Apple Inc.
APPLE INC (Form: 10-Q, Received: 04/24/2014 17:03:11)
Table of Contents

 

 

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 March 29, 2014

or

 

¨

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

For the transition period from              to              .

Commission File Number: 000-10030

 

 

APPLE INC.

(Exact name of Registrant as specified in its charter)

 

 

 

California   94-2404110

(State or other jurisdiction

of incorporation or organization)

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

1 Infinite Loop

Cupertino, California

  95014
(Address of principal executive offices)   (Zip Code)

(408) 996-1010

(Registrant’s telephone number, including area code)

 

 

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   ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes   x     No   ¨

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

 

Large accelerated filer

 

x

  

Accelerated filer

 

¨

Non-accelerated filer

 

¨   (Do not check if a smaller reporting company)

  

Smaller reporting company

 

¨

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

Yes   ¨     No   x

861,381,000 shares of common stock, par value $0.00001, issued and outstanding as of April 11, 2014

 

 

 


Table of Contents

Apple Inc.

Form 10-Q

For the Fiscal Quarter Ended March 29, 2014

TABLE OF CONTENTS

 

          Page  
Part I   

Item 1.

  

Financial Statements

     3   

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     23   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     37   

Item 4.

  

Controls and Procedures

     37   
Part II   

Item 1.

  

Legal Proceedings

     38   

Item 1A.

  

Risk Factors

     39   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     49   

Item 3.

  

Defaults Upon Senior Securities

     49   

Item 5.

  

Other Information

     49   

Item 6.

  

Exhibits

     50   

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

APPLE INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(In millions, except number of shares which are reflected in thousands and per share amounts)

 

                                                                                                   
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     March 29,
2014
     March 30,
2013
 

Net sales

   $ 45,646       $ 43,603       $ 103,240       $ 98,115   

Cost of sales

     27,699         27,254         63,447         60,706   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross margin

     17,947         16,349         39,793         37,409   
  

 

 

    

 

 

    

 

 

    

 

 

 

Operating expenses:

           

Research and development

     1,422         1,119         2,752         2,129   

Selling, general and administrative

     2,932         2,672         5,985         5,512   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total operating expenses

     4,354         3,791         8,737         7,641   
  

 

 

    

 

 

    

 

 

    

 

 

 

Operating income

     13,593         12,558         31,056         29,768   

Other income/(expense), net

     225         347         471         809   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income before provision for income taxes

     13,818         12,905         31,527         30,577   

Provision for income taxes

     3,595         3,358         8,232         7,952   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

   $ 10,223       $ 9,547       $ 23,295       $ 22,625   
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings per share:

           

Basic

   $ 11.69       $ 10.16       $ 26.31       $ 24.09   

Diluted

   $ 11.62       $ 10.09       $ 26.16       $ 23.90   

Shares used in computing earnings per share:

           

Basic

     874,757         939,629         885,415         939,273   

Diluted

     879,528         946,035         890,490         946,626   

Cash dividends declared per common share

   $ 3.05       $ 2.65       $ 6.10       $ 5.30   

See accompanying Notes to Condensed Consolidated Financial Statements.

 

3


Table of Contents

APPLE INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(In millions)

 

                                                                                                   
     Three Months Ended     Six Months Ended  
     March 29,
2014
    March 30,
2013
    March 29,
2014
    March 30,
2013
 

Net income

   $ 10,223      $ 9,547      $ 23,295      $ 22,625   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income/(loss):

        

Change in foreign currency translation, net of tax

     (19     (51     (86     (77

Change in unrecognized gains/losses on derivative instruments:

        

Change in fair value of derivatives, net of tax

     (109     457        104        603   

Adjustment for net (gains)/losses realized and included in net income, net of tax

     (13     42        59        154   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total change in unrecognized gains/losses on derivative instruments, net of tax

     (122     499        163        757   
  

 

 

   

 

 

   

 

 

   

 

 

 

Change in unrealized gains/losses on marketable securities:

        

Change in fair value of marketable securities, net of tax

     235        (52     193        (118

Adjustment for net (gains)/losses realized and included in net income, net of tax

     (39     (44     (50     (97
  

 

 

   

 

 

   

 

 

   

 

 

 

Total change in unrealized gains/losses on marketable securities, net of tax

     196        (96     143        (215
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other comprehensive income/(loss)

     55        352        220        465   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total comprehensive income

   $ 10,278      $ 9,899      $ 23,515      $ 23,090   
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

4


Table of Contents

APPLE INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(In millions, except number of shares which are reflected in thousands)

 

                                                 
     March 29,
2014
    September 28,
2013
 
ASSETS:     

Current assets:

    

Cash and cash equivalents

   $ 18,949      $ 14,259   

Short-term marketable securities

     22,401        26,287   

Accounts receivable, less allowances of $88 and $99, respectively

     9,700        13,102   

Inventories

     1,829        1,764   

Deferred tax assets

     4,014        3,453   

Vendor non-trade receivables

     6,120        7,539   

Other current assets

     7,528        6,882   
  

 

 

   

 

 

 

Total current assets

     70,541        73,286   

Long-term marketable securities

     109,239        106,215   

Property, plant and equipment, net

     15,120        16,597   

Goodwill

     2,055        1,577   

Acquired intangible assets, net

     3,928        4,179   

Other assets

     5,106        5,146   
  

 

 

   

 

 

 

Total assets

   $ 205,989      $ 207,000   
  

 

 

   

 

 

 
LIABILITIES AND SHAREHOLDERS’ EQUITY:     

Current liabilities:

    

Accounts payable

   $ 18,914      $ 22,367   

Accrued expenses

     15,984        13,856   

Deferred revenue

     8,310        7,435   
  

 

 

   

 

 

 

Total current liabilities

     43,208        43,658   

Deferred revenue – non-current

     3,164        2,625   

Long-term debt

     16,962        16,960   

Other non-current liabilities

     22,476        20,208   
  

 

 

   

 

 

 

Total liabilities

     85,810        83,451   
  

 

 

   

 

 

 

Commitments and contingencies

    

Shareholders’ equity:

    

Common stock and additional paid-in capital, $0.00001 par value: 1,800,000 shares authorized; 861,745 and 899,213 shares issued and outstanding, respectively

     21,496        19,764   

Retained earnings

     98,934        104,256   

Accumulated other comprehensive income/(loss)

     (251     (471
  

 

 

   

 

 

 

Total shareholders’ equity

     120,179        123,549   
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 205,989      $ 207,000   
  

 

 

   

 

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

5


Table of Contents

APPLE INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(In millions)

 

                                                 
     Six Months Ended  
     March 29,
2014
    March 30,
2013
 

Cash and cash equivalents, beginning of the period

   $ 14,259      $ 10,746   
  

 

 

   

 

 

 

Operating activities:

    

Net income

     23,295        22,625   

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

    

Depreciation and amortization

     4,031        3,280   

Share-based compensation expense

     1,377        1,120   

Deferred income tax expense

     2,059        1,957   

Changes in operating assets and liabilities:

    

Accounts receivable, net

     3,401        3,846   

Inventories

     (65     (454

Vendor non-trade receivables

     1,419        1,510   

Other current and non-current assets

     14        1,269   

Accounts payable

     (2,375     (4,422

Deferred revenue

     1,414        1,541   

Other current and non-current liabilities

     1,638        3,658   
  

 

 

   

 

 

 

Cash generated by operating activities

     36,208        35,930   
  

 

 

   

 

 

 

Investing activities:

    

Purchases of marketable securities

     (90,360     (81,163

Proceeds from maturities of marketable securities

     10,869        9,243   

Proceeds from sales of marketable securities

     80,241        49,188   

Payments made in connection with business acquisitions, net

     (559     (299

Payments for acquisition of property, plant and equipment

     (3,367     (4,325

Payments for acquisition of intangible assets

     (163     (429

Other

     (23     (93
  

 

 

   

 

 

 

Cash used in investing activities

     (3,362     (27,878
  

 

 

   

 

 

 

Financing activities:

    

Proceeds from issuance of common stock

     341        275   

Excess tax benefits from equity awards

     363        502   

Taxes paid related to net share settlement of equity awards

     (430     (588

Dividends and dividend equivalents paid

     (5,430     (4,984

Repurchase of common stock

     (23,000     (1,950
  

 

 

   

 

 

 

Cash used in financing activities

     (28,156     (6,745
  

 

 

   

 

 

 

Increase in cash and cash equivalents

     4,690        1,307   
  

 

 

   

 

 

 

Cash and cash equivalents, end of the period

   $ 18,949      $ 12,053   
  

 

 

   

 

 

 

Supplemental cash flow disclosure:

    

Cash paid for income taxes, net

   $ 5,369      $ 4,258   

Cash paid for interest

   $ 161      $ 0   

See accompanying Notes to Condensed Consolidated Financial Statements.

 

6


Table of Contents

Apple Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1 – Summary of Significant Accounting Policies

Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, manufactures, and markets mobile communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of third-party iPhone, iPad, Mac, and iPod compatible products, including application software, and various accessories through its online and retail stores. The Company sells to consumers; small and mid-sized businesses; and education, enterprise 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 (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in these condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.

These condensed consolidated financial statements and accompanying notes should be read in conjunction with the Company’s annual consolidated financial statements and the notes thereto for the fiscal year ended September 28, 2013, included in its Annual Report on Form 10-K (the “2013 Form 10-K”). The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. An additional week is included in the first fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters. The Company’s fiscal years 2014 and 2013 each include 52 weeks. Unless otherwise stated, references to particular years, quarters or months refer to the Company’s fiscal years ended in September and the associated quarters or months of those fiscal years.

During the first quarter of 2014, the Company adopted updated accounting standards that (i) required disclosure of additional information about the amounts reclassified out of Accumulated Other Comprehensive Income (“AOCI”) by component and (ii) required gross and net disclosures about offsetting assets and liabilities. The adoption of these updated standards only impacted the disclosures in the Notes to the Condensed Consolidated Financial Statements; accordingly, the adoption had no impact on the Company’s financial position or results of operations. The Company has provided these additional disclosures in this Form 10-Q in Note 8, “Comprehensive Income” and Note 2, “Financial Instruments,” respectively.

Revenue Recognition

In 2013, the Company’s combined best estimates of selling price (“ESPs”) for the unspecified software upgrade rights and the rights to receive the non-software services included with its qualifying hardware devices ranged from $5 to $25. Beginning in the first quarter of 2014, the Company adjusted the combined ESPs for Mac from $20 to $40 to reflect additions to unspecified software upgrade rights related to expansion of bundled essential software.

 

7


Table of Contents

Earnings Per Share

Basic earnings per 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 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 potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, shares to be purchased under the Company’s employee stock purchase plan and unvested restricted stock units (“RSUs”). The dilutive effect of potentially dilutive securities 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 potentially dilutive securities.

The following table shows the computation of basic and diluted earnings per share for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (in thousands, except net income in millions and per share amounts):

 

                                                                                                   
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     March 29,
2014
     March 30,
2013
 

Numerator:

           

Net income

   $ 10,223       $ 9,547       $ 23,295       $ 22,625   

Denominator:

           

Weighted-average shares outstanding

     874,757         939,629         885,415         939,273   

Effect of dilutive securities

     4,771         6,406         5,075         7,353   
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted-average diluted shares

     879,528         946,035         890,490         946,626   
  

 

 

    

 

 

    

 

 

    

 

 

 

Basic earnings per share

   $ 11.69       $ 10.16       $ 26.31       $ 24.09   

Diluted earnings per share

   $ 11.62       $ 10.09       $ 26.16       $ 23.90   

Potentially dilutive securities, the effect of which would have been antidilutive, were not significant for the three- and six-month periods ended March 29, 2014 and the three- and six-month periods ended March 30, 2013. The Company excluded these securities from the computation of diluted earnings per share.

 

8


Table of Contents

Note 2 – Financial Instruments

Cash, Cash Equivalents and Marketable Securities

The following tables show the Company’s cash and available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category recorded as cash and cash equivalents or short- or long-term marketable securities as of March 29, 2014 and September 28, 2013 (in millions):

 

                                                                                                                                                         
     March 29, 2014  
     Adjusted
Cost
     Unrealized
Gains
     Unrealized
Losses
     Fair
Value
     Cash and
Cash
Equivalents
     Short-Term
Marketable
Securities
     Long-Term
Marketable
Securities
 

Cash

   $ 10,948       $ 0       $ 0       $ 10,948       $ 10,948       $ 0       $ 0   

Level 1 (a):

                    

Money market funds

     3,203         0         0         3,203         3,203         0         0   

Mutual funds

     4,063         0         (213      3,850         0         3,850         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal

     7,266         0         (213      7,053         3,203         3,850         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Level 2 (b):

                    

U.S. Treasury securities

     24,645         12         (26      24,631         1,359         5,445         17,827   

U.S. agency securities

     10,766         5         (24      10,747         234         1,340         9,173   

Non-U.S. government securities

     6,406         42         (109      6,339         10         480         5,849   

Certificates of deposit and time deposits

     3,344         0         0         3,344         1,735         771         838   

Commercial paper

     2,627         0         0         2,627         1,350         1,277         0   

Corporate securities

     63,575         351         (145      63,781         110         8,373         55,298   

Municipal securities

     4,117         32         (3      4,146         0         839         3,307   

Mortgage- and asset-backed securities

     17,004         34         (65      16,973         0         26         16,947   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal

     132,484         476         (372      132,588         4,798         18,551         109,239   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 150,698       $ 476       $ (585    $ 150,589       $ 18,949       $ 22,401       $ 109,239   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

                                                                                                                                                         
     September 28, 2013  
     Adjusted
Cost
     Unrealized
Gains
     Unrealized
Losses
     Fair
Value
     Cash and
Cash
Equivalents
     Short-Term
Marketable
Securities
     Long-Term
Marketable
Securities
 

Cash

   $ 8,705       $ 0       $ 0       $ 8,705       $ 8,705       $ 0       $ 0   

Level 1 (a):

                    

Money market funds

     1,793         0         0         1,793         1,793         0         0   

Mutual funds

     3,999         0         (197      3,802         0         3,802         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal

     5,792         0         (197      5,595         1,793         3,802         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Level 2 (b):

                    

U.S. Treasury securities

     27,642         24         (47      27,619         431         7,554         19,634   

U.S. agency securities

     16,878         12         (52      16,838         177         3,412         13,249   

Non-U.S. government securities

     5,545         35         (137      5,443         50         313         5,080   

Certificates of deposit and time deposits

     2,344         0         0         2,344         1,264         844         236   

Commercial paper

     2,998         0         0         2,998         1,835         1,163         0   

Corporate securities

     54,586         275         (252      54,609         0         8,077         46,532   

Municipal securities

     6,257         45         (22      6,280         4         1,114         5,162   

Mortgage- and asset-backed securities

     16,396         23         (89      16,330         0         8         16,322   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal

     132,646         414         (599      132,461         3,761         22,485         106,215   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 147,143       $ 414       $ (796    $ 146,761       $ 14,259       $ 26,287       $ 106,215   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

 

(a)

The fair value of Level 1 securities is estimated based on quoted prices in active markets for identical assets or liabilities.

 

(b)

The fair value of Level 2 securities is estimated based on observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

9


Table of Contents

The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration management. The net realized gains or losses recognized by the Company related to such sales were not significant during the three- and six-month periods ended March 29, 2014 and March 30, 2013. The maturities of the Company’s long-term marketable securities generally range from one to five years.

As of March 29, 2014 and September 28, 2013, gross unrealized losses related to individual securities that had been in a continuous loss position for 12 months or longer were not significant.

As of March 29, 2014, the Company considers the declines in market value of its marketable securities investment portfolio to be temporary in nature and does not consider any of its investments other-than-temporarily impaired. The Company typically invests in highly-rated securities, and its investment policy limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade, with the primary objective of minimizing the potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than-temporary impairment the Company reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell the investment before recovery of the investment’s cost basis. During the three- and six-month periods ended March 29, 2014 and March 30, 2013, the Company did not recognize any significant impairment charges.

Derivative Financial Instruments

The Company uses derivatives to partially offset its business exposure to foreign currency and interest rate risk. The Company may enter into forward contracts, option contracts, swaps, or other derivative instruments to offset some of the risk on expected future cash flows, on net investments in certain foreign subsidiaries, and on certain existing assets and liabilities.

To help protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar hedge a portion of forecasted foreign currency revenue. The Company’s subsidiaries whose functional currency is not the U.S. dollar and who sell in local currencies may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company typically hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months.

To help protect the net investment in a foreign operation from adverse changes in foreign currency exchange rates, the Company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates.

To help protect against adverse fluctuations in interest rates, the Company may enter into interest rate swaps, options, or other instruments to offset a portion of the changes in income or expense due to fluctuations in interest rates.

The Company may also enter into foreign currency forward and option contracts to partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies. However, the Company may choose not to hedge certain foreign currency exchange exposures for a variety of reasons including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange rates.

The Company records all derivatives in the Condensed Consolidated Balance Sheets at fair value. The Company’s accounting treatment for these instruments is based on whether the instruments are designated as hedge or non-hedge instruments. The effective portions of cash flow hedges are recorded in AOCI until the hedged item is recognized in earnings. The effective portions of net investment hedges are recorded in other comprehensive income (“OCI”) as a part of the cumulative translation adjustment. The ineffective portions of cash flow hedges and net investment hedges are recorded in other income and expense. Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line item to which the derivative relates.

Deferred gains and losses associated with cash flow hedges of foreign currency revenue are recognized as a component of net sales in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in the same period as the related costs are recognized. Deferred gains and losses associated with cash flow hedges of interest income or expense are recognized as a component of other income/(expense), net in the same period as the related income or expense is recognized. The Company’s hedged foreign currency transactions and hedged interest rate transactions as of March 29, 2014 are expected to occur within 12 months and five years, respectively.

 

10


Table of Contents

Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified immediately into other income and expense. Any subsequent changes in fair value of such derivative instruments are reflected in other income and expense unless they are re-designated as hedges of other transactions. The Company did not recognize any significant net gains or losses related to the loss of hedge designation on discontinued cash flow hedges during the three- and six-month periods ended March 29, 2014 and March 30, 2013.

The Company’s unrealized net gains and losses on net investment hedges, included in the cumulative translation adjustment account of AOCI, were not significant as of March 29, 2014 and September 28, 2013. The ineffective portions and amounts excluded from the effectiveness test of net investment hedges are recorded in other income and expense.

The gain/loss recognized in other income and expense for foreign currency forward and option contracts not designated as hedging instruments was not significant during the three- and six-month periods ended March 29, 2014 and March 30, 2013.

The following table shows the notional principal amounts of the Company’s outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as of March 29, 2014 and September 28, 2013 (in millions):

 

                                                                                                   
     March 29, 2014      September 28, 2013  
     Notional
Principal
     Credit
Risk
     Notional
Principal
     Credit
Risk
 

Instruments designated as accounting hedges:

           

Foreign exchange contracts

   $ 18,099       $ 160       $ 35,013       $ 159   

Interest rate contracts

   $ 3,000       $ 45       $ 3,000       $ 44   

Instruments not designated as accounting hedges:

           

Foreign exchange contracts

   $ 22,155       $ 28       $ 16,131       $ 25   

The notional principal amounts for outstanding derivative instruments provide one measure of the transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency or interest rates at each respective date. The Company’s gross exposure on these transactions may be further mitigated by collateral received from certain counterparties. The Company’s exposure to credit loss and market risk will vary over time as currency and interest rates change. Although the table above reflects the notional principal and credit risk amounts of the Company’s derivative instruments, it does not reflect the gains or losses associated with the exposures and transactions that the instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments.

The Company generally enters into master netting arrangements, which are designed to reduce credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values. As of March 29, 2014, the Company received $15 million of net cash collateral related to the derivative instruments under its collateral security arrangements, which were recorded as accrued expenses in the Condensed Consolidated Balance Sheet. As of September 28, 2013, the Company posted cash collateral related to the derivative instruments under its collateral security arrangements of $164 million, which it recorded as other current assets in the Condensed Consolidated Balance Sheet. The Company did not have any derivative instruments with credit-risk related contingent features that would require it to post additional collateral as of March 29, 2014 or September 28, 2013.

Under master netting arrangements with the respective counterparties to the Company’s derivative contracts, the Company is allowed to net settle transactions with a single net amount payable by one party to the other. However, the Company has elected to present the derivative assets and derivative liabilities on a gross basis in its Condensed Consolidated Balance Sheets. As of March 29, 2014 and September 28, 2013, the potential effects of these rights of set-off associated with the Company’s derivative contracts, including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $166 million and $333 million, respectively, resulting in net derivative assets of $73 million and net derivative liabilities of $57 million, respectively.

 

11


Table of Contents

The following tables show the Company’s derivative instruments at gross fair value as reflected in the Condensed Consolidated Balance Sheets as of March 29, 2014 and September 28, 2013 (in millions):

 

                                                                          
     March 29, 2014  
     Fair Value of
Derivatives
Designated
as Hedge
Instruments
     Fair Value of
Derivatives
Not Designated
as  Hedge
Instruments
     Total
Fair
Value
 

Derivative assets (a):

  

Foreign exchange contracts

   $ 160       $ 28       $ 188   

Interest rate contracts

   $ 45       $ 0       $ 45   

Derivative liabilities (b):

        

Foreign exchange contracts

   $ 110       $ 35       $ 145   

 

                                                                          
     September 28, 2013  
     Fair Value of
Derivatives
Designated
as Hedge
Instruments
     Fair Value of
Derivatives
Not Designated
as  Hedge
Instruments
     Total
Fair
Value
 

Derivative assets (a):

  

Foreign exchange contracts

   $ 145       $ 25       $ 170   

Interest rate contracts

   $ 44       $ 0       $ 44   

Derivative liabilities (b):

        

Foreign exchange contracts

   $ 389       $ 46       $ 435   

 

 

(a)

The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets in the Condensed Consolidated Balance Sheets.

 

(b)

The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued expenses in the Condensed Consolidated Balance Sheets.

The following tables show the pre-tax effect of the Company’s derivative instruments designated as cash flow and net investment hedges in the Condensed Consolidated Statements of Operations for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (in millions):

 

    Three Months Ended  
    Gains/(Losses)
Recognized in OCI -
Effective Portion
    Gains/(Losses)
Reclassified from AOCI
into Net Income -
Effective Portion
   

Gains/(Losses) Recognized - Ineffective

Portion and Amount Excluded from

Effectiveness Testing

 
    March 29,
2014
    March 30,
2013
    March 29,
2014
    March 30,
2013
   

Financial Statement Line Item

  March 29,
2014
    March 30,
2013
 

Cash flow hedges:                

             

Foreign exchange contracts

  $ (121   $ 741      $ 22      $ (29  

Other income/(expense), net

  $ (8   $ (61

Interest rate contracts

    (27     0        (4     0     

Other income/(expense), net

    0        0   

Net investment hedges:

             

Foreign exchange contracts

    (19     70        0        0     

Other income/(expense), net

    0        1   
 

 

 

   

 

 

   

 

 

   

 

 

     

 

 

   

 

 

 

Total

  $ (167   $ 811      $ 18      $ (29     $ (8   $ (60
 

 

 

   

 

 

   

 

 

   

 

 

     

 

 

   

 

 

 

 

    Six Months Ended  
    Gains/(Losses)
Recognized in OCI -
Effective Portion
    Gains/(Losses)
Reclassified from AOCI
into Net Income -
Effective  Portion
   

Gains/(Losses) Recognized - Ineffective

Portion and Amount Excluded from

Effectiveness Testing

 
    March 29,
2014
    March 30,
2013
    March 29,
2014
    March 30,
2013
   

Financial Statement Line Item

  March 29,
2014
    March 30,
2013
 

Cash flow hedges:                

             

Foreign exchange contracts

  $ 143      $ 946      $ (52   $ (188  

Other income/(expense), net

  $ (11   $ (52

Interest rate contracts

    (6     0        (8     0     

Other income/(expense), net

    0        0   

Net investment hedges:

             

Foreign exchange contracts

    5        106        0        0      Other income/(expense), net     1        1   
 

 

 

   

 

 

   

 

 

   

 

 

     

 

 

   

 

 

 

Total

  $ 142      $ 1,052      $ (60   $ (188     $ (10   $ (51
 

 

 

   

 

 

   

 

 

   

 

 

     

 

 

   

 

 

 

 

12


Table of Contents

Accounts Receivable

The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, value-added resellers, small and mid-sized businesses, and education, enterprise and government customers that are not covered by collateral, third-party financing arrangements or credit insurance. As of March 29, 2014, the Company had one customer that accounted for 13% of the Company’s trade receivables. As of September 28, 2013, the Company had two customers that represented 10% or more of total trade receivables, one of which accounted for 13% and the other 10%. The Company’s cellular network carriers accounted for 59% and 68% of trade receivables as of March 29, 2014 and September 28, 2013, respectively.

Additionally, the Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these manufacturing vendors who manufacture sub-assemblies or assemble final products for the Company. Vendor non-trade receivables from three of the Company’s vendors accounted for 52%, 22% and 12% of total non-trade receivables as of March 29, 2014 and three of the Company’s vendors accounted for 47%, 21% and 15% of total non-trade receivables as of September 28, 2013.

Note 3 – Condensed Consolidated Financial Statement Details

The following tables show the Company’s condensed consolidated financial statement details as of March 29, 2014 and September 28, 2013 (in millions):

Inventories

 

                                                                 
     March 29, 2014      September 28, 2013  

Components

   $ 444       $ 683   

Finished goods

     1,385         1,081   
  

 

 

    

 

 

 

Total inventories

   $ 1,829       $ 1,764   
  

 

 

    

 

 

 

Property, Plant and Equipment

 

                                                                 
     March 29, 2014     September 28, 2013  

Land and buildings

   $ 4,029      $ 3,309   

Machinery, equipment and internal-use software

     22,147        21,242   

Leasehold improvements

     4,230        3,968   
  

 

 

   

 

 

 

Gross property, plant and equipment

     30,406        28,519   

Accumulated depreciation and amortization

     (15,286     (11,922
  

 

 

   

 

 

 

Net property, plant and equipment

   $ 15,120      $ 16,597   
  

 

 

   

 

 

 

Accrued Expenses

 

                                                                 
     March 29, 2014      September 28, 2013  

Accrued warranty and related costs

   $ 4,368       $ 2,967   

Accrued taxes

     2,160         1,200   

Deferred margin on component sales

     1,145         1,262   

Accrued marketing and selling expenses

     1,403         1,291   

Accrued compensation and employee benefits

     980         959   

Other current liabilities

     5,928         6,177   
  

 

 

    

 

 

 

Total accrued expenses

   $ 15,984       $ 13,856   
  

 

 

    

 

 

 

Non-Current Liabilities

 

                                                                 
     March 29, 2014      September 28, 2013  

Deferred tax liabilities

   $ 19,471       $ 16,489   

Other non-current liabilities

     3,005         3,719   
  

 

 

    

 

 

 

Total other non-current liabilities

   $ 22,476       $ 20,208   
  

 

 

    

 

 

 

 

13


Table of Contents

Other Income and Expense

The following table shows the detail of other income and expense for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (in millions):

 

                                                                                                   
     Three Months Ended     Six Months Ended  
     March 29,
2014
    March 30,
2013
    March 29,
2014
    March 30,
2013
 

Interest and dividend income

   $ 410      $ 420      $ 837      $ 841   

Interest expense

     (85     0        (169     0   

Other expense, net

     (100     (73     (197     (32
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other income/(expense), net

   $ 225      $ 347      $ 471      $ 809   
  

 

 

   

 

 

   

 

 

   

 

 

 

Note 4 – Goodwill and Other Intangible Assets

The Company’s acquired intangible assets with definite useful lives primarily consist of patents and licenses and are amortized over periods typically from three to seven years. The following table summarizes the components of gross and net intangible asset balances as of March 29, 2014 and September 28, 2013 (in millions):

 

                                                                                                                                                     
     March 29, 2014      September 28, 2013  
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net
Carrying
Amount
     Gross
Carrying
Amount
     Accumulated
Amortization
    Net
Carrying
Amount
 

Definite-lived and amortizable acquired intangible assets

   $ 6,361       $ (2,533   $ 3,828       $ 6,081       $ (2,002   $ 4,079   

Indefinite-lived and non-amortizable acquired intangible assets

     100         0        100         100         0        100   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total acquired intangible assets

   $ 6,461       $ (2,533   $ 3,928       $ 6,181       $ (2,002   $ 4,179   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

During the six-months ended March 29, 2014, the Company completed various business acquisitions. The aggregate cash consideration paid, net of cash acquired, was $559 million, of which $474 million was allocated to goodwill, $165 million to acquired intangible assets and $80 million to net liabilities assumed.

Note 5 – Income Taxes

As of March 29, 2014, the Company recorded gross unrecognized tax benefits of $3.0 billion, of which $1.6 billion, if recognized, would affect the Company’s effective tax rate. As of September 28, 2013, the total amount of gross unrecognized tax benefits was $2.7 billion, of which $1.4 billion, if recognized, would affect the Company’s effective tax rate. Additionally, the Company had $590 million of gross interest and penalties accrued as of March 29, 2014 and September 28, 2013. The Company’s unrecognized tax benefits, interest and penalties are presented net of related tax deposits and are classified as other non-current liabilities in the Condensed Consolidated Balance Sheets.

During the second quarter of 2014, the U.S. Internal Revenue Service Appeals Office concluded its review of the years 2004 through 2006, which resulted in the Company reducing its gross unrecognized tax benefits by $95 million and recognizing a tax benefit of $68 million.

Management believes that an 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. If any issues addressed in the Company’s tax audits are 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. Although timing of the resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that tax audit resolutions could reduce its unrecognized tax benefits by between $40 million and $70 million in the next 12 months.

 

14


Table of Contents

Note 6 – Long-Term Debt

In May 2013, the Company issued floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $17.0 billion (collectively the “Notes”). The Notes are senior unsecured obligations, and interest is payable in arrears, quarterly for the floating-rate notes and semi-annually for the fixed-rate notes.

The principal amounts and associated effective interest rates of the Notes as of March 29, 2014, are as follows:

 

                                                 
     Amount
(in  millions)
     Effective
Interest
Rate
 

Floating-rate notes, due 2016

   $ 1,000         0.51

Floating-rate notes, due 2018

     2,000         1.10

Fixed-rate 0.45% notes due 2016

     1,500         0.51

Fixed-rate 1.00% notes due 2018

     4,000         1.08

Fixed-rate 2.40% notes due 2023

     5,500         2.44

Fixed-rate 3.85% notes due 2043

     3,000         3.91
  

 

 

    

Total

   $ 17,000      
  

 

 

    

The floating-rate notes due 2016 and 2018 bear interest at the three-month London InterBank Offered Rate (“LIBOR”) plus 0.05% and 0.25%, respectively. To manage the risk of fluctuations in interest rates associated with the floating-rate notes, the Company entered into interest rate swaps with an aggregate notional amount of $3.0 billion designated as cash flow hedges of its floating-rate notes. These hedges effectively convert the floating interest rate on the floating-rate notes to a fixed interest rate. The gains and losses related to changes in the fair value of the interest rate swaps are recorded in OCI with a portion reclassified to interest expense each period to offset changes in interest rates on the floating-rate notes. The effective rates for the Notes include the interest on the Notes, amortization of the discount and, if applicable, adjustments related to hedging. The Company recognized $84 million and $168 million of interest expense on its long-term debt for the three- and six-month periods ended March 29, 2014, respectively. As of March 29, 2014, the aggregate unamortized discount for the Company’s Notes was $38 million.

Future principal payments for the Company’s Notes as of March 29, 2014, are as follows (in millions):

 

                        

2014

   $ 0   

2015

     0   

2016

     2,500   

2017

     0   

2018

     6,000   

Thereafter

     8,500   
  

 

 

 

Total

   $ 17,000   
  

 

 

 

As of March 29, 2014, the fair value of the Company’s Notes, based on Level 2 inputs, was $16.2 billion.

Note 7 – Shareholders’ Equity

Preferred and Common Stock

During the second quarter of 2014, the Company’s shareholders approved amendments (the “Amendments”) to the Company’s Restated Articles of Incorporation. The Amendments included the elimination of the Board of Directors’ authority to issue preferred stock and established a par value for the Company’s common stock of $0.00001 per share.

 

15


Table of Contents

Dividends

The Company declared and paid cash dividends per common share during the periods presented as follows:

 

                                                 
     Dividends
Per Share
     Amount
(in  millions)
 

2014:

     

Second quarter

   $ 3.05       $ 2,655   

First quarter

     3.05         2,739   
  

 

 

    

 

 

 

Total

   $ 6.10       $ 5,394   
  

 

 

    

 

 

 

2013:

     

Fourth quarter

   $ 3.05       $ 2,763   

Third quarter

     3.05         2,789   

Second quarter

     2.65         2,490   

First quarter

     2.65         2,486   
  

 

 

    

 

 

 

Total

   $ 11.40       $ 10,528   
  

 

 

    

 

 

 

Future dividends are subject to declaration by the Board of Directors.

Share Repurchase Program

In 2012, the Company’s Board of Directors authorized a program to repurchase up to $10 billion of the Company’s common stock beginning in 2013. In April 2013, the Company’s Board of Directors increased the share repurchase authorization from $10 billion to $60 billion, of which $45.9 billion had been utilized as of March 29, 2014. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

The Company has entered into three accelerated share repurchase arrangements (“ASRs”) with financial institutions beginning in August 2012. In exchange for up-front payments, the financial institutions deliver shares of the Company’s common stock during the purchase periods of each ASR. The total number of shares ultimately delivered, and therefore the average repurchase price paid per share, will be determined at the end of the applicable purchase period of each ASR based on the volume weighted-average price of the Company’s common stock during that period. The shares received are retired in the periods they are delivered, and the up-front payments are accounted for as a reduction to shareholders’ equity in the Company’s Condensed Consolidated Balance Sheet in the periods the payments are made. The Company reflects the ASRs as a repurchase of common stock in the period delivered for purposes of calculating earnings per share and as forward contracts indexed to its own common stock. The ASRs met all of the applicable criteria for equity classification, and, therefore, were not accounted for as derivative instruments.

The following table presents the Company’s ASRs:

 

                                                                                                   
     Purchase
Period End
Date
     Number of
Shares

(in thousands)
     Average
Repurchase
Price Per

Share
     ASR Amount
(in  millions)
 

January 2014 ASR

     (a)         19,178 (a)         (a)       $ 12,000   

April 2013 ASR

     March 2014         24,650 (b)       $ 486.82       $ 12,000   

August 2012 ASR

     April 2013         4,078            $ 478.20       $ 1,950   

 

 

(a)

The number of shares represents shares delivered in the second quarter of 2014 and does not represent the final number of shares to be delivered under the January 2014 ASR. The total number of shares ultimately delivered under the January 2014 ASR, and therefore the average repurchase price paid per share, will be determined at the end of the applicable purchase period based on the volume weighted-average price of the Company’s common stock during that period. The January 2014 ASR purchase period will end in or before December 2014.

 

(b)

In April 2013, the Company entered into an ASR to purchase up to $12 billion of the Company’s common stock. In March 2014, the purchase period for this ASR ended and an additional 1.1 million shares were delivered and retired.

 

16


Table of Contents

The Company repurchased shares of its common stock in the open market, which were retired upon repurchase, during the periods presented as follows:

 

                                                                          
     Number of
Shares

(in thousands)
     Average
Repurchase
Price
Per Share
     Amount
(in  millions)
 

2014:

        

Second quarter

     11,392       $ 526.67       $ 6,000   

First quarter

     9,550       $ 523.51         5,000   
  

 

 

       

 

 

 

Total

     20,942          $ 11,000   
  

 

 

       

 

 

 

Note 8 – Comprehensive Income

Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, and gains and losses that under GAAP 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, net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges, and unrealized gains and losses on marketable securities classified as available-for-sale.

The following table shows the gross amounts reclassified from AOCI into the Condensed Consolidated Statements of Operations and the associated financial statement line item, for the three- and six-month periods ended March 29, 2014 (in millions):

 

        Three Months Ended     Six Months Ended  

Comprehensive Income Components

  Financial Statement Line Item   March 29, 2014  

Unrecognized gains/losses on derivative instruments:

     

Foreign exchange contracts

  Revenue   $ 119      $ 303   
  Cost of sales     (141     (251
  Other income/expense, net     4        14   

Interest rate contracts

  Other income/expense, net     4        8   
   

 

 

   

 

 

 
      (14     74   

Unrealized gains/losses on marketable securities

  Other income/expense, net     (60     (77
   

 

 

   

 

 

 

Total amounts reclassified from AOCI

    $ (74   $ (3
   

 

 

   

 

 

 

The following table shows the changes in AOCI by component for the six months ended March 29, 2014 (in millions):

 

                                                                                                   
     Cumulative
Foreign
Currency
Translation
    Unrecognized
Gains/Losses
on

Derivative
Instruments
    Unrealized
Gains/Losses
on
Marketable
Securities
    Total  

September 28, 2013

   $ (105   $ (175   $ (191   $ (471
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income/(loss) before reclassifications

     (103     125        297        319   

Amounts reclassified from AOCI

     0        74        (77     (3

Tax effect

     17        (36     (77     (96
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income/(loss)

     (86     163        143        220   
  

 

 

   

 

 

   

 

 

   

 

 

 

March 29, 2014

   $ (191   $ (12   $ (48   $ (251
  

 

 

   

 

 

   

 

 

   

 

 

 

Note 9 – Benefit Plans

Stock Plans

The Company had approximately 70.3 million shares reserved for future issuance under its stock plans as of March 29, 2014. RSUs granted reduce the number of shares available for grant under the Company’s stock plans utilizing a factor of two times the number of RSUs granted. Similarly, RSUs cancelled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the Company’s stock plans utilizing a factor of two times the number of RSUs cancelled or shares withheld. Stock options count against the number of shares available for grant on a one-for-one basis.

 

17


Table of Contents

2014 Employee Stock Plan

In the second quarter of 2014, shareholders approved the 2014 Employee Stock Plan (the “2014 Plan”) and terminated the Company’s authority to grant new awards under the 2003 Employee Stock Plan (the “2003 Plan”). The 2014 Plan provides for broad-based equity grants to employees, including executive officers, and permits the granting of stock options, stock appreciation rights, stock grants and RSUs, as well as cash bonus awards. RSUs granted under the 2014 Plan are settled upon vesting in shares of the Company’s common stock on a one-for-one basis. Currently, all RSUs granted under the 2014 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. Upon approval of the 2014 Plan, the Company reserved 55 million shares plus any shares that were reserved but not issued under the 2003 Plan for future issuance.

Rule 10b5-1 Trading Plans

During the three months ended March 29, 2014, Section 16 officers Timothy D. Cook, Peter Oppenheimer, D. Bruce Sewell, Luca Maestri, Daniel Riccio and Jeffrey E. Williams had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity 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 shares acquired pursuant to the Company’s employee and director equity plans.

Restricted Stock Units

A summary of the Company’s RSU activity and related information for the six months ended March 29, 2014, is as follows:

 

                                                                          
     Number of
RSUs
(in thousands)
    Weighted-
Average

Grant  Date
Fair Value
     Aggregate
Intrinsic
Value

(in millions)
 

Balance at September 28, 2013

     13,326      $ 435.70      

RSUs granted

     6,964      $ 496.99      

RSUs vested

     (2,626   $ 383.21      

RSUs cancelled

     (440   $ 469.00      
  

 

 

      

Balance at March 29, 2014

     17,224      $ 467.61       $ 9,247   
  

 

 

      

RSUs that vested during the three- and six-month periods ended March 29, 2014 had fair values of $198 million and $1.3 billion, respectively, as of the vesting date. RSUs that vested during the three- and six-month periods ended March 30, 2013 had fair values of $151 million and $1.7 billion, respectively, as of the vesting date.

Stock Options

The Company had 2.4 million stock options outstanding as of March 29, 2014, with a weighted average exercise price per share of $157.93 and weighted average remaining contractual term of 1.1 years, substantially all of which are exercisable. The aggregate intrinsic value of the stock options outstanding as of March 29, 2014 was $926.0 million, which represents the value of the Company’s closing stock price on the last trading day of the period in excess of the weighted-average exercise price multiplied by the number of options outstanding.

The total intrinsic value of options at the time of exercise was $148 million and $707 million for the three- and six-month periods ended March 29, 2014, respectively, and $211 million and $558 million for the three- and six-month periods ended March 30, 2013, respectively.

Share-Based Compensation

Share-based compensation cost for RSUs is measured based on the closing fair market value of the Company’s common stock on the date of grant. Share-based compensation cost for stock options and employee stock purchase plan rights (“stock purchase rights”) is measured at the grant date and offering date, respectively, based on the fair-value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing model. The BSM option-pricing model incorporates various assumptions including expected volatility, estimated expected life and interest rates. The Company recognizes share-based compensation cost over the award’s requisite service period on a straight-line basis for time-based RSUs and on a graded basis for RSUs that are contingent on the achievement of performance metrics.

 

18


Table of Contents

The following table shows a summary of the share-based compensation expense included in the Condensed Consolidated Statements of Operations for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (in millions):

 

                                                                                                   
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     March 29,
2014
     March 30,
2013
 

Cost of sales

   $ 110       $ 87       $ 219       $ 172   

Research and development

     300         239         589         463   

Selling, general and administrative

     286         249         569         485   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total share-based compensation expense

   $ 696       $ 575       $ 1,377       $ 1,120   
  

 

 

    

 

 

    

 

 

    

 

 

 

The income tax benefit related to share-based compensation expense was $230 million and $495 million for the three- and six-month periods ended March 29, 2014, respectively, and was $195 million and $409 million for the three- and six-month periods ended March 30, 2013, respectively. As of March 29, 2014, the total unrecognized compensation cost related to outstanding stock options and RSUs expected to vest was $6.4 billion, which the Company expects to recognize over a weighted-average period of 3.0 years.

Note 10 – Commitments and Contingencies

Accrued Warranty and Indemnification

The following table shows changes in the Company’s accrued warranties and related costs for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (in millions):

 

                                                                                                   
     Three Months Ended     Six Months Ended  
     March 29,
2014
    March 30,
2013
    March 29,
2014
    March 30,
2013
 

Beginning accrued warranty and related costs

   $ 3,980      $ 2,310      $ 2,967      $ 1,638   

Cost of warranty claims

     (865     (847     (1,929     (1,533

Accruals for product warranty

     1,253        1,551        3,330        2,909   
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending accrued warranty and related costs

   $ 4,368      $ 3,014      $ 4,368      $ 3,014   
  

 

 

   

 

 

   

 

 

   

 

 

 

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 it or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or application software for infringement of third-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of March 29, 2014 or September 28, 2013.

The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made under these agreements historically have not been material.

Concentrations in the Available Sources of Supply of Materials and Product

Although most components essential to the Company’s business are generally available from multiple sources, a number of components are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that can materially adversely affect the Company’s financial condition and operating results.

 

19


Table of Contents

The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially 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 at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common components instead of components customized to meet the Company’s requirements.

The Company has entered into various agreements for the supply of components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that can materially adversely affect its financial condition and operating results.

Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for many of the Company’s products. 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. The Company’s purchase commitments typically cover its requirements for periods up to 150 days.

Other Off-Balance Sheet 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 typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for terms ranging from five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of March 29, 2014, the Company’s total future minimum lease payments under noncancelable operating leases were $4.8 billion, of which $3.6 billion related to leases for retail space.

The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up 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. Where appropriate, the purchases are applied to inventory component prepayments that are outstanding with the respective supplier. As of March 29, 2014, the Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $12.6 billion.

In addition to the commitments mentioned above, the Company had additional off-balance sheet obligations of $2.8 billion as of March 29, 2014, which were comprised mainly of commitments to acquire capital assets, including product tooling and manufacturing process equipment, and commitments related to advertising, research and development, Internet and telecommunications services and other obligations.

Contingencies

The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully adjudicated, certain of which are discussed in Part II, Item 1 of this Form 10-Q under the heading “Legal Proceedings” and in Part II, Item 1A of this Form 10-Q under the heading “Risk Factors.” In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies. However, the outcome of litigation is inherently uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected.

 

20


Table of Contents

Apple Inc. v. Samsung Electronics Co., Ltd, et al.

On August 24, 2012, a jury returned a verdict awarding the Company $1.05 billion in its lawsuit against Samsung Electronics Co., Ltd and affiliated parties in the United States District Court, Northern District of California, San Jose Division. On March 6, 2014, the Court entered final judgment in favor of the Company in the amount of approximately $930 million. Because the award is now subject to appeal, the Company has not recognized the award in its results of operations.

VirnetX, Inc. v. Apple Inc. et al.

On August 11, 2010, VirnetX, Inc. filed an action against the Company alleging that certain of its products infringed on four patents relating to network communications technology. On November 6, 2012, a jury returned a verdict against the Company, and awarded damages of $368 million. On March 3, 2014, the Court entered a ruling awarding a royalty of 0.98% against adjudicated products and products not colorably different than those adjudicated at trial. The Company has appealed the verdict, believes it has valid defenses and has not recorded a loss accrual at this time.

Note 11 – Segment Information and Geographic Data

The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments.

The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Greater China, Japan, Rest of Asia Pacific and Retail operations. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and Asian countries, other than those countries included in the Company’s other operating segments. The results of the Company’s geographic segments do not include results of the Retail segment. Each operating segment provides similar hardware and software products and similar services. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in Part II, Item 8 of the Company’s 2013 Form 10-K.

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 customers, while Retail segment net sales are based on sales through 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 research and development, corporate marketing expenses, share-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs and certain manufacturing period expenses. The Company does not include intercompany transfers between segments for management reporting purposes.

 

21


Table of Contents

The following table shows information by operating segment for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (in millions):

 

                                                                                                   
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     March 29,
2014
     March 30,
2013
 

Americas:

           

Net sales

   $ 14,310       $ 14,052       $ 34,408       $ 34,393   

Operating income

   $ 5,433       $ 5,148       $ 12,699       $ 12,497   

Europe:

           

Net sales

   $ 10,230       $ 9,800       $ 23,303       $ 22,264   

Operating income

   $ 3,753       $ 3,449       $ 8,329       $ 7,858   

Greater China:

           

Net sales

   $ 9,289       $ 8,213       $ 18,133       $ 15,043   

Operating income

   $ 3,524       $ 2,787       $ 6,664       $ 5,331   

Japan:

           

Net sales

   $ 3,963       $ 3,135       $ 8,911       $ 7,578   

Operating income

   $ 1,892       $ 1,555       $ 4,271       $ 3,815   

Rest of Asia Pacific:

           

Net sales

   $ 2,627       $ 3,162       $ 6,260       $ 7,155   

Operating income

   $ 898       $ 1,034       $ 2,227       $ 2,369   

Retail:

           

Net sales

   $ 5,227       $ 5,241       $ 12,225       $ 11,682   

Operating income

   $ 1,151       $ 1,092       $ 2,895       $ 2,649   

A reconciliation of the Company’s segment operating income to the condensed consolidated financial statements for the three- and six-month periods ended March 29, 2014 and March 30, 2013 is as follows (in millions):

 

                                                                                                   
     Three Months Ended     Six Months Ended  
     March 29,
2014
    March 30,
2013
    March 29,
2014
    March 30,
2013
 

Segment operating income

   $ 16,651      $ 15,065      $ 37,085      $ 34,519   

Share-based compensation expense

     (696     (575     (1,377     (1,120

Other corporate expenses, net

     (2,362     (1,932     (4,652     (3,631
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating income

   $ 13,593      $ 12,558      $ 31,056      $ 29,768   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

22


Table of Contents
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, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements also can be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “will,” “would,” “could,” “can,” “may,” 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 of this Form 10-Q under the heading “Risk Factors,” which are incorporated herein by reference. The following discussion should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended September 28, 2013 (the “2013 Form 10-K”) filed with the U.S. Securities and Exchange Commission (the “SEC”) and the condensed consolidated financial statements and notes thereto included elsewhere in this Form 10-Q. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references in this report to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months, or periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. 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 (the “Exchange Act”), are filed with the SEC. The Company is subject to the informational requirements of the Exchange Act and files or furnishes reports, proxy statements, and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge on the Company’s website at investor.apple.com/sec.cfm when such reports are available on the SEC’s 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 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at 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.

Overview and Highlights

Company Background

The Company designs, manufactures, and markets mobile communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , iPod ® , Apple TV ® , a portfolio of consumer and professional software applications, the iOS and OS X ® operating systems, iCloud ® , and a variety of accessory, service and support offerings. The Company also sells and delivers digital content and applications through the iTunes Store ® , App Store™, iBooks Store™, and Mac App Store. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party iPhone, iPad, Mac and iPod compatible products, including application software, and various accessories, through its online and retail stores. The Company sells to consumers; small and mid-sized businesses; and education, enterprise and government customers.

 

23


Table of Contents

Business Strategy

The Company is committed to bringing the best user experience to its customers through its innovative hardware, software and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative design. The Company believes continual investment in research and development, marketing and advertising is critical to the development and sale of innovative products and technologies. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of third-party digital content and applications through the iTunes Store. As part of the iTunes Store, the Company’s App Store and iBooks Store allow customers to discover and download applications and books through either a Mac or Windows-based computer or through “iOS devices,” namely iPhone, iPad and iPod touch ® . The Company’s Mac App Store allows customers to easily discover, download and install Mac applications. The Company also supports a community for the development of third-party software and hardware products and digital content that complement the Company’s offerings. The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its ability to attract and retain customers. Therefore, the Company’s strategy also includes enhancing and expanding its own retail and online stores and its third-party distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales support experience.

Business Seasonality and Product Introductions

The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new product inventory following a product introduction, and often, channel inventory of a particular product declines as the next related major product launch approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. However, neither historical seasonal patterns nor historical patterns of product introductions should be considered reliable indicators of the Company’s future pattern of product introductions, future net sales or financial performance.

Second Quarter Fiscal 2014 Highlights

Net sales rose $2 billion in the second quarter of 2014 compared to the same period in 2013, representing growth of 5%. Net sales and unit sales increased for iPhone and Mac following the launches of new iPhones and upgraded Macs in the latter half of calendar 2013, and net sales of iTunes ® , Software and Services grew primarily due to increased revenue from sales of iOS Apps, AppleCare ® and licensing. Net sales and unit sales for iPad declined in the second quarter of 2014 compared to the same period in 2013 due in large part to year-over-year differences in the timing of iPad product launches in certain countries and changes in channel inventory in 2014 versus 2013. Growth in total net sales during the second quarter of 2014 was also negatively impacted by weakness in some foreign currencies, particularly the Japanese Yen, and by the continuing decline of iPod net sales.

Growth in net sales was particularly strong in Greater China and Japan, with both operating segments reporting double-digit year-over-year growth, while net sales in the Rest of Asia Pacific segment declined year-over-year.

During the second quarter of 2014, the Company utilized $18 billion to repurchase its common stock and paid dividends of $2.7 billion, or $3.05 per common share.

 

24


Table of Contents

Sales Data

The following table shows net sales by operating segment and net sales and unit sales by product during the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions and units in thousands):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net Sales by Operating Segment :

                 

Americas

   $ 14,310       $ 14,052         2%       $ 34,408       $ 34,393         0%   

Europe

     10,230         9,800         4%         23,303         22,264         5%   

Greater China (a)

     9,289         8,213         13%         18,133         15,043         21%   

Japan

     3,963         3,135         26%         8,911         7,578         18%   

Rest of Asia Pacific

     2,627         3,162         (17)%         6,260         7,155         (13)%   

Retail

     5,227         5,241         0%         12,225         11,682         5%   
  

 

 

    

 

 

       

 

 

    

 

 

    

Total net sales

   $ 45,646       $ 43,603         5%       $ 103,240       $ 98,115         5%   
  

 

 

    

 

 

       

 

 

    

 

 

    

Net Sales by Product:

                 

iPhone (b)

   $ 26,064       $ 22,955         14%       $ 58,562       $ 53,615         9%   

iPad (b)

     7,610         8,746         (13)%         19,078         19,420         (2)%   

Mac (b)

     5,519         5,447         1%         11,914         10,966         9%   

iPod (b)

     461         962         (52)%         1,434         3,105         (54)%   

iTunes, Software and Services (c)

     4,573         4,114         11%         8,970         7,801         15%   

Accessories (d)

     1,419         1,379         3%         3,282         3,208         2%   
  

 

 

    

 

 

       

 

 

    

 

 

    

Total net sales

   $ 45,646       $ 43,603         5%       $ 103,240       $ 98,115         5%   
  

 

 

    

 

 

       

 

 

    

 

 

    

Unit Sales by Product :

                 

iPhone

     43,719         37,430         17%         94,744         85,219         11%   

iPad

     16,350         19,477         (16)%         42,385         42,337         0%   

Mac

     4,136         3,952         5%         8,973         8,013         12%   

iPod

     2,761         5,633         (51)%         8,810         18,312         (52)%   

 

 

(a)

Greater China includes China, Hong Kong and Taiwan.

 

(b)

Includes deferrals and amortization of related non-software services and software upgrade rights.

 

(c)

Includes revenue from sales on the iTunes Store, the App Store, the Mac App Store, and the iBooks Store, and revenue from sales of AppleCare, licensing and other services.

 

(d)

Includes sales of hardware peripherals and Apple-branded and third-party accessories for iPhone, iPad, Mac and iPod.

 

25


Table of Contents

Product Performance

iPhone

The following table presents iPhone net sales and unit sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions and units in thousands):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 26,064       $ 22,955         14%       $ 58,562       $ 53,615         9%   

Percentage of total net sales

     57%         53%            57%         55%      

Unit sales

     43,719         37,430         17%         94,744         85,219         11%   

The year-over-year growth in iPhone net sales and unit sales in the second quarter and first six months of 2014 resulted from strong customer acceptance of iPhone 5s and 5c, continued demand for the Company’s entry-priced iPhone and expanded distribution. iPhone net sales and unit sales growth were particularly strong in the Greater China and Japan segments. Overall average selling prices (“ASPs”) for iPhone were down slightly during the second quarter and first six months of 2014 compared to the same periods in 2013.

iPad

The following table presents iPad net sales and unit sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions and units in thousands):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 7,610       $ 8,746         (13)%       $ 19,078       $ 19,420         (2)%   

Percentage of total net sales

     17%         20%            18%         20%      

Unit sales

     16,350         19,477         (16)%         42,385         42,337         0%   

Net sales and unit sales for iPad declined in the second quarter of 2014 and were relatively flat in the first six months of 2014 compared to the same periods in 2013. The decline in iPad net sales and unit sales in the second quarter of 2014 was primarily due to changes in iPad channel inventory, and also reflects a slight decline in iPad unit sell-through to end users. iPad channel inventory increased from the beginning to the end of the second quarter of 2013 as the Company met pent-up demand for new iPads introduced in the first quarter of 2013 and supplied distribution channels to achieve appropriate channel inventory levels. In contrast, the Company entered the second quarter of 2014 near supply and demand balance for iPad, and channel inventory declined from the beginning to the end of the quarter to achieve appropriate channel inventory levels based on anticipated future demand. Partially offsetting these factors, iPad ASPs increased approximately 4% during the second quarter of 2014 compared to the second quarter of 2013 primarily as a result of a shift in mix towards iPad mini with Retina display and iPad Air. iPad ASPs were down slightly for the first six months of 2014 compared to the same period in 2013.

Mac

The following table presents Mac net sales and unit sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions and units in thousands):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 5,519       $ 5,447         1%       $ 11,914       $ 10,966         9%   

Percentage of total net sales

     12%         12%            12%         11%      

Unit sales

     4,136         3,952         5%         8,973         8,013         12%   

The year-over-year growth in Mac net sales and unit sales for the second quarter and first six months of 2014 was driven by increased sales of MacBook Pro ® and MacBook Air ® . Mac ASPs decreased during the second quarter of 2014 and first six months of 2014 compared to the same periods in 2013 primarily due to price reductions on certain Mac models and the shift in mix towards Mac portable systems.

 

26


Table of Contents

iTunes, Software and Services

The following table presents net sales information of iTunes, Software and Services for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 4,573       $ 4,114         11%       $ 8,970       $ 7,801         15%   

Percentage of total net sales

     10%         9%            9%         8%      

The increase in net sales of iTunes, Software and Services in the second quarter and first six months of 2014 compared to the same periods in 2013 was due to growth in net sales from the iTunes Store, AppleCare and licensing. The iTunes Store generated a total of $2.6 billion and $5.1 billion in net sales during the second quarter and first six months of 2014, respectively, compared to $2.4 billion and $4.6 billion during the second quarter and first six months of 2013, respectively. Growth in net sales from the iTunes Store, which includes the App Store, the Mac App Store and the iBooks Store, was driven by increases in revenue from App sales reflecting continued growth in the installed base of iOS devices and the expansion in the number of third-party iOS Apps available. This was partially offset by a decline in sales of digital music.

Segment Operating Performance

The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its reportable operating segments, which are generally based on the nature and location of its customers, to be the Americas, Europe, Greater China, Japan, Rest of Asia Pacific and Retail. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and Asian countries, other than those countries included in the Company’s other operating segments. The results of the Company’s geographic segments do not include results of the Retail segment. Each operating segment provides similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Note 11, “Segment Information and Geographic Data” in Notes to Condensed Consolidated Financial Statements of this Form 10-Q.

Americas

The following table presents Americas net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 14,310       $ 14,052         2%       $ 34,408       $ 34,393         0%   

Percentage of total net sales

     31%         32%            33%         35%      

Americas experienced increases in net sales of iPhone and iTunes, Software and Services in the second quarter and first six months of 2014 compared to the same periods in 2013. This growth was largely offset by a decline in net sales of both iPod and iPad, and weakness in foreign currencies relative to the U.S. dollar. The decline in iPad sales was due in part to channel inventory changes. iPad channel inventory increased from the beginning to the end of the second quarter and first six months of 2013 as the Company met pent-up demand for new iPads introduced in the first quarter of 2013 and supplied distribution channels to achieve appropriate channel inventory levels. In contrast, channel inventory declined from the beginning to the end of the second quarter of 2014 and increased much less significantly from the beginning to the end of the first six months of 2014 compared to the same periods in 2013 to achieve appropriate channel inventory levels based on anticipated future demand.

 

27


Table of Contents

Europe

The following table presents Europe net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 10,230       $ 9,800         4%       $ 23,303       $ 22,264         5%   

Percentage of total net sales

     22%         23%            23%         23%      

The increase in Europe net sales during the second quarter and first six months of 2014 compared to the same periods of 2013 reflects increases in net sales of iPhone, Mac and iTunes, Software and Services, partially offset by a decline in net sales of iPod and iPad. Net sales growth in the second quarter of 2014 was experienced in both developed and emerging markets within Europe, while net sales growth in the first six months of 2014 was driven primarily by increased demand in emerging markets.

Greater China

The following table presents Greater China net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 9,289       $ 8,213         13%       $ 18,133       $ 15,043         21%   

Percentage of total net sales

     20%         19%            18%         15%      

During the second quarter and first six months of 2014, Greater China experienced year-over-year increases in net sales that were significantly higher than those experienced by the Company overall. The second quarter growth compared to the same period in 2013 was driven by higher net sales and unit sales of iPhone and Mac and higher net sales of iTunes, Software and Services, partially offset by lower net sales and unit sales of iPad and iPod. The growth in the first six months of 2014 was driven by higher net sales and unit sales of all major product categories except iPod. Higher iPhone net sales and unit sales resulted from the launch of new iPhones in Greater China at the end of 2013, increased demand for the Company’s entry-priced iPhone, and the addition of a significant new carrier in the second quarter of 2014. Net sales and unit sales of iPad grew year-over-year in the first six months of 2014 due to strong demand for iPad Air and iPad mini with Retina display which were launched in China during the first quarter of 2014. Net sales and unit sales of iPad declined year-over-year in the second quarter of 2014 due to differences in timing of new product launches in 2014 versus 2013. iPad channel inventory increased significantly from the beginning to the end of the second quarter of 2013 to support demand for new iPads launched in China near the end of the first quarter of 2013. In contrast, new iPads were launched in China in the early part of the first quarter of 2014 and channel inventory declined from the beginning to the end of the second quarter of 2014 to achieve appropriate channel inventory levels based on anticipated demand.

Japan

The following table presents Japan net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 3,963       $ 3,135         26%       $ 8,911       $ 7,578         18%   

Percentage of total net sales

     9%         7%            9%         8%      

Japan generated strong year-over-year increases in net sales that were significantly higher than those experienced by the Company overall. The growth reflects higher net sales of every major product category except iPod and growth in net sales of iTunes, Software and Service. iPhone net sales and unit sales were particularly strong in Japan following the launch of new iPhones and the addition of a significant new carrier in the fourth quarter of 2013. iPad unit sales were down slightly in the second quarter of 2014 and relatively flat in the first six months of 2014 due in part to changes in channel inventory year-over-year. iPhone channel inventory declined from the beginning to the end of the second quarter and first six months of 2014 and iPad channel inventory was relatively flat in the second quarter of 2014 but increased from the beginning to the end of the first six months of 2014 to achieve appropriate channel inventory levels based on anticipated demand. The increases in overall product net sales were partially offset by weakness in the Japanese Yen relative to the U.S. dollar.

 

28


Table of Contents

Rest of Asia Pacific

The following table presents Rest of Asia Pacific net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 2,627       $ 3,162         (17)%       $ 6,260       $ 7,155         (13)%   

Percentage of total net sales

     6%         7%            6%         7%      

During the second quarter and first six months of 2014, Rest of Asia Pacific experienced year-over-year declines in net sales and unit sales in all major product categories except Mac, and experienced declines in net sales in most countries included in the segment. Net sales were negatively affected by several factors including the impact of weakness in several currencies relative to the U.S. dollar, including the Australian dollar. Net sales were also negatively impacted by changes in iPhone channel inventory, which grew from the beginning to the end of the second quarter and first six months of 2013 following the launch of new iPhones but declined from the beginning to the end of second quarter of 2014 and increased much less significantly from the beginning to the end of the first six months of 2014 compared to the same periods in 2013. iPad channel inventory increased less significantly from the beginning to the end of the second quarter of 2014 compared to the second quarter of 2013, but iPad channel inventory increased more significantly from the beginning to the end of the first six months of 2014 than from the beginning to the end of the first six months of 2013.

Retail

The following tables present Retail net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 and Retail store and headcount information as of March 29, 2014 and March 30, 2013 (dollars in millions):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     Change      March 29,
2014
     March 30,
2013
     Change  

Net sales

   $ 5,227       $ 5,241         0%       $ 12,225       $ 11,682         5%   

Percentage of total net sales

     11%         12%            12%         12%      

 

                                                                 
     March 29, 2014      March 30, 2013  

U.S. stores

     254         251   

International stores

     169         151   
  

 

 

    

 

 

 

Total store count

     423         402   
  

 

 

    

 

 

 

Headcount

     42,400         42,600   

Growth in Retail net sales and unit sales of iPhone and Mac in the second quarter and first six months of 2014 were offset in the second quarter and first six months of 2014 by declines in net sales and unit sales of iPad. With an average of 422 and 401 stores open during the second quarters of 2014 and 2013, respectively, average revenue per store declined to $12.4 million in the second quarter of 2014 from $13.1 million in the second quarter of 2013. Average revenue per store declined to $29.1 million in the first six months of 2014 from $29.4 million in the first six months of 2013.

Retail reported operating income of $1.2 billion during the second quarter of 2014 compared to $1.1 billion in the second quarter of 2013, and reported operating income of $2.9 billion during the first six months of 2014 compared to $2.6 billion in the first six months of 2013. The year-over-year increase in Retail operating income during the second quarter and first six months of 2014 was primarily attributable to higher gross margin.

 

29


Table of Contents

Gross Margin

Gross margin for the three- and six-month periods ended March 29, 2014 and March 30, 2013 was as follows (dollars in millions):

 

                                                                                                   
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     March 29,
2014
     March 30,
2013
 

Net sales

   $ 45,646       $ 43,603       $ 103,240       $ 98,115   

Cost of sales

     27,699         27,254         63,447         60,706   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross margin

   $ 17,947       $ 16,349       $ 39,793       $ 37,409   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross margin percentage

     39.3%         37.5%         38.5%         38.1%   

The increase in the gross margin percentage during the second quarter and first six months of 2014 compared to the same periods in 2013 was driven by multiple factors including a favorable shift in mix to products with higher margins, lower commodity costs, and improved leverage on fixed costs from higher net sales. The impact of these factors was partially offset by higher cost structures on new products and by changes in some foreign currency exchange rates.

The Company anticipates gross margin during the third quarter of 2014 to be between 37% and 38%. The foregoing statement regarding the Company’s expected gross margin percentage in the third quarter of 2014 is forward-looking and could differ from actual results. The Company’s future gross margins can be impacted by multiple factors including, but not limited to, those set forth in Part II, Item 1A of this Form 10-Q under the heading “Risk Factors” and those described in this paragraph. In general, the Company believes gross margins will remain under downward pressure due to a variety of factors, including continued industry wide global product pricing pressures, increased competition, compressed product life cycles, product transitions, potential increases in the cost of components, and potential strengthening of the U.S. dollar, as well as potential increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix towards products with lower gross margins. In response to competitive pressures, the Company expects it will continue to take product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its products. Due to the Company’s significant international operations, financial results can be significantly affected by fluctuations in exchange rates.

Operating Expenses

Operating expenses for the three- and six-month periods ended March 29, 2014 and March 30, 2013 were as follows (dollars in millions):

 

                                                                                                   
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     March 29,
2014
     March 30,
2013
 

Research and development expense

   $ 1,422       $ 1,119       $ 2,752       $ 2,129   

Percentage of net sales

     3.1%         2.6%         2.7%         2.2%   

Selling, general and administrative expense

   $ 2,932       $ 2,672       $ 5,985       $ 5,512   

Percentage of net sales

     6.4%         6.1%         5.8%         5.6%   

Total operating expenses

   $ 4,354       $ 3,791       $ 8,737       $ 7,641   

Percentage of net sales

     9.5%         8.7%         8.5%         7.8%   

Research and Development (“R&D”) Expense

The growth in R&D expense during the second quarter and the first six months of 2014 compared to the same periods in 2013 was driven primarily by an increase in headcount and related expenses to support expanded R&D activities. 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 make further investments in R&D to remain competitive.

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

The growth in SG&A expense during the second quarter and the first six months of 2014 compared to the same periods in 2013 was primarily due to the Company’s continued expansion of its Retail segment, increased headcount and related expenses, and higher spending on marketing and professional services.

 

30


Table of Contents

Other Income and Expense

Other income and expense for the three- and six-month periods ended March 29, 2014 and March 30, 2013 was as follows (dollars in millions):

 

                                                                                                                                                     
     Three Months Ended      Six Months Ended  
     March 29,
2014
    March 30,
2013
    Change      March 29,
2014
    March 30,
2013
    Change  

Interest and dividend income

   $ 410      $ 420         $ 837      $ 841     

Interest expense

     (85     0           (169     0     

Other expense, net

     (100     (73        (197     (32  
  

 

 

   

 

 

      

 

 

   

 

 

   

Total other income/(expense), net

   $ 225      $ 347        (35)%       $ 471      $ 809        (42)%   
  

 

 

   

 

 

      

 

 

   

 

 

   

The decrease in other income and expense during the second quarter and first six months of 2014 compared to the same periods in 2013 was due primarily to interest expense on debt, higher expenses associated with foreign exchange rate movements, and lower realized gains from investment sales, partially offset by lower premium expenses on foreign exchange contracts. The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.04% and 1.05% in the second quarter of 2014 and 2013, respectively, and 1.03% and 1.06% in the first six months of 2014 and 2013, respectively.

Provision for Income Taxes

Provision for income taxes and effective tax rates for the three- and six-month periods ended March 29, 2014 and March 30, 2013 was as follows (dollars in millions):

 

                                                                                                   
     Three Months Ended      Six Months Ended  
     March 29,
2014
     March 30,
2013
     March 29,
2014
     March 30,
2013
 

Provision for income taxes

   $ 3,595       $ 3,358       $ 8,232       $ 7,952   

Effective tax rate

     26.0%         26.0%         26.1%         26.0%   
           

The Company’s effective tax rates for both periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S.

The Internal Revenue Service (the “IRS”) is currently examining the years 2007 through 2012. All IRS audit issues for years prior to 2007 have been resolved. In addition, the Company is subject to audits by state, local, and foreign tax authorities. Management believes that adequate provisions have been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs.

 

31


Table of Contents

Liquidity and Capital Resources

The following tables present selected financial information and statistics as of March 29, 2014 and September 28, 2013 and during the first six months of 2014 and 2013 (in millions):

 

                                                                 
     March 29, 2014      September 28, 2013  

Cash, cash equivalents and marketable securities

   $ 150,589       $ 146,761   

Property, plant and equipment, net

   $ 15,120       $ 16,597   

Long-term debt

   $ 16,962       $ 16,960   

Working capital

   $ 27,333       $ 29,628   

 

                                                                 
     Six Months Ended  
     March 29, 2014     March 30, 2013  

Cash generated by operating activities

   $ 36,208      $ 35,930   

Cash used in investing activities

   $ (3,362   $ (27,878

Cash used in financing activities

   $ (28,156   $ (6,745

The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to satisfy its working capital needs, capital asset purchases, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months. To provide additional flexibility in managing liquidity, the Company plans to access the commercial paper markets beginning in 2014. The Company currently anticipates the cash used for future dividends and the share repurchase program will come from its current domestic cash, cash generated from on-going U.S. operating activities and from borrowings.

As of March 29, 2014 and September 28, 2013, $132.2 billion and $111.3 billion, respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are typically subject to U.S. income taxation on repatriation to the U.S. The Company’s marketable securities investment portfolio is invested primarily in highly-rated securities and its investment policy limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade with the objective of minimizing the potential risk of principal loss.

During the six months ended March 29, 2014, cash generated from operating activities of $36.2 billion was a result of $23.3 billion of net income, non-cash adjustments to net income of $7.5 billion and an increase in net change in operating assets and liabilities of $5.4 billion. Cash used in investing activities of $3.4 billion during the six months ended March 29, 2014 consisted primarily of cash used to acquire property, plant and equipment of $3.4 billion. Cash used in financing activities during the six months ended March 29, 2014 consisted primarily of cash used to repurchase common stock of $23.0 billion and cash used to pay dividends and dividend equivalents of $5.4 billion.

During the six months ended March 30, 2013, cash generated from operating activities of $35.9 billion was a result of $22.6 billion of net income, non-cash adjustments to net income of $6.4 billion and an increase in net change in operating assets and liabilities of $6.9 billion. Cash used in investing activities of $27.9 billion during the six months ended March 30, 2013 consisted primarily of cash used for purchases, net of sales and maturities, of marketable securities of $22.7 billion and cash used to acquire property, plant and equipment of $4.3 billion. Cash used in financing activities during the six months ended March 30, 2013 consisted primarily of cash used to pay dividends and dividend equivalents of $5.0 billion and cash used to repurchase common stock of $1.95 billion.

Capital Assets

The Company’s capital expenditures were $2.0 billion during the first six months of 2014 consisting of $198 million for retail store facilities and $1.8 billion for other capital expenditures, including product tooling and manufacturing process equipment, and other corporate facilities and infrastructure. The Company’s actual cash payments for capital expenditures during the first six months of 2014 were $3.4 billion.

The Company anticipates utilizing approximately $11.0 billion for capital expenditures during 2014, including approximately $550 million for retail store facilities and approximately $10.5 billion for other capital expenditures, including product tooling and manufacturing process equipment, and corporate facilities and infrastructure, including information systems hardware, software and enhancements.

During 2014, the Company expects to open about 30 new retail stores, with approximately two-thirds located outside of the U.S. During 2014, the Company also expects to remodel approximately 20 of its existing stores.

 

32


Table of Contents

Long-Term Debt

In the third quarter of 2013, the Company issued $17.0 billion of long-term debt, which included $3.0 billion of floating-rate notes. To manage the risk of adverse fluctuations in interest rates associated with the floating-rate notes, the Company entered into interest rate swaps with an aggregate notional amount of $3.0 billion, which, in effect, fixed the interest rate of the floating-rate notes. Of the aggregate principal amount of $17.0 billion, $2.5 billion is due in 2016 and $14.5 billion is due in 2018 through 2043.

Dividend and Share Repurchase Program

In April 2013, the Company’s Board of Directors authorized a program to repurchase up to $60 billion of the Company’s common stock, of which $45.9 billion had been utilized as of March 29, 2014. The share repurchase program is expected to be completed by the end of December 2015. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act.

The following table presents the Company’s dividends, dividend equivalents, share repurchases and net share settlement activity from the start of the capital return program in August 2012 through the second quarter of 2014 (in millions):

 

                                                                                                                            
     Dividends
and
Dividend
Equivalents
Paid
     Accelerated
Share
Repurchases
     Open
Market
Share
Repurchases
     Taxes
Related to
Settlement
of Equity
Awards
     Total  

2012

   $ 2,488       $ 0       $ 0       $ 56       $ 2,544   

2013

     10,564         13,950         9,000         1,082         34,596   

Q1 2014

     2,769         0         5,000         365         8,134   

Q2 2014

     2,661         12,000         6,000         65         20,726   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 18,482       $ 25,950       $ 20,000       $ 1,568       $ 66,000   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

On April 23, 2014, the Company announced that the Board of Directors raised the cash dividend by approximately 8% to $3.29 per common share, beginning with the dividend to be paid during the third quarter of 2014. The Company expects to pay approximately $2.8 billion in quarterly dividends to common shareholders during the third quarter of 2014. The Company also plans to increase its dividend on an annual basis, subject to declaration by the Board of Directors.

Additionally, the Company announced that the Board of Directors increased the share repurchase authorization from $60 billion to $90 billion, increasing the total capital return program from $100 billion to over $130 billion, which the Company expects to execute by the end of December 2015 by paying dividends and dividend equivalents, repurchasing shares, and remitting withheld taxes related to net share settlement of restricted stock units. To assist in funding its capital return program, the Company expects to access the public debt markets during 2014, both domestically and internationally, for an amount of term debt similar to what the Company raised during 2013.

In addition to the announced changes to the capital return program, the Company also announced that the Board of Directors approved a seven-for-one split of its common stock. Effective at the close of business on June 6, 2014, shareholders of record will receive six additional shares for each share held on June 2, 2014.

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

The Company’s major facility leases are typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for terms ranging from five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of March 29, 2014, the Company’s total future minimum lease payments under noncancelable operating leases were $4.8 billion, of which $3.6 billion related to leases for retail space.

 

33


Table of Contents

Purchase Commitments with Outsourcing Partners and Component Suppliers

The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up 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. Where appropriate, the purchases are applied to inventory component prepayments that are outstanding with the respective supplier. As of March 29, 2014, the Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $12.6 billion.

Other Obligations

In addition to the commitments mentioned above, the Company had additional off-balance sheet obligations of $2.8 billion as of March 29, 2014, that were comprised mainly of commitments to acquire capital assets, including product tooling and manufacturing process equipment, and commitments related to advertising, research and development, Internet and telecommunications services and other obligations.

The Company’s other non-current liabilities in the Condensed Consolidated Balance Sheets consist primarily of deferred tax liabilities, gross unrecognized tax benefits and the related gross interest and penalties. As of March 29, 2014, the Company had non-current deferred tax liabilities of $19.5 billion. Additionally, as of March 29, 2014, the Company had gross unrecognized tax benefits of $3.0 billion and an additional $590 million for gross interest and penalties classified as non-current liabilities. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes.

Indemnification

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 it or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or application software for infringement of third-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of March 29, 2014 or September 28, 2013.

The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made under these agreements historically have not been material.

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results 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, “Summary of Significant Accounting Policies” of this Form 10-Q and in the Notes to Consolidated Financial Statements in Part II, Item 8 of the Company’s 2013 Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s condensed 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, valuation and impairment of marketable securities, inventory valuation and valuation of manufacturing-related assets and estimated purchase commitment cancellation fees, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. 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.

 

34


Table of Contents

Revenue Recognition

Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, peripherals, and service and support contracts. 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. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware, and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware.

For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware product’s essential software, and/or undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis.

For sales of qualifying versions of iOS devices, Mac and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades and features free of charge to customers. The Company also provides various non-software services to owners of qualifying versions of iOS devices and Mac. Because the Company has neither VSOE nor TPE for the unspecified software upgrade rights or the non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Revenue allocated to the unspecified software upgrade rights and non-software services based on the Company’s ESPs is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided for each of these devices, which ranges from two to four years.

The Company’s process for determining ESPs involves management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and circumstances change, the Company’s ESPs and the future rate of related amortization for software upgrades and non-software services related to future sales of these devices could change. Factors subject to change include the unspecified software upgrade rights offered, the estimated value of unspecified software upgrade rights, the estimated or actual costs incurred to provide non-software services, and the estimated period software upgrades and non-software services are expected to be provided.

The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. 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. The Company’s policy requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company’s other customer incentive programs, the estimated cost 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 that could result in reductions to future revenue. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeems such incentives, the Company would be required to record additional reductions to revenue, which would have an adverse impact on the Company’s results of operations.

 

35


Table of Contents

Valuation and Impairment of Marketable Securities

The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated other comprehensive income, net of tax, in the Company’s Condensed Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities impact the Company’s net income only when such securities are sold or an other-than-temporary impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if any security is other-than-temporarily impaired, which would require the Company to record an impairment charge in the period any such determination is made. In making this judgment, the Company evaluates, among other things, the duration and extent to which the fair value of a security is less than its cost; the financial condition of the issuer and any changes thereto; and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. The Company’s assessment on whether a security is other-than-temporarily impaired could change in the future due to new developments or changes in assumptions related to any particular security.

Inventory Valuation and Valuation of Manufacturing-Related Assets and Estimated Purchase Commitment Cancellation Fees

The Company must order components for its products and build inventory in advance of product shipments and has invested in manufacturing process equipment, including capital assets held at its suppliers’ facilities. In addition, the Company has made prepayments to certain of its suppliers associated with long-term supply agreements to secure supply of inventory components. 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 that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The Company also reviews its manufacturing-related capital assets and inventory prepayments for impairment whenever events or circumstances indicate the carrying amount of such assets may not be recoverable. If the Company determines that an asset is not recoverable, it records an impairment loss equal to the amount by which the carrying value of such an asset exceeds its fair value.

The industries in which the Company competes are subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. In certain circumstances the Company may be required to record additional write-downs of inventory, inventory prepayments and/or manufacturing-related capital assets. These circumstances include future demand or market conditions for the Company’s products being less favorable than forecasted, unforeseen technological changes or changes to the Company’s product development plans that negatively impact the utility of any of these assets, or significant deterioration in the financial condition of one or more of the Company’s suppliers that hold any of the Company’s manufacturing process equipment or to whom the Company has made an inventory prepayment. Such write-downs would adversely affect the Company’s results of operations in the period when the write-downs were recorded.

The Company records accruals 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 in each case based on projected demand. Where appropriate, the purchases are applied to inventory component prepayments that are outstanding with the respective supplier. Purchase commitments typically cover the Company’s forecasted component and manufacturing requirements for periods up to 150 days. If there is an abrupt and substantial decline in demand for one or more of the Company’s products, if the Company’s product development plans change, or if there is an unanticipated change in technological requirements for any of the Company’s products, then the Company may be required to record additional accruals for cancellation fees that would adversely affect its results of operations in the period when the cancellation fees are identified and recorded.

Warranty Costs

The Company provides for the estimated cost of 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 these 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 liabilities would be required and could materially affect the Company’s results of operations.

 

36


Table of Contents

Income Taxes

The Company records a tax provision for the anticipated tax consequences of the reported results of operations. 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.

The Company recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.

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 future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. In the event that the Company determines all or part of the net deferred tax assets are not realizable in the future, the Company will make an adjustment to the valuation allowance that 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 GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results.

Legal and Other Contingencies

As discussed in Part II, Item 1 of this Form 10-Q under the heading “Legal Proceedings” and in Note 10, “Commitments and Contingencies” in the Notes to Condensed Consolidated Financial Statements of this Form 10-Q, the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable. There is significant judgment required in both the probability determination and as to whether an exposure can be reasonably estimated. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for legal and other contingencies. However, the outcome of legal proceedings and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company’s market risk disclosures set forth in Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” of its 2013 Form 10-K have not changed materially for the first six months of 2014.

 

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 Exchange Act were effective as of March 29, 2014 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 SEC 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 second quarter of 2014, 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.

 

37


Table of Contents

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

The Company is subject to the various legal proceedings and claims discussed below as well as certain other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies. However, the outcome of legal proceedings and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. See the risk factor “ The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights ” in Part II, Item 1A of this Form 10-Q under the heading “Risk Factors.” The Company settled certain matters during the second quarter of 2014 that did not individually or in the aggregate have a material impact on the Company’s financial condition or results of operations.

The Apple iPod iTunes Antitrust Litigation (formerly Charoensak v. Apple Computer, Inc. and Tucker v. Apple Computer, Inc.)

These related cases were filed on January 3, 2005 and July 21, 2006 in the United States District Court for the Northern District of California on behalf of a purported class of direct purchasers of iPods and iTunes Store content, alleging various claims including alleged unlawful tying of music and video purchased on the iTunes Store with the purchase of iPods and unlawful acquisition or maintenance of monopoly market power under §§1 and 2 of the Sherman Act, the Cartwright Act, California Business & Professions Code §17200 (unfair competition), the California Consumer Legal Remedies Act and California monopolization law. Plaintiffs are seeking unspecified compensatory and punitive damages for the class, treble damages, injunctive relief, disgorgement of revenues and/or profits and attorneys fees. Plaintiffs are also seeking digital rights management free versions of any songs downloaded from iTunes or an order requiring the Company to license its digital rights management to all competing music players. The cases are currently pending.

Apple eBooks Antitrust Litigation (United States of America v. Apple Inc., et al.)

On April 11, 2012, the U.S. Department of Justice filed a civil antitrust action against the Company and five major book publishers in the U.S. District Court for the Southern District of New York, alleging an unreasonable restraint of interstate trade and commerce in violation of §1 of the Sherman Act and seeking, among other things, injunctive relief, the District Court’s declaration that the Company’s agency agreements with the publishers are null and void and/or the District Court’s reformation of such agreements. On July 10, 2013, the District Court found, following a bench trial, that the Company conspired to restrain trade in violation of §1 of the Sherman Act and relevant state statutes to the extent those laws are congruent with §1 of the Sherman Act. The District Court entered a permanent injunction, which took effect on October 6, 2013 and will be in effect for five years unless the judgment is overturned on appeal. The Company has taken the necessary steps to comply with the terms of the District Court’s order, including renegotiating agreements with the five major eBook publishers, updating its antitrust training program and hiring an antitrust compliance monitor. A damages trial is set for July 2014. The Company has appealed the District Court’s decision.

 

38


Table of Contents
Item 1A. Risk Factors

The following description of risk factors includes any material changes to, and supersedes the description of, risk factors associated with the Company’s business previously disclosed in Part I, Item 1A of the Company’s 2013 Form 10-K and in Part II, Item 1A of the Form 10-Q for the quarter ended December 28, 2013, in each case under the heading “Risk Factors.” The business, financial condition and operating results of the Company can be affected by a number of factors, whether currently known or unknown, including but not limited to those described below, any one or more of which could, directly or indirectly, cause the Company’s actual results of operations and financial condition to vary materially from past, or from anticipated future, results of operations and financial condition. Any of these factors, in whole or in part, could materially and adversely affect the Company’s business, financial condition, results of operations and common stock price.

The following discussion of risk factors contains forward-looking statements. These risk factors may be important to understanding any statement in this Form 10-Q or elsewhere. The following information should be read in conjunction with the condensed consolidated financial statements and related notes in Part I, Item 1, “Financial Statements” and Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-Q.

Because of the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.

Global and regional economic conditions could materially adversely affect the Company.

The Company’s operations and performance depend significantly on global and regional economic conditions. Uncertainty about global and regional economic conditions poses a risk as consumers and businesses postpone spending in response to tighter credit, higher unemployment, financial market volatility, government austerity programs, negative financial news, declines in income or asset values and/or other factors. These worldwide and regional economic conditions could have a material adverse effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s expectations as a result of currency fluctuations because the Company generally raises prices on goods and services sold outside the U.S. to correspond with the effect of a strengthening of the U.S. dollar. Other factors that could influence worldwide or regional demand include increases in fuel and other energy costs, conditions in the real estate and mortgage markets, unemployment, labor and healthcare costs, access to credit, consumer confidence, and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could materially adversely affect demand for the Company’s products and services.

In the event of further financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be a new or incremental tightening in the credit markets, low liquidity, and extreme volatility in fixed income, credit, currency, and equity markets. This could have a number of effects on the Company’s business, including the insolvency or financial instability of outsourcing partners or suppliers or their inability to obtain credit to finance development and/or manufacture products resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of the Company’s products; failure of derivative counterparties and other financial institutions; and restricting the Company’s ability to issue new debt. Other income and expense also could vary materially from expectations depending on gains or losses realized on the sale or exchange of financial instruments; impairment charges resulting from revaluations of debt and equity securities and other investments; interest rates; cash balances; volatility in foreign exchange rates; and changes in fair value of derivative instruments. Increased volatility in the financial markets and overall economic uncertainty would increase the risk of the actual amounts realized in the future on the Company’s financial instruments differing significantly from the fair values currently assigned to them.

 

39


Table of Contents

Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets.

The Company’s products and services compete in highly competitive global markets characterized by aggressive price cutting and resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of consumers.

The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications, and related services. As a result, the Company must make significant investments in research and development. The Company currently holds a significant number of patents and copyrights and has registered and/or has applied to register numerous patents, trademarks and service marks. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and emulating the Company’s products and infringing on its intellectual property. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected.

The Company markets certain mobile communication and media devices based on the iOS mobile operating system and also markets related third-party digital content and applications. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships; and the Company has a minority market share in the smartphone market. Additionally, the Company faces significant price competition as competitors reduce their selling prices and attempt to imitate the Company’s product features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company also competes with illegitimate ways to obtain third-party digital content and applications. Some of the Company’s competitors have greater experience, product breadth and distribution channels than the Company. Because some current and potential competitors have substantial resources and/or experience and a lower cost structure, they may be able to provide products and services at little or no profit or even at a loss. The Company also expects competition to intensify as competitors attempt to imitate the Company’s approach to providing components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve iOS and iOS devices in order to maintain their functional and design advantages.

The Company is the only authorized maker of hardware using OS X, which has a minority market share in the personal computer market. This market is dominated by computer makers using competing operating systems, most notably Windows. In the market for personal computers and peripherals, the Company faces a significant number of competitors, many of which have broader product lines, lower priced products, and a larger installed customer base. Historically, consolidation in this market has resulted in larger competitors. Price competition has been particularly intense as competitors selling Windows-based personal computers have aggressively cut prices and lowered product margins. An increasing number of Internet-enabled devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with the Company’s existing products. The Company’s financial condition and operating results also depend on its ability to continually improve the Mac platform to maintain its functional and design advantages.

There can be no assurance the Company will be able to continue to provide products and services that compete effectively.

To remain competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and transitions.

Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, and effectively stimulate customer demand for new and upgraded products. The success of new product introductions depends on a number of factors including, but not limited to, timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and costs to meet anticipated demand, and the risk that new products may have quality or other defects or deficiencies in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and transitions.

 

40


Table of Contents

The Company depends on the performance of distributors, carriers and other resellers.

The Company distributes its products through cellular network carriers, wholesalers, national and regional retailers, and value-added resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and third-party products in most of its major markets directly to education, enterprise and government customers, and consumers and small and mid-sized businesses through its online and retail stores.

Carriers providing cellular network service for iPhone typically subsidize users’ purchases of the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers.

Many resellers have narrow operating margins and have been adversely affected in the past by weak economic conditions. Some resellers have perceived the expansion of the Company’s direct sales as conflicting with their business interests as distributors and resellers of the Company’s products. Such a perception could discourage resellers from investing resources in the distribution and sale of the Company’s products or lead them to limit or cease distribution of those products. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products.

The Company faces substantial inventory and other asset risk in addition to purchase commitment cancellation risk.

The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand or net realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the carrying amount of an asset may not be recoverable. If the Company determines that impairment has occurred, it records a write-down equal to the amount by which the carrying value of the assets exceeds its fair value. Although the Company believes its provisions related to inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently adequate, no assurance can be given that the Company will not incur additional related charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes.

The Company must order components for its products and build inventory in advance of product announcements and shipments. Consistent with industry practice, components are normally acquired through a combination of purchase orders, supplier contracts, and open orders, in each case based on projected demand. Where appropriate, the purchases are applied to inventory component prepayments that are outstanding with the respective supplier. Purchase commitments typically cover forecasted component and manufacturing requirements for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments.

Future operating results depend upon the Company’s ability to obtain components in sufficient quantities.

Because the Company currently obtains components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. While the Company has entered into various agreements for the supply of components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. The follow-on effects from global economic conditions on the Company’s suppliers, described in “ Global and regional economic conditions could materially adversely affect the Company” above, also could affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases.

The Company and other participants in the markets for mobile communication and media devices and personal computers also compete for various components with other industries that have experienced increased demand for their products. The Company uses some custom components that are not common to the rest of these industries. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The supply of components for a new or existing product could be delayed or constrained, or a key manufacturing vendor could delay shipments of completed products to the Company.

 

41


Table of Contents

The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of whom are located outside of the U.S.

Substantially all of the Company’s manufacturing is performed in whole or in part by a few outsourcing partners located primarily in Asia. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects and could experience an unanticipated product defect or warranty liability. While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur.

The Company relies on sole-sourced outsourcing partners in the U.S., Asia and Europe to supply and manufacture many critical components, and on outsourcing partners in Asia, and to a much lesser extent the United States, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform may have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations may be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information technology system failures, commercial disputes, military actions or economic, business, labor, environmental, public health, or political issues.

The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, the net realizable value of these assets could be negatively impacted.

The Company’s products and services may experience quality problems from time to time that can result in decreased sales and operating margin and harm to the Company’s reputation.

The Company sells complex hardware and software products and services that can contain design and manufacturing defects. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s intended operation. The Company’s online services may from time to time experience outages, service slowdowns, or errors. Defects may also occur in components and products the Company purchases from third parties. There can be no assurance the Company will be able to detect and fix all defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, significant warranty and other expenses, and harm to the Company’s reputation.

The Company relies on access to third-party digital content, which may not be available to the Company on commercially reasonable terms or at all.

The Company contracts with numerous third parties to offer their digital c