Source: https://research.investors.com/et/dfs/2014/320193/0001193125-14-277160/d740164d10q.HTM
Timestamp: 2018-01-22 21:34:43
Document Index: 156195202

Matched Legal Cases: ['§232', '§1', '§17200', '§1', '§1', '§1']

Indicate bycheck 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 tofile such reports), and (2) has been subject to such filing requirements for the past 90 days.
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 Rule405 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).
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.
5,987,867,000 shares of common stock, par value $0.00001, issued and outstandingas of July 11, 2014
Common stock and additional paid-in capital, $0.00001 par value: 12,600,000 shares authorized; 5,989,171 and 6,294,494 sharesissued and outstanding, respectively
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 andapplications. 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, theCompany 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; andeducation, enterprise and government customers.
The accompanying condensed consolidated financial statements include the accounts of the Company. Intercompany accounts and transactionshave 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 theamounts 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 fiscalyear 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 includedin the first fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters. The Companys fiscal years 2014 and 2013 include 52 weeks each. Unless otherwise stated, references to particular years, quarters ormonths 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 additionalinformation 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 updatedstandards 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 theseadditional disclosures in this Form 10-Q in Note 8, Comprehensive Income and Note 2, Financial Instruments, respectively.
On June 6, 2014, the Company effected aseven-for-one stock split to shareholders of record as of June 2, 2014. All share and per share information has been retroactively adjusted to reflect the stock split.
In 2013, the Companys combined best estimates ofselling 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 Companyadjusted the combined ESPs for Mac from $20 to $40 to reflect additions to unspecified software upgrade rights related to expansion of bundled essential software.
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 shareis 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 beenoutstanding 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 theCompanys common stock can result in a greater dilutive effect from potentially dilutive securities.
The following tableshows the computation of basic and diluted earnings per share for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 (in thousands, except net income in millions and per share amounts):
Potentially dilutive securities, the effect of which would have been antidilutive, were not significantfor the three- and nine-month periods ended June 28, 2014 and the three- and nine-month periods ended June 29, 2013. The Company excluded these securities from the computation of diluted earnings per share.
The following tables show the Companys cash and available-for-sale securities adjusted cost, gross unrealizedgains, 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 June 28, 2014 and September 28, 2013 (in millions):
The fair value of Level 2 securities is estimated based on observable inputs other than quoted prices in active markets for identical assets andliabilities, 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.
The Company may sell certain of its marketable securities prior to their stated maturitiesfor 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 nine-monthperiods ended June 28, 2014 and June 29, 2013. The maturities of the Companys long-term marketable securities generally range from one to five years.
As of June 28, 2014, the Company considers the declines in market value of its marketable securities investmentportfolio 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 oneissuer. 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. Whenevaluating 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, changesin 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 nine-month periods endedJune 28, 2014 and June 29, 2013, the Company did not recognize any significant impairment charges.
The Company uses derivatives to partially offset its business exposure to foreign currency and interest raterisk. 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 assetsand liabilities. However, the Company may choose not to hedge certain 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 noassurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange or interest rates.
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 forecastedforeign 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 functionalcurrencies. 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 thechanges in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates.
The Company mayalso enter into foreign currency forward contracts 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.
The Company may enter into interest rate swaps, options, or other instruments to manage interest rate risk. These instrumentsmay offset a portion of changes in income or expense, or changes in fair value of the Companys long-term debt or investments.
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 the hedge designation. Theeffective portions of cash flow hedges are recorded in AOCI until the hedged item is recognized in earnings. Gains and losses related to changes in fair value hedges are recognized in earnings along with a corresponding loss or gain related to thechange in value of the underlying hedged item. 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 flowhedges 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 arerecognized 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 therelated 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 foreign currency and interest rate transactions hedged with cash flow hedges as of June 28, 2014 are expected to occur within 12 months and four years, respectively.
Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedgedtransaction 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 andexpense. 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 lossesrelated to the loss of hedge designation on discontinued cash flow hedges during the three- and nine-month periods ended June 28, 2014 and June 29, 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 June 28, 2014 andSeptember 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 nine-month periodsended June 28, 2014 and June 29, 2013.
The following table shows the notional principal amounts of theCompanys outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as of June 28, 2014 and September 28, 2013 (in millions):
The notional principal amounts for outstanding derivative instruments provide one measure of thetransaction 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 thatare 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 grossexposure 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 tableabove 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. Theamounts 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 reducecredit 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 netfair 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 June 28, 2014, the Company received $27million 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 postedcash 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 derivativeinstruments with credit-risk related contingent features that would require it to post additional collateral as of June 28, 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 byone 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 June 28, 2014 and September 28, 2013, thepotential 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 $140 million and $333million, respectively, resulting in net derivative assets of $128 million and net derivative liabilities of $57 million, respectively.
The following tables show the Companys derivative instruments at gross fair value as reflected in the Condensed Consolidated Balance Sheets as of June 28, 2014 and September 28, 2013 (inmillions):
DerivativesNot
The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets in the CondensedConsolidated Balance Sheets.
The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued expenses in the CondensedConsolidated Balance Sheets.
The following tables show the pre-tax effect of the Companys derivative instrumentsdesignated as cash flow, net investment and fair value hedges in the Condensed Consolidated Statements of Operations for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 (in millions):
Amount Excludedfrom
Gains/(Losses)On
HedgedItems
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 June 28, 2014, the Company had two customers that represented 10% or more of total trade receivables, one ofwhich accounted for 12% and the other 11%. 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 networkcarriers accounted for 55% and 68% of trade receivables as of June 28, 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 tothese manufacturing vendors who manufacture sub-assemblies or assemble final products for the Company. Three of the Companys vendors accounted for 50%, 19% and 13% of total vendor non-trade receivables as of June 28, 2014 and three of theCompanys vendors accounted for 47%, 21% and 15% of total vendor non-trade receivables as of September 28, 2013.
The following tables show the Companys condensed consolidated financial statement details as of June 28,2014 and September 28, 2013 (in millions):
The Companys acquired intangible assets with definite useful lives primarily consist of patents andlicenses 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 June 28, 2014 and September 28, 2013 (in millions):
During the nine months ended June 28, 2014, the Company completed various business acquisitions. Theaggregate cash consideration paid, net of cash acquired, was $898 million, of which $789 million was allocated to goodwill, $247 million to acquired intangible assets and $138 million to net liabilities assumed. During the nine months endedJune 29, 2013, the aggregate cash consideration paid, net of cash acquired, was $443 million, of which $369 million was allocated to goodwill, $167 million to acquired intangible assets and $93 million to net liabilities assumed.
As of June 28, 2014, the Company recorded gross unrecognized tax benefits of $3.1 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 effectivetax rate. Additionally, the Company had $606 million and $590 million of gross interest and penalties accrued as of June 28, 2014 and September 28, 2013, respectively. The Companys unrecognized tax benefits, interest and penaltiesare 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 taxbenefits by $95 million and recognizing a tax benefit of $68 million.
Management believes that an adequate provision has beenmade 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 withmanagement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 isreasonably possible that tax audit resolutions could reduce its unrecognized tax benefits by between $400 million and $550 million in the next 12 months.
In April 2014, the Board of Directors authorized the Company to issue unsecured short-term promissory notes (Commercial Paper) pursuant to a commercial paper program. The Company intends touse net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of June 28, 2014, the Company had $2.0 billion of Commercial Paper outstanding, with a weighted average interestrate of 0.09% and maturities generally less than nine months.
In the third quarter of 2014 and 2013, the Company issued $12.0 billion and $17.0 billion of long-term debt, respectively. The debtissuances included floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $29.0 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 following table provides a summary of theCompanys long-term debt as of June 28, 2014 and September 28, 2013:
The Company has entered, and may enter in the future, into interest rate swaps to manage interest raterisk on the Notes. Such swaps allow the Company to effectively convert fixed-rate payments to floating-rate or floating-rate payments into fixed-rate payments. In the third quarter of 2013, the Company entered into interest rate swaps with anaggregate $3.0 billion notional, which effectively converted the floating-rate notes due 2016 and 2018 to a fixed interest rate. In the third quarter of 2014, the Company entered into interest rate swaps with an aggregate $9.0 billion notional,which effectively converted the fixed-rate notes due 2017, 2019, 2021 and 2024 to a floating interest rate.
The effectiverates for the Notes include the interest on the Notes, amortization of the discount and, if applicable, adjustments related to hedging. The Company recognized $100 million and $268 million of interest expense on its long-term debt for the three- andnine-month periods ended June 28, 2014, respectively.
Future principal payments for the Companys Notes as of June 28, 2014, are as follows (inmillions):
As of June 28, 2014 and September 28, 2013, the fair value of the Companys Notes, basedon Level 2 inputs, was $28.5 billion and $15.9 billion, respectively.
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 theelimination 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.
The Company declared and paid cash dividends per common share during the periodspresented as follows:
In 2012, the Companys Board of Directors authorized a program to repurchase up to $10 billion of the Companys common stockbeginning in 2013. In April 2013, the Companys Board of Directors increased the share repurchase authorization from $10 billion to $60 billion. In April 2014, the Companys Board of Directors increased the share repurchase authorizationfrom $60 billion to $90 billion, of which $50.9 billion had been utilized as of June 28, 2014. The Companys share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may berepurchased 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 inAugust 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 averagerepurchase 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 theperiods 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 arepurchase 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, werenot accounted for as derivative instruments.
Date Numberof
The number of shares represents shares delivered in the second quarter of 2014 and does not represent the final number of shares to be deliveredunder 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 volumeweighted-average price of the Companys common stock during that period. The January 2014 ASR purchase period will end in or before December 2014.
Includes 8.0 million shares that were delivered and retired at the end of the purchase period, which concluded in the second quarter of2014.
The Company repurchased shares of its common stock in the open market, which were retired uponrepurchase, during the periods presented as follows:
Comprehensive income consists of two components, net income and OCI. OCI refers to revenue, expenses, and gains andlosses that under GAAP are recorded as an element of shareholders equity but are excluded from net income. The Companys OCI consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as theirfunctional 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 CondensedConsolidated Statements of Operations and the associated financial statement line item, for the three- and nine-month periods ended June 28, 2014 (in millions):
The Company had 495.7 million shares reserved for future issuance under its stock plans as of June 28, 2014. RSUs granted reduce the number of shares available for grant under the Companysstock 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 plansutilizing 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.
In the second quarter of 2014, shareholdersapproved 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 toemployees, 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 theCompany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 385 million shares plusany shares that were reserved but not issued under the 2003 Plan for future issuance.
During the three months ended June 28, 2014, Section 16 officers Timothy D. Cook, Luca Maestri, Peter Oppenheimer, Daniel Riccio, Philip W. Schiller, D. Bruce Sewell and Jeffrey E. Williams anddirector William V. Campbell 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 determiningthe 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.
A summary of the Companys RSU activity and relatedinformation for the nine months ended June 28, 2014, is as follows:
RSUs that vested during the three- and nine-month periods ended June 28, 2014 had fair values of$1.3 billion and $2.6 billion, respectively, as of the vesting date. RSUs that vested during the three- and nine-month periods ended June 29, 2013 had fair values of $1.2 billion and $2.9 billion, respectively, as of the vesting date.
The Company had 13.1 million stock options outstanding as of June 28, 2014, with a weighted average exercise price per share of$22.39 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 June 28, 2014 was $908 million, which represents the value ofthe 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 $271 million and $978 million for the three- and nine-month periods ended June 28, 2014, respectively, and $180 million and $738million for the three- and nine-month periods ended June 29, 2013, respectively.
Share-based compensation cost for RSUs is measured based on the closing fair market value of the Companys common stock on the dateof 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 theBlack-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-basedcompensation 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.
The following table shows a summary of the share-based compensation expense included in theCondensed Consolidated Statements of Operations for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 (in millions):
The income tax benefit related to share-based compensation expense was $260 million and $755 million forthe three- and nine-month periods ended June 28, 2014, respectively, and was $197 million and $606 million for the three- and nine-month periods ended June 29, 2013, respectively. As of June 28, 2014, the total unrecognizedcompensation cost related to outstanding stock options and RSUs expected to vest was $6.1 billion, which the Company expects to recognize over a weighted-average period of 2.9 years.
The Company generally does not indemnify end-users of its operating system and application softwareagainst 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 inthe 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 indemnifiedthird-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 ofthird-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of June 28, 2014 or September 28, 2013.
The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Companyhas 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 legalproceedings. 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 circumstancesinvolved 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.
Although most components essential to the Companys business are generally available from multiple sources, a number of componentsare 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 usedby the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that could materially adversely affect the Companys financial condition and operatingresults.
The Company uses some custom components that are not commonly used by its competitors, and new products introducedby 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 hasincreased. 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 andoperating 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, orto 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 ofcomponents customized to meet the Companys requirements.
The Company has entered into agreements for the supply of manycomponents; 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 thatcould materially adversely affect its financial condition and operating results.
Substantially all of the Companyshardware 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 ofthese 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soperating 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.
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 financingarrangements. 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, themajority of which are for 10 years, and often contain multi-year renewal options. As of June 28, 2014, the Companys total future minimum lease payments under noncancelable operating leases were $5.0 billion, of which $3.8 billion relatedto leases for retail space.
The Company utilizes several outsourcing partners to manufacture sub-assemblies for theCompany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 150days. 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, andopen 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 June 28, 2014, the Companyhad outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $15.4 billion.
In addition to the commitments mentioned above, the Company had additional off-balance sheet obligations of $5.6 billion as ofJune 28, 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 andtelecommunications services and other obligations.
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 possibilitythe 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 thelikelihood 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 statementsfor that reporting period could be materially adversely affected.
On August 24, 2012, a jury returned a verdict awarding the Company $1.05 billion in its lawsuit against Samsung Electronics Co., Ltdand 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 $930million. Because the award is now subject to appeal, the Company has not recognized the award in its results of operations.
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. OnNovember 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 notcolorably 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.
The Company reports segment information based on the management approach. The management approachdesignates 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 Retailoperations. 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 AsiaPacific 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. Eachoperating 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 toConsolidated Financial Statements in Part II, Item 8 of the Companys 2013 Form 10-K.
The Company evaluates theperformance 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 retailstores. 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 theexpenditures 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 asresearch 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. TheCompany does not include intercompany transfers between segments for management reporting purposes.
The following table shows information by operating segment for the three- and nine-monthperiods ended June 28, 2014 and June 29, 2013 (in millions):
A reconciliation of the Companys segment operating income to the condensed consolidated financialstatements for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 is as follows (in millions):
This section and other parts of this Form 10-Q contain forward-looking statements, within the meaning of the Private SecuritiesLitigation 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 orcurrent 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 areincorporated 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. Securitiesand 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. Unlessotherwise 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 anyreason, except as required by law.
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 ExchangeAct 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. Suchreports 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 copyany 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 at1-800-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 notincorporated into this filing. Further, the Companys references to the URLs for these websites are intended to be inactive textual references only.
The Company designs, manufactures, and markets mobile communication and media devices, personal computers, andportable 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, aswell 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, andvarious accessories, through its online and retail stores. The Company sells to consumers; small and mid-sized businesses; and education, enterprise and government customers.
The Company is committed tobringing 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, applicationsoftware, 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 iscritical 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 iTunesStore. 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, iPadand iPod touch®. The Companys Mac App Store allows customers to easily discover, download and install Macapplications. 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 withknowledgeable 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 retailand 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.
The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in partto 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 asthese 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 consumersand 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 productintroductions, future net sales or financial performance.
Net sales rose $2.1 billion in the third quarter of 2014 compared to the same period in 2013, representing growth of6%. Net sales and unit sales increased for iPhone resulting primarily from the successful introduction of new iPhones in the latter half of calendar year 2013 and expanded distribution. Net sales and unit sales increased for Mac due to strong demandfor MacBook Air® which was updated with faster processors and lower prices in April 2014 and due to sales of thenew Mac Pro® which became available in December 2013. 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 third quarter of 2014 compared to the same periodin 2013 due to lower unit sales in many markets. Growth in total net sales during the third quarter of 2014 was also negatively impacted by the continuing decline of iPod sales. Growth in net sales was particularly strong in Greater China whererevenue grew 28% in the third quarter of 2014 compared to the same period in 2013.
At its Worldwide Developers Conference inJune 2014, the Company announced new versions of its operating systems, iOS 8 and OS X Yosemite, both of which are expected to be available in the fall of 2014.
During the third quarter of 2014, the Company utilized $5 billion to repurchase its common stock and paid dividends and dividend equivalents of $2.9 billion. Additionally, the Company issued $12.0 billionof long-term debt and $2.0 billion of commercial paper during the third quarter of 2014.
The following table shows net sales by operating segment and net sales and unit sales by product during the three- and nine-month periods ended June 28, 2014 and June 29, 2013 (dollars inmillions and units in thousands):
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.
The following table presents iPhone net sales and unit salesinformation for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 (dollars in millions and units in thousands):
The year-over-year growth in iPhone net sales and unit sales in the third quarter and first nine monthsof 2014 resulted primarily from the successful introduction of new iPhones in the latter half of calendar year 2013 and expanded distribution. Compared to the same periods in 2013, iPhone net sales and unit sales growth were particularly strong inthe Greater China and Rest of Asia Pacific segments in the third quarter of 2014, and in the Greater China and Japan segments in the first nine months of 2014. Overall average selling prices (ASPs) for iPhone were down during the thirdquarter and first nine months of 2014 compared to the same periods in 2013, primarily due to a shift in product mix and to weakening of foreign currencies relative to the U.S. dollar.
The following table presents iPad net sales and unit salesinformation for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 (dollars in millions and units in thousands):
Net sales and unit sales for iPad declined in the third quarter and first nine months of 2014 compared tothe same periods in 2013. iPad net sales and unit sales grew overall in developing markets in the third quarter and first nine months of 2014, but this growth was more than offset by a decline in overall iPad net sales and unit sales in maturemarkets. iPad ASPs increased in the third quarter of 2014 compared to the same period in 2013 primarily as a result of a shift in mix toward higher priced iPads, while iPad ASPs declined in the first nine months of 2014 compared to the first ninemonths of 2013 with a shift in iPad product mix being more than offset by the October 2013 price reduction of iPad mini.
The year-over-year growth in Mac net sales and unit sales for the third quarter and first nine months of2014 was primarily driven by increased sales of MacBook Air and Mac Pro. Mac ASPs decreased during the third quarter and first nine months of 2014 compared to the same periods in 2013 primarily due to price reductions on certain Mac models and ashift in mix towards Mac portable systems.
The following table presents net sales information of iTunes, Software and Services for the three- and nine-month periods endedJune 28, 2014 and June 29, 2013 (dollars in millions):
The increase in net sales of iTunes, Software and Services in the third quarter and first nine months of2014 compared to the same periods in 2013 was primarily due to growth in net sales from the iTunes Store, AppleCare and licensing. The iTunes Store generated a total of $2.6 billion and $7.6 billion in net sales during the third quarter and firstnine months of 2014, respectively, compared to $2.4 billion and $6.9 billion during the third quarter and first nine months of 2013, respectively. Growth in net sales from the iTunes Store was driven by increases in revenue from App sales reflectingcontinued 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.
The Company manages its business primarilyon 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 Pacificsegment 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 operatingsegment 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 CondensedConsolidated Financial Statements of this Form 10-Q.
Americas experienced increases in net sales of Mac and iTunes, Software and Services that were largelyoffset by a decline in net sales of both iPod and iPad and weakness in foreign currencies relative to the U.S. dollar in the third quarter and first nine months of 2014 compared to the same periods in 2013. Mac growth was driven by increased netsales and unit sales of MacBook Air and Mac Pro. Net sales of iPhone were relatively flat in the third quarter of 2014 and were up only slightly in the first nine months of 2014 compared to the same periods in 2013.
The followingtable presents Europe net sales information for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 (dollars in millions):
The increase in Europe net sales during the third quarter and first nine months of 2014 compared to thesame periods in 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 third quarter and first nine months of 2014 was mostpronounced in developing markets within Europe. Strength of foreign currencies relative to the U.S. dollar also contributed to net sales growth in the third quarter and first nine months of 2014.
Thefollowing table presents Greater China net sales information for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 (dollars in millions):
During the third quarter and first nine months of 2014, Greater China experienced year-over-yearincreases in net sales that were significantly higher than those experienced by the Company overall. The growth in 2014 compared to 2013 was driven by higher unit sales and net sales of all major product categories, except iPod, in addition tohigher net sales of iTunes, Software and Services. Growth in net sales and unit sales of iPhone was especially strong, driven by the successful launch of new iPhones in Greater China at the end of 2013, increased demand for the Companysentry-priced iPhones and the addition of a significant new carrier in the second quarter of 2014.
In the third quarter of 2014, Japan generated increases in net sales of iPad, Mac, and iTunes, Softwareand Services that were largely offset by a decline in net sales of iPhone and iPod in addition to the weakening of the Japanese Yen relative to the U.S. dollar. iPhone net sales and unit sales declined in the third quarter of 2014 compared to thesame period in 2013 as changes in the regulatory environment negatively impacted growth of the Japan smartphone market. iPad unit sales were down during the third quarter of 2014 compared to the same period in 2013, but the decline was more thanoffset by higher ASPs that drove higher net sales of iPad year-over-year. In the first nine months of 2014, Japan generated year-over-year increases in net sales of every major product category except iPod and generated growth in net sales ofiTunes, Software and Service, partially offset by weakness in the Japanese Yen relative to the U.S. dollar. While net sales of iPad increased during the first nine months of 2014 compared to the same period in 2013, iPad unit sales declined over thesame period.
Net sales in Rest of Asia Pacific increased during the third quarter of 2014 compared to the same periodin 2013 due to strong growth in net sales and unit sales of iPhone and Mac. The growth of iPhone was driven by higher sales of entry-priced iPhones, while the growth of Mac was driven by higher sales of MacBook Air. Net sales declined in the firstnine months of 2014 compared to the same period in 2013 due to year-over-year reductions in net sales in all major product categories except Mac in most countries in Rest of Asia Pacific. Net sales in both the third quarter and first nine months of2014 were negatively affected by the weakness in several currencies relative to the U.S. dollar, including the Australian dollar.
The following tables present Retail net sales information for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 and Retail store and headcount information as ofJune 28, 2014 and June 29, 2013 (dollars in millions):
Growth in Retail net sales in the third quarter and first nine months of 2014 was driven by increases innet sales and unit sales of iPhone and Mac, partially offset by declines in net sales and unit sales of iPad and iPod. With an average of 424 and 405 stores open during the third quarters of 2014 and 2013, respectively, average revenue per storedeclined to $9.7 million in the third quarter of 2014 from $10.1 million in the third quarter of 2013. Average revenue per store declined to $38.8 million in the first nine months of 2014 from $39.3 million in the first nine months of 2013.
Retail generated operating income of $711 million during the third quarter of 2014 compared to $667 million in the thirdquarter of 2013, and generated operating income of $3.6 billion during the first nine months of 2014 compared to $3.3 billion in the first nine months of 2013. The year-over-year increase in Retail operating income during the third quarter and firstnine months of 2014 was primarily attributable to a higher gross margin percentage.
The increase in the gross margin percentage during the third quarter and first nine months of 2014compared 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 factorswas partially offset by higher cost structures on certain new products and by changes in some foreign currency exchange rates.
The Company anticipates gross margin during the fourth quarter of 2014 to be between 37% and 38%. The foregoing statement regarding theCompanys expected gross margin percentage in the fourth 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, thoseset 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 aspotential 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 takeproduct 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. Dueto the Companys significant international operations, financial results can be significantly affected by fluctuations in exchange rates.
The growth in R&D expense during the third quarter and the first nine months of 2014 compared to the same periods in 2013 was drivenprimarily 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 andare 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.
The growth in SG&A expense during the third quarter and the first nine months of 2014 compared to the same periods in 2013 was primarily due to increased headcount and related expenses, and higherspending on marketing and professional services.
Other income and expense for the three- and nine-month periods ended June 28, 2014 and June 29, 2013 was as follows (dollars inmillions):
(100) (53) (269) (53)
(137) (98) (334) (130)
$ 202 $ 234 (14)% $ 673 $ 1,043 (35)%
The decrease in other income and expense during the third quarter of 2014 compared to the same period in2013 was due primarily to higher interest expense on debt and lower realized gains on marketable securities, partially offset by higher interest income. The decrease in other income and expense during the first nine months of 2014 compared to thesame period in 2013 was due primarily to higher 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 exchangecontracts. The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.09% and 1.00% in the third quarter of 2014 and 2013, respectively, and 1.05% and 1.04% in the first nine months of 2014and 2013, respectively.
$ 2,736 $ 2,535 $ 10,968 $ 10,487
26.1% 26.9% 26.1% 26.2%
The Companys effective tax rates for both periods differ from the statutory federal income tax rateof 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 reinvestedoutside the U.S.
The Internal Revenue Service (the IRS) is currently examining the years 2007 through 2012. AllIRS 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 mayresult 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 Companycould be required to adjust its provision for income taxes in the period such resolution occurs.
In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, Revenue fromContracts with Customers (Topic 606) (ASU 2014-09), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to beentitled when products are transferred to customers. ASU 2014-09 will be effective for the Company beginning in its first quarter of 2018. Early adoption is not permitted. The new revenue standard may be applied retrospectively to each prior periodpresented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company is currently evaluating the impact of adopting the new revenue standard on its consolidated financial statements.
$ 164,490 $ 146,761
$ 21,744 $ 29,628
$ 46,463 $ 43,758
$ (25,576 ) $ (34,385 )
$ (22,169 ) $ (8,871 )
The Company believes its existing balances of cash, cash equivalents and marketable securities will besufficient 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 managingliquidity, the Company began accessing the commercial paper markets in the third quarter of 2014. The Company currently anticipates the cash used for future dividends and the share repurchase program will come from its current domestic cash, cashgenerated from on-going U.S. operating activities and from borrowings.
As of June 28, 2014 and September 28, 2013, $137.7 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 foreignsubsidiaries 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 ofcredit 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 nine months ended June 28, 2014, cash generated from operating activities of $46.5 billion was a result of $31.0 billion of net income, non-cash adjustments to net income of $11.2 billionand an increase in net change in operating assets and liabilities of $4.2 billion. Cash used in investing activities of $25.6 billion during the nine months ended June 28, 2014 consisted primarily of cash used for purchases of marketablesecurities, net of sales and maturities, of $18.7 billion and cash used to acquire property, plant and equipment of $5.7 billion. Cash used in financing activities of $22.2 billion during the nine months ended June 28, 2014 consisted primarilyof cash used to repurchase common stock of $28.0 billion and cash used to pay dividends and dividend equivalents of $8.3 billion, partially offset by proceeds from the issuance of long-term debt and commercial paper of $12.0 billion and $2.0billion, respectively.
During the nine months ended June 29, 2013, cash generated from operating activities of $43.8billion was a result of $29.5 billion of net income, non-cash adjustments to net income of $9.2 billion and an increase in net change in operating assets and liabilities of $5.0 billion. Cash used in investing activities of $34.4 billion during thenine months ended June 29, 2013 consisted primarily of cash used for purchases of marketable securities, net of sales and maturities, of $27.0 billion and cash used to acquire property, plant and equipment of $6.2 billion. Cash used infinancing activities of $8.9 billion during the nine months ended June 29, 2013 consisted primarily of cash used to repurchase common stock of $18.0 billion and cash used to pay dividends and dividend equivalents of $7.8 billion, partiallyoffset by net proceeds from the issuance of long-term debt of $16.9 billion.
The Companys capital expenditures were $6.2 billion during the first nine months of 2014 consisting of $341 million for retail storefacilities and $5.9 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 thefirst nine months of 2014 were $5.7 billion.
The Company anticipates utilizing approximately $11.0 billion for capitalexpenditures during 2014, including approximately $500 million for retail store facilities and approximately $10.5 billion for other capital expenditures, including product tooling and manufacturing process equipment, and corporate facilities andinfrastructure, including information systems hardware, software and enhancements.
During 2014, the Company expects to openabout 20 new retail stores, with approximately two-thirds located outside of the U.S. During 2014, the Company also expects to remodel approximately 15 of its existing stores.
In April 2014, the Board of Directors authorized the Company to issueunsecured short-term promissory notes (Commercial Paper) pursuant to a commercial paper program. The Company intends to use net proceeds from the commercial paper program for general corporate purposes, including dividends and sharerepurchases. As of June 28, 2014, the Company had $2.0 billion of Commercial Paper outstanding, with a weighted average interest rate of 0.09% and maturities generally less than nine months.
In the third quarter of 2014 and 2013, the Company issued $12.0 billion and $17.0 billion of long-term debt, respectively. The debtissuances included floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $29.0 billion (collectively the Notes). The Company has entered, and may enter in the future, into interest rate swaps tomanage interest rate risk on the Notes. Interest rate swaps allow the Company to effectively convert fixed-rate payments to floating-rate payments or floating-rate payments into fixed-rate payments. In the third quarter of 2014, the Company enteredinto interest rate swaps with an aggregate $9.0 billion notional, which effectively converted primarily all of the fixed-rate notes to a floating interest rate, and in the third quarter of 2013, the Company entered into interest rate swaps with anaggregate $3.0 billion notional, which effectively converted the floating-rate notes to a fixed interest rate.
In April 2014, the Companys Board of Directors increased the share repurchase program authorization from $60 billion to $90 billion of the Companys common stock, of which $50.9 billion hadbeen utilized as of June 28, 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 theprogram, shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act.
The increase to the Companys share repurchase program authorization resulted in a total capital return program of over $130 billion. The Company expects to complete the capital return program by theend 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 toaccess the public debt markets, both domestically and internationally.
The following table presents the Companysdividends, dividend equivalents, share repurchases and net share settlement activity from the start of the capital return program in August 2012 through the third quarter of 2014 (in millions):
Repurchases Taxes Related to
2,867 0 5,000 409 8,276
$ 21,349 $ 25,950 $ 25,000 $ 1,977 $ 74,276
In April 2014, the Companys Board of Directors raised the cash dividend by approximately 8%. TheCompany paid cash dividends of $0.47 per common share, totaling $2.8 billion, in May 2014. The Company plans to increase its dividend on an annual basis, subject to declaration by the Board of Directors.
In addition to its capital return program activity, the Company also effected a seven-for-one split of its common stock on June 6,2014.
The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinatedretained 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 providesfinancing, liquidity, market risk, or credit risk support to the Company.
The Companys major facility leases are typically for terms not exceeding 10 years and generally provide renewal options for termsnot 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 June 28, 2014, the Companys total futureminimum lease payments under noncancelable operating leases were $5.0 billion, of which $3.8 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 finalassembly 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 individualcomponents 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 demandinformation. Where appropriate, the purchases are applied to inventory component prepayments that are outstanding with the respective supplier. As of June 28, 2014, the Company had outstanding off-balance sheetthird-party manufacturing commitments and component purchase commitments of $15.4 billion.
In addition to the commitments mentioned above, the Company had additional off-balance sheet obligations of $5.6 billion as ofJune 28, 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 telecommunicationsservices and other obligations.
The Companys other non-current liabilities in the Condensed Consolidated Balance Sheetsconsist primarily of deferred tax liabilities, gross unrecognized tax benefits and the related gross interest and penalties. As of June 28, 2014, the Company had non-current deferred tax liabilities of $20.2 billion. Additionally, as ofJune 28, 2014, the Company had gross unrecognized tax benefits of $3.1 billion and an additional $606 million for gross interest and penalties classified as non-current liabilities.
On May 28, 2014, the Company announced it entered into definitive agreements to acquire Beats Music, LLC, which offers asubscription streaming music service, and Beats Electronics, LLC, which makes Beats headphones, speakers and audio software (collectively, Beats). The Company intends to acquire Beats for a total purchase price of approximately $2.6billion, consisting primarily of cash. The Company also intends to issue approximately $400 million of its common stock, which will vest over time based on continued employment of certain executives of Beats. The transactions, which are subject toregulatory approvals, are expected to close in the fourth quarter of 2014.
The Company generally does not indemnify end-users of its operating system and application software against legal claims that the softwareinfringes 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 claimagainst 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 June 28, 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 extentpermitted 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 maximumpotential 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 maintainsdirectors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made under these agreements historically have not been material.
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 condensedconsolidated 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 Form10-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 itbelieves 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. Managementconsiders 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. TheCompany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.
Net sales consist primarily of revenue from the saleof 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 ordeterminable, 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 theproduct 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 riskof 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 Storein 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 softwareproducts, (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 hardwareproduct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 priceto 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 ofelements would be if they were sold regularly on a stand-alone basis.
For sales of qualifying versions of iOS devices, Macand 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 iOSdevices 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 theunspecified 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 providedfor each of these devices, which ranges from two to four years.
The Companys process for determining ESPs involves managements judgment andconsiders 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 forsoftware 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, theestimated 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 recognizesrevenue 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 bereliably 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 theCompany 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 producttransitions 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 actuallyredeem 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 Companywould be required to record additional reductions to revenue, which would have an adverse impact on the Companys results of operations.
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 accumulatedother 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 another-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 ifany 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 extentto 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 beforerecovery 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.
The Company must order components for its products and build inventory in advance of product shipments and has invested in manufacturingprocess 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. TheCompany 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 detailedreview 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 assetsand 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 theamount by which the carrying value of such an asset exceeds its fair value.
The industries in which the Company competes aresubject 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/ormanufacturing-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 productdevelopment 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 equipmentor 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 ordersthat 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. Whereappropriate, 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 manufacturingrequirements 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 intechnological 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 feesare identified and recorded.
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, andknowledge 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 installedbase 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 materiallyaffect the Companys results of operations.
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 whichdeferred 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 allowanceto reduce deferred tax assets to the amount that is believed more likely than not to be realized.
The Company recognizes taxbenefits 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 financialstatements 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 existingtaxable 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 tothe 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 GAAPand 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.
As discussed in Part II, Item 1 of this Form 10-Q under the heading Legal Proceedings and in Note 10, Commitmentsand 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 whenit 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 ofmanagement, 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 outcomeof 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 againstthe 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.
In the third quarter of 2014, the Company issued $12.0 billion of long-term debt, which included $10.0 billion of fixed-rate notes due 2017, 2019, 2021, 2024 and 2044 and $2.0 billion of floating-ratenotes due 2017 and 2019. To manage interest rate risk, the Company entered into interest rate swaps with an aggregate $9.0 billion notional, which effectively converted the fixed-rate notes due 2017, 2019, 2021 and 2024 to a floating interest rate.Notwithstanding the resulting interest rates applicable to the long-term debt, the Companys market risk disclosures set forth in Part II, Item 7A, Quantitative and Qualitative Disclosures About Market Risk of its 2013 Form10-K have not changed materially for the first nine months of 2014.
Evaluationof Disclosure Controls and Procedures
Based on an evaluation under the supervision and with the participation of theCompany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 Actwere effective as of June 28, 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 periodsspecified 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 requireddisclosure.
There were no changes in the Companys internal control over financial reporting during the third quarter of 2014, which wereidentified 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 internalcontrol over financial reporting.
TheCompany 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 ofmanagement, 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 claimsbrought 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 periodfor 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 unfavorableresults 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 thirdquarter of 2014 that did not individually or in the aggregate have a material impact on the Companys financial condition or results of operations.
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 directpurchasers 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 seekingunspecified 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 downloadedfrom iTunes or an order requiring the Company to license its digital rights management to all competing music players. The cases are currently pending.
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 withthe 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 theSherman 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 yearsunless 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 antitrusttraining program and hiring an antitrust compliance monitor. The Company appealed the District Courts decision. Pursuant to a settlement agreement reached by the parties in June 2014, any damages the Company may be obligated to pay will bedetermined by the outcome of the appellate decision.
Thefollowing 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 andin Part II, Item 1A of the Form 10-Q for the quarters ended December 28, 2013 and March 29, 2014, in each case under the heading Risk Factors. The business, financial condition and operating results of the Company can beaffected 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 financialcondition 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, pastfinancial 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.
The Companys operations and performance depend significantly on global and regional economic conditions. Uncertainty about globaland regional economic conditions poses a risk as consumers and businesses may postpone spending in response to tighter credit, higher unemployment, financial market volatility, government austerity programs, negative financial news, declines inincome 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sexpectations 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 influenceworldwide 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 factorsaffecting 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 institutionfailures, 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 theCompany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 ofcustomers, including channel partners, to obtain credit to finance purchases of the Companys products; failure of derivative counterparties and other financial institutions; and restrictions on the Companys ability to issue newdebt. 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 andequity 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 overalleconomic 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.
Global markets for the Companys products and services are highly competitive and subject to rapidtechnological change, and the Company may be unable to compete effectively in these markets.
The Companys productsand 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 ofinnovative 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, andrelated 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 infringingon 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 tomaintain a competitive advantage could be adversely affected.
The Company markets certain mobile communication and mediadevices 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 pricecompetition 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 competitivethan those they currently offer. The Company also competes with illegitimate ways to obtain third-party digital content and applications and with business models that include content provided to users for free. Some of the Companys competitorshave 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 andservices 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 workcollaboratively 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 anddesign advantages.
The Company is the only authorized maker of hardware using OS X, which has a minority market share in thepersonal computer market. This market has been contracting and 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 ofcompetitors, 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 ascompetitors 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 personalcomputers 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 designadvantages.
There can be no assurance the Company will be able to continue to provide products and services that competeeffectively.
To remain competitive and stimulate customer demand, the Company must successfully manage frequentproduct introductions and transitions.
Due to the highly volatile and competitive nature of the industries in which theCompany 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 productintroductions 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, theavailability 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 at expected costs tomeet 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 andtransitions.
The Company distributes its products through cellular network carriers, wholesalers, national and regional retailers, and value-addedresellers, 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 smalland mid-sized businesses through its online and retail stores.
Carriers providing cellular network service for iPhonetypically 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 entersinto with new carriers.
Many resellers have narrow operating margins and have been adversely affected in the past by weakeconomic 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 discourageresellers 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 andmarketing of the Companys products.
The Company faces substantial inventory and other asset risk in addition to purchase commitmentcancellation risk.
The Company records a write-down for product and component inventories that have become obsolete orexceed 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 theamount 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, noassurance 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 withindustry 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 inventorycomponent 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 arevolatile, 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 purchasecommitments.
Future operating results depend upon the Companys ability to obtain components in sufficientquantities.
Because the Company currently obtains components from single or limited sources, the Company is subject tosignificant 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 intoagreements for the supply of many components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. A number of suppliers of components may suffer from poor financial conditions,which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Companys ability to obtain sufficient quantities of components. The follow-on effects from global economic conditionson 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 participantsin 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 arenot 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 thesuppliers 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 decide to concentrate on the production of common componentsinstead 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 theCompany.
The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of whomare located outside of the U.S.
Substantially all of the Companys manufacturing is performed in whole or in part bya 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 overproduction 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 thesepartners 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 extentthe 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. Inaddition, 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, commercialdisputes, military actions or economic, business, labor, environmental, public health, or political issues.
The Company hasinvested 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 thesupply 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 canresult in decreased sales and operating margin and harm to the Companys reputation.
The Company sells complexhardware 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 unexpectedlyinterfere 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 thirdparties. 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 theCompanys reputation.
The Company relies on access to third-party digital content, which may not be available to the Company oncommercially reasonable terms or at all.
The Company contracts with numerous third parties to offer their digital contentthrough the iTunes Store. This includes the right to make available music, movies, TV shows and books currently available through the iTunes Store. The licensing or other distribution arrangements with these third parties are short-term and do notguarantee the continuation or renewal of these arrangements on reasonable terms, if at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and could take action to make itmore difficult or impossible for the Company to license or otherwise distribute their content in the future. Other content owners, providers or distributors may seek to limit the Companys access to, or increase the cost of, such content. TheCompany may be unable to continue to offer a wide variety of content at reasonable prices with acceptable usage rules, or continue to expand its geographic reach. Failure to obtain the right to make available third-party digital content, or to makeavailable such content on commercially reasonable terms, could have a material adverse impact on the Companys financial condition and operating results.
Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license newtechnology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislationthat would force the Company to license its digital rights management, which could lessen the protection of content and subject it to piracy and also could negatively affect arrangements with the Companys content providers.
The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Companys products. Ifthird-party software applications and services cease to be developed and maintained for the Companys products, customers may choose not to buy the Companys products.
With respect to its Mac products, the Company believes the availability of third-party softwareapplications and services depends in part on the developers perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Companys products compared to Windows-based products. Thisanalysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of Mac sales, and the costs of developing such applications and services. If theCompanys minority share of the global personal computer market causes developers to question the Macs prospects, developers could be less inclined to develop or upgrade software for the Companys Mac products and more inclined todevote their resources to developing and upgrading software for the larger Windows market.
With respect to iOS devices, theCompany relies on the continued availability and development of compelling and innovative software applications, which are distributed through a single distribution channel, the App Store. iOS devices are subject to rapid technological change, and,if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might not successfully operate and may result in dissatisfied customers. As with applications for the Companys Mac products,the availability and development of these applications also depend on developers perceptions and analysis of the relative benefits of developing software for the Companys iOS devices rather than its competitors platforms, such asAndroid. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Companys iOS devices may suffer.
The Company relies on access to third-party intellectual property, which may not be available to theCompany on commercially reasonable terms or at all.
Many of the Companys products include third-party intellectualproperty, which requires licenses from those third parties. Based on past experience and industry practice, the Company believes such licenses generally can be obtained on reasonable terms. There is, however, no assurance that the necessary licensescan be obtained on acceptable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, could preclude the Company from selling certain products orotherwise have a material adverse impact on the Companys financial condition and operating results.
The Company could be impacted byunfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights.
TheCompany is subject to various legal proceedings and claims that have not yet been fully resolved and that have arisen in the ordinary course of business, and additional claims may arise in the future.
For example, technology companies, including many of the Companys competitors, frequently enter into litigation based onallegations of patent infringement or other violations of intellectual property rights. In addition, patent holding companies seek to monetize patents they have purchased or otherwise obtained. As the Company has grown, the intellectual propertyrights claims against it have increased and may continue to increase. In particular, the Companys cellular enabled products compete with mobile communication and media device companies that hold significant patent portfolios, and the number ofpatent claims against the Company has significantly increased. The Company is vigorously defending infringement actions in courts in a number of U.S. jurisdictions and before the U.S. International Trade Commission, as well as internationallyin various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages.
Regardless of thescope or validity of such patents or other intellectual property rights, or the merits of any claims by potential or actual litigants, the Company may have to engage in protracted litigation. If the Company is found to infringe one or morepatents or other intellectual property rights, regardless of whether it can develop non-infringing technology, it may be required to pay substantial damages or royalties to a third-party, or it may be subject to a temporary or permanent injunctionprohibiting the Company from marketing or selling certain products.
In certain cases, the Company may consider thedesirability of entering into licensing agreements, although no assurance can be given that such licenses can be obtained on acceptable terms or that litigation will not occur. These licenses may also significantly increase the Companysoperating expenses.
Regardless of the merit of particular claims, litigation may be expensive, time-consuming, disruptive tothe Companys operations, and distracting to management. In recognition of these considerations, the Company may enter into arrangements to settle litigation.
In managements opinion, there is 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 losscontingencies, including matters related to infringement of intellectual property rights. However, the outcome of litigation is inherently uncertain.
Although management considers the likelihood of such an outcome to be remote, if one or more legal matters were resolved against the Company in a reporting period for amounts in excess ofmanagements expectations, the Companys consolidated financial statements for that reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetarydamages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results.
The Company is subject to laws and regulations worldwide, changes to which could increase theCompanys costs and individually or in the aggregate adversely affect the Companys business.
The Company issubject to laws and regulations affecting its domestic and international operations in a number of areas. These U.S. and foreign laws and regulations affect the Companys activities including, but not limited to, in areas of labor,advertising, digital content, consumer protection, real estate, billing, e-commerce, promotions, quality of services, telecommunications, mobile communications and media, television, intellectual property ownership and infringement, tax, import andexport requirements, anti-corruption, foreign exchange controls and cash repatriation restrictions, data privacy requirements, anti-competition, environmental, health, and safety.
By way of example, laws and regulations related to mobile communications and media devices in the many jurisdictions in which the Companyoperates are extensive and subject to change. Such changes could include, among others, restrictions on the production, manufacture, distribution, and use of devices, locking devices to a carriers network, or mandating the use of devices onmore than one carriers network. These devices are also subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. These certification processesare extensive and time consuming, and could result in additional testing requirements, product modifications, or delays in product shipment dates, or could preclude the Company from selling certain products.
Compliance with these laws, regulations and similar requirements may be onerous and expensive, and they may be inconsistent fromjurisdiction to jurisdiction, further increasing the cost of compliance and doing business. Any such costs, which may rise in the future as a result of changes in these laws and regulations or in their interpretation, could individually or in theaggregate make the Companys products and services less attractive to the Companys customers, delay the introduction of new products in one or more regions, or cause the Company to change or limit its business practices. The Company hasimplemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance that the Companys employees, contractors, or agents will not violate such laws and regulations or theCompanys policies and procedures.
The Company derives a significant portion of its revenue and earnings from its international operations. Compliance with applicable U.S.and foreign laws and regulations, such as import and export requirements, anti-corruption laws, tax laws, foreign exchange controls and cash repatriation restrictions, data privacy requirements, environmental laws, labor laws, and anti-competitionregulations, increases the costs of doing business in foreign jurisdictions. Although the Company has implemented policies and procedures to comply with these laws and regulations, a violation by the Companys employees, contractors, or agentscould nevertheless occur.
The Company also could be significantly affected by other risks associated with internationalactivities including, but not limited to, economic and labor conditions, increased duties, taxes and other costs, and political instability. Margins on sales of the Companys products in foreign countries, and on sales of products that includecomponents obtained from foreign suppliers, could be materially adversely affected by international trade regulations, including duties, tariffs and antidumping penalties. The Company is also exposed to credit and collectability risk on its tradereceivables with customers in certain international markets. There can be no assurance the Company can effectively limit its credit risk and avoid losses.
The Companys Retail segment has required and will continue to require a substantial investment andcommitment of resources and is subject to numerous risks and uncertainties.
The Companys retail stores have requiredsubstantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space. Certain stores have been designed and built toserve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require substantially more investment than theCompanys more typical retail stores. Due to the high cost structure associated with the Retail segment, a decline in sales or the closure or poor performance of individual or multiple stores could result in significant lease termination costs,write-offs of equipment and leasehold improvements, and severance costs.
Many factors unique to retail operations, some ofwhich are beyond the Companys control, pose risks and uncertainties. These risks and uncertainties include, but are not limited to, macro-economic factors that could have an adverse effect on general retail activity, as well as theCompanys inability to manage costs associated with store construction and operation, the Companys failure to manage relationships with its existing retail partners, more challenging environments in managing retail operations outside theU.S., costs associated with unanticipated fluctuations in the value of retail inventory, and the Companys inability to obtain and renew leases in quality retail locations at a reasonable cost.
Investment in new business strategies and acquisitions could disrupt the Companys ongoing business and present risks not originallycontemplated.
The Company has invested, and in the future may invest, in new business strategies or acquisitions. Suchendeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater than expected liabilities and expenses, inadequate return of capital, and unidentified issues not discovered in theCompanys due diligence. These new ventures are inherently risky and may not be successful.
The Companys business andreputation may be impacted by information technology system failures or network disruptions.
The Company may be subject toinformation technology system failures and network disruptions. These may be caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, orother events or disruptions. System redundancy may be ineffective or inadequate, and the Companys disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions could prevent access to the Companysonline stores and services, preclude retail store transactions, compromise Company or customer data, and result in delayed or cancelled orders. System failures and disruptions could also impede the manufacturing and shipping of products, delivery ofonline services, transactions processing and financial reporting.
There may be breaches of the Companys information technologysystems that materially damage business partner and customer relationships, curtail or otherwise adversely impact access to online stores and services, or subject the Company to significant reputational, financial, legal, and operationalconsequences.
The Companys business requires it to use and store customer, employee, and business partner personallyidentifiable information (PII). This may include, among other information, names, addresses, phone numbers, email addresses, contact preferences, tax identification numbers, and payment account information. Although malicious attacks togain access to PII affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the amount of PII it manages.
The Company requires user names and passwords in order to access its information technology systems. The Company also uses encryption andauthentication technologies designed to secure the transmission and storage of data and prevent access to Company data or accounts. As with all companies, these security measures are subject to third-party security breaches, employee error,malfeasance, faulty password management, or other irregularities. For example, third parties may attempt to fraudulently induce employees or customers into disclosing user names, passwords or other sensitive information, which may in turn be used toaccess the Companys information technology systems. To help protect customers and the Company, the Company monitors accounts and systems for unusual activity and may freeze accounts under suspicious circumstances, which may result in the delayor loss of customer orders.
The Company devotes significant resources to network security, data encryption, and othersecurity measures to protect its systems and data, but these security measures cannot provide absolute security. To the extent the Company was to experience a breach of its systems and was unable to protect sensitive data, such a breach couldmaterially damage business partner and customer relationships, and curtail or otherwise adversely impact access to online stores and services. Moreover, if a computer security breach affects the Companys systems or results in the unauthorizedrelease of PII, the Companys reputation and brand could be materially damaged, use of the Companys products and services could decrease, and the Company could be exposed to a risk of loss or litigation and possible liability. While theCompany maintains insurance coverage that, subject to policy terms and conditions and subject to a significant self-insured retention, is designed to address certain aspects of cyber risks, such insurance coverage may be insufficient to cover alllosses or all types of claims that may arise in the continually evolving area of cyber risk.
The Companys business is subject to avariety of U.S. and international laws, rules, policies and other obligations regarding data protection.
The Company issubject to federal, state and international laws relating to the collection, use, retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also to transfers of information between the Companyand its subsidiaries, and among the Company, its subsidiaries and other parties with which the Company has commercial relations. Several jurisdictions have passed laws in this area, and other jurisdictions are considering imposing additionalrestrictions. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to changeits business practices. Noncompliance could result in penalties or significant legal liability.
The Companys privacypolicy, which includes related practices concerning the use and disclosure of data, is posted on its website. Any failure by the Company, its suppliers or other parties with whom the Company does business to comply with its posted privacy policy orwith other federal, state or international privacy-related or data protection laws and regulations could result in proceedings against the Company by governmental entities or others.
The Company is also subject to payment card association rules and obligations under its contracts with payment card processors. Underthese rules and obligations, if information is compromised, the Company could be liable to payment card issuers for associated expenses and penalties. In addition, if the Company fails to follow payment card industry security standards, even if nocustomer information is compromised, the Company could incur significant fines or experience a significant increase in payment card transaction costs.
Much of the Companys future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees.Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Companys key personnel are located.
The Companys business may be impacted by political events, war, terrorism, public health issues, natural disasters and other businessinterruptions.
War, terrorism, geopolitical uncertainties, public health issues, and other business interruptions havecaused and could cause damage or disruption to international commerce and the global economy, and thus could have a material adverse effect on the Company, its suppliers, logistics providers, manufacturing vendors and customers, including channelpartners. The Companys business operations are subject to interruption by, among others, natural disasters, fire, power shortages, nuclear power plant accidents, terrorist attacks and other hostile acts, labor disputes, public health issues,and other events beyond its control. Such events could decrease demand for the Companys products, make it difficult or impossible for the Company to make and deliver products to its customers, including channel partners, or to receivecomponents from its suppliers, and create delays and inefficiencies in the Companys supply chain. Should major public health issues, including pandemics, arise, the Company could be adversely affected by more stringent employee travelrestrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products, and disruptions in the operations of the Companys manufacturingvendors and component suppliers. The majority of the Companys research and development activities, its corporate headquarters, information technology systems, and other critical business operations, including certain component suppliers andmanufacturing vendors, are in locations that could be affected by natural disasters. In the event of a natural disaster, the Company could incur significant losses, require substantial recovery time and experience significant expenditures in orderto resume operations.
The Companys profit margins vary across its products and distribution channels. The Companys software, accessories, andservice and support contracts generally have higher gross margins than certain of the Companys other products. Gross margins on the Companys hardware products vary across product lines and can change over time as a result of producttransitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Companys direct sales generally have higher associated gross margins than its indirect sales through its channel partners. In addition,the Companys gross margin and operating margin percentages, as well as overall profitability, may be materially adversely impacted as a result of a shift in product, geographic or channel mix, component cost increases, the strengthening U.S.dollar, price competition, or the introduction of new products, including those that have higher cost structures with flat or reduced pricing.
The Company has typically experienced higher net sales in its first quarter compared to other quarters due in part to seasonal holiday demand. Additionally, new product introductions can significantlyimpact net sales, product costs and operating expenses. The Company could be subject to unexpected developments late in a quarter, such as lower-than-anticipated demand for the Companys products, issues with new product introductions, aninternal systems failure, or failure of one of the Companys logistics, components supply, or manufacturing partners.
TheCompanys stock price is subject to volatility.
The Companys stock continues to experience substantial pricevolatility. Additionally, the Company, the technology industry, and the stock market as a whole have experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to thesecompanies operating performance. Price volatility over a given period may cause the average price at which the Company repurchases its own stock to exceed the stocks price at a given point in time. The Company believes its stock pricereflects expectations of future growth and profitability. The Company also believes its stock price reflects expectations that its cash dividend will continue at current levels or grow and that its current share repurchase program will be fullyconsummated. Future dividends are subject to declaration by the Companys Board of Directors, and the Companys share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet any ofthese expectations related to future growth, profitability, dividends, share repurchases or other market expectations, its stock price may decline significantly, which could have a material adverse impact on investor confidence and employeeretention.
The Companys financial performance is subject to risks associated with changes in the value of the U.S. dollar versuslocal currencies.
The Companys primary exposure to movements in foreign currency exchange rates relates to non-U.S.dollar denominated sales and operating expenses worldwide. Weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Companys foreign currency-denominated sales and earnings, and generally leadsthe Company to raise international pricing, potentially reducing demand for the Companys products. Margins on sales of the Companys products in foreign countries, and on sales of products that include components obtained from foreignsuppliers, could be materially adversely affected by foreign currency exchange rate fluctuations. In some circumstances, for competitive or other reasons, the Company may decide not to raise local prices to fully offset the dollarsstrengthening, or at all, which would adversely affect the U.S. dollar value of the Companys foreign currency denominated sales and earnings. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generallybeneficial to the Companys foreign currency-denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally,strengthening of foreign currencies may also increase the Companys cost of product components denominated in those currencies, thus adversely affecting gross margins.
The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedgingactivities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place.
Given the global nature of its business, the Company has both domestic and international investments. Credit ratings andpricing of the Companys investments can be negatively affected by liquidity, credit deterioration, financial results, economic risk, political risk, sovereign risk or other factors. As a result, the value and liquidity of the Companyscash, cash equivalents and marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents and marketable securities, future fluctuations in their value couldresult in a significant realized loss.
The Company is exposed to credit risk on its trade accounts receivable, vendor non-tradereceivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen.
The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers. The Company also sells its products directly to small and mid-sizedbusinesses and education, enterprise and government customers. A substantial majority of the Companys outstanding trade receivables are not covered by collateral, third-party financing arrangements or credit insurance. The Companysexposure to credit and collectability risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting frompurchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supplyof inventory components. As of June 28, 2014, a significant portion of the Companys trade receivables was concentrated within cellular network carriers, and its non-trade receivables and prepayments related to long-term supply agreementswere concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables as well as long-term prepayments, there can be noassurance such procedures will effectively limit its credit risk and avoid losses.
The Company could be subject to changes in its taxrates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities.
The Company issubject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Companys subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject tosignificant change. The Companys future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in taxlaws or their interpretation, including in the U.S. and Ireland. For example, in June 2014, the European Commission opened a formal investigation to examine whether decisions by the tax authorities in Ireland with regard to the corporate income taxto be paid by two of the Companys Irish subsidiaries comply with European Union rules on state aid. If the European Commission were to take a final decision against Ireland, it could require changes to existing tax rulings that, in turn, couldincrease the Companys taxes in the future. The European Commission could also require Ireland to recover from the Company past taxes reflective of the disallowed state aid.
The Company is also subject to the examination of its tax returns and other tax matters by the Internal Revenue Service and other taxauthorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of theseexaminations. If the Companys effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Companys taxes owed is for an amount in excess of amounts previously accrued, theCompanys operating results, cash flows, and financial condition could be adversely affected.
Share repurchase activity during the three months ended June 28, 2014 was as follows:
Q3 2014 Fiscal Periods
Part ofPublicly
Plansor
(in thousands) Approximate
May YetBe
16,965 $ 80.74 16,965
35,165 $ 86.17 35,165
6,531 $ 91.87 6,531
58,661 58,661 $ 39,050
In 2012, the Companys Board of Directors authorized a program to repurchase up to $10 billion of the Companys common stock beginning in2013. In April 2013, the Companys Board of Directors increased the share repurchase authorization to $60 billion. In April 2014, the Companys Board of Directors increased the share repurchase authorization to $90 billion, of which $50.9billion had been utilized