typically covers periods ranging from 30 to 150 days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase commitments typically cover the Company’s forecasted component and manufacturing requirements for periods ranging from 30 to 150 days. As of June 30, 2007, the Company had outstanding third-party manufacturing commitments and component purchase commitments of approximately $2.7 billion.

During the first quarter of 2006, the Company entered into long-term supply agreements with Hynix Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND flash memory through calendar year 2010.  As part of these agreements, the Company prepaid $1.25 billion for flash memory components during 2006, which will be applied to certain inventory purchases made over the life of each respective agreement. Approximately $142 million of the prepayment had been utilized by the Company as of June 30, 2007.

28




Asset Retirement Obligations

The Company’s asset retirement obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. As of June 30, 2007, the Company estimated that gross expected future cash flows of approximately $23 million would be required to fulfill these obligations.

Other Obligations

Other outstanding obligations were approximately $19 million as of June 30, 2007, primarily related to Internet and telecommunications services.

Indemnifications

The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against itself or an indemnified third-party and, in the opinion of management, does not have a liability related to unresolved infringement claims subject to indemnification that would have a material adverse effect on its financial condition, liquidity or results of operations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company’s market risk profile has not changed significantly during the first nine months of 2007.

Interest Rate and Foreign Currency Risk Management

The Company regularly reviews its foreign exchange forward and option positions, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. However, given the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. In addition, the timing of the accounting for recognition of gains and losses related to mark-to-market instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s operating results and financial position.

Interest Rate Risk

While the Company is exposed to interest rate fluctuations in many of the world’s leading industrialized countries, the Company’s interest income and expense is most sensitive to fluctuations in the general level of U.S. interest rates. In this regard, changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents, and short-term investments as well as costs associated with foreign currency hedges.

The Company’s short-term investment policy and strategy is to ensure the preservation of capital, meet liquidity requirements, and optimize return in light of the current credit and interest rate environment.  A portion of the Company’s cash is managed by external managers within the guidelines of the Company’s investment policy and to an objective market benchmark.  The Company’s internal portfolio is benchmarked against external manager performance, allowing for differences in liquidity needs.

The Company’s exposure to market risk for changes in interest rates relates primarily to the Company’s investment portfolio. The Company places its short-term investments in highly liquid securities issued by high credit quality issuers and, by policy, limits the amount of credit exposure to any one issuer. The Company’s general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with initial maturities of three months or less are classified as cash equivalents; highly liquid investments with initial maturities greater than three months are classified as short-term investments.  As of June 30, 2007, approximately $2.1 billion of the Company’s short-term investments had underlying maturities ranging from 1 to 5 years.  The remainder all had underlying maturities of less than 12 months.  The Company may sell its investments prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company recognized no material net gains or losses during the third quarter of 2007 or 2006 related to such sales.

29




Foreign Currency Risk

In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, may negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates.

The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company’s practice is to hedge a majority of its existing material foreign exchange transaction exposures in the future. However, the Company may choose not to hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular exposures, and/or limited availability of appropriate hedging instruments.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”) were effective as of June 30, 2007 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

There were no changes in the Company’s internal control over financial reporting during the third quarter of 2007, which were identified in connection with management’s evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The Company is subject to various legal proceedings and claims as of June 30, 2007, the end of the quarterly period covered by this report, that are discussed below. The Company is also subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and which 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. The Company settled certain matters during the third quarter of 2007 that did not individually or in the aggregate have a material impact on the Company’s results of operations.

Apple Computer, Inc. v. Burst.com, Inc.

The Company filed an action for declaratory judgment against defendant Burst.com, Inc. on January 4, 2006 in the United States District Court for the Northern District of California. The Company seeks declaratory judgment that U.S. Patent Nos. 4,963,995, 5,164,839, 5,057,932 and 5,995,705 (“Burst patents”) are invalid and not infringed by the Company. Burst filed an answer and counterclaim on April 17, 2006. Burst alleges that the following Apple products and services infringe U.S. Patent Nos. 4,963,995, 5,057,932, 5,164,839, and 5,995,705; iTunes Store, iPod devices, QuickTime products (including QuickTime player and QuickTime Streaming Server), iTunes software, other Apple software products (Final Cut Studio, GarageBand, iMovie, iDVD, iWeb), the use of the ..Mac services and Apple computers and servers running iTunes, QuickTime, or the other named Apple software products. The Burst patents allegedly relate to methods and devices used for “burst” transmission of audio or video files. The case is in discovery. A claim construction hearing was held on February 8, 2007, and the court issued its claim construction ruling on May 8, 2007. Trial is set for February 26, 2008.

30




Bader v. Anderson, et al.

Plaintiff filed this purported shareholder derivative action against the Company and each of its then current executive officers and members of its Board of Directors on May 19, 2005 in Santa Clara County Superior Court asserting claims for breach of fiduciary duty, material misstatements and omissions and violations of California Business & Professions Code §17200 (unfair competition). Plaintiff alleges that the Company’s March 14, 2005, proxy statement was false and misleading for failure to disclose certain information relating to the Apple Computer, Inc. Performance Bonus Plan, which was approved by shareholders at the annual meeting held on April 21, 2005. Plaintiff, who ostensibly brings suit on the Company’s behalf, has made no demand on the Board of Directors and alleges that such demand is excused. Plaintiff seeks injunctive and other relief for purported injury to the Company. On July 27, 2005, plaintiff filed an amended complaint alleging that, in addition to the purported derivative claims, adoption of the bonus plan and distribution of the proxy statement describing that plan also inflicted injury on her directly as an individual shareholder. On January 10, 2006, the Court sustained defendants’ demurrer to the amended complaint, with leave to amend. Plaintiff filed a second amended complaint on February 7, 2006, and the Company filed a demurrer. After a hearing on June 13, 2006, the Court sustained the demurrer without leave to amend as to the non-director officers and with leave to amend as to the directors. On July 24, 2006, plaintiff filed a third amended complaint, which purports to bring claims derivatively as well as directly on behalf of a class of common stockholders who have been or will be harmed by virtue of the allegedly misleading proxy statement. In addition to reasserting prior causes of action, the third amended complaint included a claim that the Company violated the terms of the plan, and a claim for waste related to restricted stock unit grants to certain officers in 2003 and 2004 and an option grant to the Company’s CEO in January 2000. The Company filed a demurrer to the third amended complaint. On January 30, 2007, the Court sustained the Company’s demurrer with leave to amend.  Plaintiff filed a fourth amended complaint on May 8, 2007, and the Company filed a demurrer, which will be heard on September 28, 2007.

Birdsong v. Apple Computer, Inc.

This action alleges that the Company’s iPod music players, and the ear bud headphones sold with them, are inherently defective in design and are sold without adequate warnings concerning the risk of noise-induced hearing loss by iPod users. The Birdsong action was initially filed on January 30, 2006 in the United States District Court for the Western District of Louisiana asserting Louisiana causes of action on behalf of a purported Louisiana class of iPod purchasers. A similar action (Patterson v. Apple Computer, Inc.) was filed on January 31, 2006 in the United States District Court for the Northern District of California asserting California causes of action on behalf of a purported class of all iPod purchasers within the four-year period before January 31, 2006.  The Birdsong action was transferred to the Northern District of California, and the Patterson action was dismissed. An amended complaint was subsequently filed in Birdsong, dropping the Louisiana law-based claims and adding California law-based claims equivalent to those in Patterson. After the Company filed a motion to dismiss on November 3, 2006, plaintiffs agreed not to oppose the motion and filed a second amended complaint on January 16, 2007. That complaint alleges California law-based claims for breaches of implied and express warranties, violations of California Business & Professions Code §17200 (unfair competition), California Business & Professions Code §17500 (false advertising), the Consumer Legal Remedies Act and negligent misrepresentation on behalf of a putative nationwide class and a Louisiana law-based claim for redhibition for a Louisiana sub-class.  On March 1, 2007, the Company filed a motion to dismiss the California law based claims.  The court held a hearing on the motion to dismiss on June 4, 2007 but has not yet issued a ruling.

A similar complaint, Royer-Brennan v. Apple Computer, Inc. and Apple Canada, Inc., was filed in Montreal, Quebec, Canada, on February 1, 2006, seeking authorization to institute a class action on behalf of iPod purchasers in Quebec.  At the request of plaintiffs’ counsel, the court has postponed class certification proceedings in this action indefinitely.

Branning et al. v. Apple Computer, Inc.

Plaintiffs originally filed this purported class action in San Francisco County Superior Court on February 17, 2005. The initial complaint alleged violations of California Business & Professions Code §17200 (unfair competition) and violation of the Consumer Legal Remedies Act (“CLRA”) regarding a variety of purportedly unfair and unlawful conduct including, but not limited to, allegedly selling used computers as new and failing to honor warranties. Plaintiffs also brought causes of action for misappropriation of trade secrets, breach of contract and violation of the

31




Song-Beverly Consumer Warranty Act. Plaintiffs requested unspecified damages and other relief. On May 9, 2005, the Court granted the Company’s motion to transfer the case to Santa Clara County Superior Court. On May 2, 2005, plaintiffs filed an amended complaint adding two new named plaintiffs and three new causes of action including a claim for treble damages under the Cartwright Act (California Business & Professions Code §16700 et seq.) and a claim for false advertising. The Company filed a demurrer to the amended complaint, which the Court sustained in its entirety on November 10, 2005. The Court granted plaintiffs leave to amend and they filed an amended complaint on December 29, 2005. Plaintiffs’ amended complaint added three plaintiffs and alleged many of the same factual claims as the previous complaints, such as alleged selling of used equipment as new, alleged failure to honor warranties and service contracts for the consumer plaintiffs, and alleged fraud related to the opening of the Apple retail stores.  Plaintiffs continued to assert causes of action for unfair competition (§17200), violations of the CLRA, breach of contract, misappropriation of trade secrets, violations of the Cartwright Act, and alleged new causes of action for fraud, conversion, and breach of the implied covenant of good faith and fair dealing. The Company filed a demurrer to the amended complaint on January 31, 2006, which the Court sustained on March 3, 2006 on sixteen of seventeen causes of action. Plaintiffs filed an amended complaint adding one new plaintiff. The Company filed a demurrer, which was granted in part on September 9, 2006. Plaintiffs filed a further amended complaint on September 21, 2006. On October 2, 2006, the Company filed an answer denying all allegations and asserting numerous affirmative defenses. The case is in discovery.

European Commission Investigation

The European Commission is investigating certain matters relating to the iTunes Stores in Europe. The European Commission had previously notified the Company that it was investigating claims made by Which?, a United Kingdom (“U.K.”) consumer association, that the Company is violating EU competition law by charging more for online music in the U.K. than in Eurozone countries and preventing U.K. consumers from purchasing online music from the iTunes Store for Eurozone countries. The Which? claims were originally lodged with the U.K. Office of Fair Trading, which subsequently referred them to the European Commission.

On March 30, 2007, the European Commission issued Statements of Objections to the major record labels, Apple Inc. and iTunes S.à.r.l.  In the Statements of Objections, the Commission challenges provisions in the agreements pursuant to which each major record company authorizes iTunes S.à.r.l. to distribute digital music downloads through the iTunes Store. The Commission contends that, because of these provisions, residents of the European Economic Area are only permitted to buy music from the iTunes Store for the country that issued the customer’s credit card. The Commission contends that these provisions are territorial sales restrictions which violate Article 81 of the European Community Treaty. The Commission seeks fines and behavioral relief.  The Company filed its responses to the Statements of Objections on June 20, 2007.

Gordon v. Apple Computer, Inc.

Plaintiff filed this purported class action on August 31, 2006 in the United States District Court for the Northern District of California, San Jose Division, on behalf of a purported nationwide class of consumers who purchased 65W Power Adapters for iBooks and Powerbooks between November 2002 and the present. The complaint alleges various problems with the 65W Adapter, including fraying, sparking, and premature failure. Plaintiffs allege violations of California Business & Professions Code §17200 (unfair competition), the Consumer Legal Remedies Act, the Song-Beverly Consumer Warranty Act and breach of warranties. The complaint seeks damages and equitable relief. The Company filed an answer on October 20, 2006 denying the material allegations and asserting numerous affirmative defenses. A mediation was held on March 13, 2007. The litigation has been suspended pending ongoing settlement discussions.

Greaves v. Apple Computer, Inc.

On June 30, 2006, plaintiff filed this purported class action in San Diego Superior Court on behalf of a purported class of California purchasers alleging discoloration of the MacBook case. Plaintiff asserts claims under California Business & Professions Code §17500 (false advertising), California Business & Professions Code §17200 (unfair competition), the Consumer Legal Remedies Act and misrepresentation. Plaintiff’s complaint seeks damages and equitable relief. Plaintiff filed a First Amended Complaint on August 16, 2006. The Company filed an answer on October 3, 2006 denying all allegations and asserting numerous affirmative defenses. The parties have reached a settlement and the matter is concluded.  The settlement did not have a material effect on the Company’s financial position or results of operation.

32




Honeywell International, Inc., et al. v. Apple Computer, Inc., et al.

Plaintiffs Honeywell International, Inc. and Honeywell Intellectual Properties, Inc. filed this action on October 6, 2004 in the United States District Court in Delaware alleging infringement by the Company and other defendants of U.S. Patent 5,280,371 entitled “Directional Diffuser for a Liquid Crystal Display.” Plaintiffs seek unspecified damages and other relief. The Company filed an answer on December 21, 2004 denying all material allegations and asserting numerous affirmative defenses. The Company has tendered the case to several liquid crystal display manufacturer suppliers. On May 18, 2005 the Court stayed the case against the Company and the other non-manufacturer defendants. Plaintiffs filed an amended complaint on November 7, 2005 adding additional defendants and expanding the scope of the accused products. Given the stay, the Company’s response to the amended complaint is not yet due.

In re Apple Computer, Inc. Derivative Litigation (formerly Karant v. Jobs, et al. and Related Actions) (Federal Action)

On June 30, 2006, a putative derivative action captioned Karant v. Jobs, et. al., was filed in the United States District Court for the Northern District of California, San Jose Division. A number of related actions were filed in the subsequent weeks and have been consolidated into a single action captioned In re Apple Computer, Inc. Derivative Litigation, Master File No. C-06-04128-JF before the Hon. Jeremy Fogel. The actions were filed after the Company’s announcement on June 29, 2006 that an internal investigation had discovered irregularities related to the issuance of certain stock option grants made between 1997 and 2001, that a special committee of the Company’s outside directors had retained independent counsel to perform an investigation and that the Company had informed the Securities and Exchange Commission. A Consolidated Shareholder Derivative Complaint was filed on December 18, 2006. The action purports to assert claims on behalf of the Company against several current and former executive officers and members of the Board of Directors alleging improper backdating of stock option grants to maximize certain defendants’ profits, failing to properly account for and take tax deductions for those grants, insider trading, and issuing false financial statements. The Company is named as a nominal defendant. The consolidated complaint alleges various causes of action under federal and California law, including claims for unjust enrichment, breach of fiduciary duty, violation of the California Corporations Code, abuse of control, gross mismanagement, rescission, constructive fraud and waste of corporate assets, as well as claims under Sections 10(b), 14(a) and 20(a) of the Securities Exchange Act. Plaintiffs seek damages, disgorgement, restitution and imposition of a constructive trust. A First Amended Shareholder Derivative Complaint was filed on March 6, 2007.  The Company and other defendants filed a motion to dismiss the amended complaint on April 20, 2007. The hearing on the motion is scheduled for September 7, 2007.

In re Apple Computer, Inc. Derivative Litigation (formerly Plumbers and Pipefitters v. Jobs, et al. and Related Actions) (State Action); Boston Retirement Board v. Apple Computer, Inc.

On July 5, 2006, a putative derivative action captioned Plumbers and Pipefitters v. Jobs, et. al., was filed in California Superior Court for the County of Santa Clara. A number of related actions were filed in the subsequent weeks, and have been consolidated into a single action captioned In re Apple Computer, Inc. Derivative Litigation, No. 1:06CV066692, assigned to the Hon. Joseph Huber. These actions purport to assert claims on behalf of the Company against several current and former executive officers and members of the Board of Directors alleging improper backdating of stock option grants to maximize certain defendants’ profits, failing to properly account for and take tax deductions for those grants and issuing false financial statements. The Company is named as a nominal defendant. A consolidated complaint was filed on October 5, 2006, alleging a variety of causes of action under California law, including claims for unjust enrichment, breach of fiduciary duty, violation of the California Corporations Code, abuse of control, accounting, constructive trust, rescission, deceit, gross mismanagement and waste of corporate assets. On December 7, 2006, the Court granted the Company’s motion to stay these actions.

On November 3, 2006, the Boston Retirement Board, a purported shareholder, filed a petition for writ of mandate against the Company in California Superior Court for the County of Santa Clara County (Boston Retirement Board v. Apple Computer Inc.). The petition seeks to compel the Company to allow inspection of certain corporate records relating to the Company’s option practices and the Special Committee’s investigation. On January 16, 2007, the Company filed a demurrer to the petition. The Court entered an order overruling the demurrer on March 13, 2007.  The Company filed its answer to the petition on April 5, 2007.  A trial is set for August 20, 2007.

33




In re Apple iPod Nano Products Liability Litigation (formerly Wimmer v. Apple Computer, Inc.; Moschella, et al., v. Apple Computer, Inc.; Calado, et al. v. Apple Computer, Inc.; Kahan, et al., v. Apple Computer, Inc.; Jennings, et al., v. Apple Computer, Inc.; Rappel v. Apple Computer, Inc.; Mayo v. Apple Computer, Inc.; Valencia v. Apple Computer, Inc.; Williamson v. Apple Computer, Inc.; Sioson v. Apple Computer, Inc.

Beginning on October 19, 2005, eight complaints were filed in various United States District Courts and two complaints were filed in California State Court alleging that the Company’s iPod nano was defectively designed so that it scratches excessively during normal use, rendering the screen unreadable.

The federal actions were coordinated in the United States District Court for the Northern District of California and assigned to the Hon. Ronald Whyte pursuant to an April 17, 2006 order of the Judicial Panel on Multidistrict Litigation. Plaintiffs filed a First Consolidated and Amended Master Complaint on September 21, 2006, alleging violations of California and other states’ consumer protection and warranty laws and claiming unjust enrichment. The Master Complaint alleges two putative plaintiff classes: (1) all U.S. residents (excluding California residents) who purchased an iPod nano that was not manufactured or designed using processes necessary to ensure normal resistance to scratching of the screen; and (2) all iPod nano purchasers other than U.S. residents who purchased an iPod nano that was not manufactured or designed using processes necessary to ensure normal resistance to scratching of the screen. The Company answered the Master Complaint on November 20, 2006. The case is in discovery.

The two California State Court actions were coordinated on May 4, 2006, and assigned to the Hon. Carl West in Los Angeles Superior Court. Plaintiffs filed a Consolidated Amended Class Action Complaint on June 8, 2006, alleging violations of California state consumer protection, unfair competition, false advertising and warranty laws and claiming unjust enrichment. The Consolidated Complaint alleges a putative plaintiff class of all California residents who own an iPod nano containing a manufacturing defect that results in the nano being susceptible to excessive scratching. The Company answered the Consolidated Amended Complaint on October 6, 2006.

Two similar complaints, Carpentier v. Apple Canada, Inc., and Royer-Brennan v. Apple Computer, Inc. and Apple Canada, Inc. were filed in Montreal, Quebec, Canada on October 27, 2005 and November 9, 2005, respectively, seeking authorization to institute class actions on behalf of iPod nano purchasers in Quebec. The Royer-Brennan file was stayed in May 2006 in favor of the Carpentier file. A similar complaint, Mund v. Apple Canada Inc. and Apple Computer, Inc., was filed in Ontario, Canada on January 9, 2006 seeking authorization to institute a class action on behalf of iPod nano purchasers in Canada. Apple Canada Inc. and Apple Computer, Inc. have served Notices of Intent to Defend.

Intertainer, Inc. v. Apple Computer, Inc., et al.

Plaintiff Intertainer, Inc. filed this action on December 29, 2006 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement by the Company of U.S. Patent No.6,925,469 entitled “Digital Entertainment Service Platform.” The complaint seeks unspecified damages and other relief. The Company filed an answer on February 21, 2007 denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of noninfringement and invalidity.

Lenzi v. Apple Canada, Inc.; Wolfe v. Apple Computer, Inc. and Apple Canada, Inc.; Hirst v. Apple Canada, Inc.; Hamilton v. Apple Computer, Inc. and Apple Canada, Inc.

Plaintiff filed a purported class action on June 7, 2005, in Superior Court, in Montreal, Quebec, Canada allegedly on behalf of Quebec customers claiming false advertising and breach of warranty relating to iPod battery life. Plaintiff sought authorization to institute a class action on behalf of Generations 1, 2 and 3 iPod owners in Quebec. On February 2, 2006, the Court dismissed plaintiff’s motion for authorization to institute a class action.  Plaintiff appealed this ruling.

Two similar complaints relative to iPod battery life, Wolfe v. Apple and Hirst v. Apple, were filed in Toronto, Ontario, Canada on August 15, 2005 and September 12, 2005, respectively. Counsel subsequently amended the complaint, now called Waddell vs. Apple. The Waddell lawsuit is brought on behalf of all Canadian purchasers other than Quebec purchasers. On January 17, 2007, the Company filed its statement of defence to the Waddell complaint. In addition, a similar complaint regarding iPod battery life, Hamilton v. Apple Computer, Inc. and Apple Canada, Inc. was filed in Calgary, Alberta, Canada on October 5, 2005, purportedly on behalf of all purchasers of iPods in Alberta, Canada. The complaint was served on September 27, 2006.  The Company’s response is not yet due.

34




Macadam v. Apple Computer, Inc.; Santos v. Apple Computer, Inc. (Santa Clara County Superior Court)

Plaintiff filed this action in late 2002 asserting various causes of action including breach of contract, fraud, negligent and intentional interference with economic relationship, negligent misrepresentation, trade libel, unfair competition and false advertising. Plaintiff requests unspecified damages and other relief. The Company filed an answer on December 3, 2004 denying all allegations and asserting numerous defenses.

On October 1, 2003, Macadam was deauthorized as an Apple reseller. Macadam filed a motion for a temporary order to reinstate it as a reseller, which the Court denied. The Court denied Macadam’s motion for a preliminary injunction on December 19, 2003. On December 6, 2004, Macadam filed for Chapter 11 bankruptcy in the Northern District of California, which placed a stay on the litigation as to Macadam. The Company filed a claim in the bankruptcy proceedings on February 16, 2005. The Macadam bankruptcy case was converted to Chapter 7 (liquidation) on April 29, 2005. The Company has reached a settlement of Macadam’s claims against the Company with the Chapter 7 Bankruptcy Trustee. The Bankruptcy Court approved the settlement on July 17, 2006 over the objection of Tom Santos, MacAdam’s principal. Santos appealed the ruling approving the settlement to the United States District Court but the ruling was affirmed on June 28 2007. Santos has appealed the District Court’s ruling to the Ninth Circuit Court of Appeals.

On December 19, 2005, Tom Santos, who was an original plaintiff in the Macadam case, filed a Fifth Amended Complaint on his own behalf (not on behalf of Macadam) alleging fraud, violations of California Business & Professions Code §17200 (unfair competition), California Business & Professions Code §17500 (false advertising) and the Consumer Legal Remedies Act. The Company filed a cross complaint against Santos on January 20, 2006 alleging violations of California Business & Professions Code §17200 and California Penal Code §502, fraud and deceit and breach of contract. The Company also filed a demurrer to Santos’ amended complaint and a special motion to strike the defamation cause of action on January 20, 2006. The Court sustained the demurrer in part but denied the special motion to strike. Santos filed a Sixth Amended Complaint on July 14, 2006. The Company filed a demurrer, which was granted on September 9, 2006. Santos filed a Seventh Amended Complaint in late September, 2006. The Company filed a motion to strike, which was granted in part and denied in part on December 15, 2006. Santos filed an Eighth Amended Complaint on January 29, 2007. The Company filed a demurrer, which was granted on July 3, 2007. Santos filed a Ninth Amended Complaint on July 11, 2007.

Macsolutions, Inc. v. Apple Computer, Inc.

Plaintiff Macsolutions, Inc., a former Apple authorized reseller, filed this lawsuit against the Company on January 20, 2006 alleging breach of contract, fraud, misappropriation of trade secrets, intentional interference with economic advantage, violation of the Cartwright Act, violation of California Business & Professions Code §17200 (unfair competition) and fraudulent concealment. The factual allegations in this complaint were similar to those in the Macadam case and the Branning class action. Principally, plaintiffs alleged that the Company treated Macsolutions unfairly compared to other resellers, competed unfairly in opening the Apple retail stores and sold used goods as new. Macsolutions filed an amended complaint on June 5, 2006, adding Tech Data Corporation as a defendant. The Company filed an answer on July 5, 2006 generally denying all allegations and asserting numerous affirmative defenses. The parties have reached a settlement and the matter is concluded.  Settlement of this matter did not have a material effect on the Company’s financial position or results of operations.

OPTi Inc. v. Apple Inc.

Plaintiff OPTi Inc. filed this action against the Company on January 16, 2007 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement of U.S. Patent Nos. 5,710,906, 5,813,036 and 6,405,291, all entitled “Predictive Snooping of Cache Memory for Master-Initiated Accesses.”  The complaint seeks unspecified damages and other relief. The Company filed an answer on April 17, 2007 denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of noninfringement and invalidity.

35




PhatRat Technology LLC v. Apple Computer, Inc.

Plaintiff PhatRat Technology LLC filed this action on October 24, 2006 in the United States District Court for the District of Colorado alleging infringement of U.S. Patent number 6,499,000 entitled “System and Method for Determining Loft Time, Speed, Height and Distance,” U.S. Patent number 6,885,971 entitled “Methods and Systems for Assessing Athletics Performance,” U.S. Patent number 6,963,818 entitled “Mobile Speedometer Systems and Associated Methods,” and U.S. Patent number 7,092,846 entitled “Systems and Methods for Determining Performance Data,” as well as allowed U.S. Patent A