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Apple Inc. (NASDAQ:AAPL)

F2Q10 Earnings Call

April 20, 2010 5:00 pm ET

Executives

Nancy Paxton - Senior Director, Investor Relations and Corporate Finance

Peter Oppenheimer - Chief Financial Officer, Senior Vice President

Timothy D. Cook - Chief Operating Officer

Gary Wipfler - Treasurer

Analysts

Gene Munster – Piper Jaffray

Benjamin Reitzes – Barclays Capital

Shannon Cross - Cross Research

Bill Shope – Credit Suisse

Toni Sacconaghi - Sanford Bernstein

Richard Gardner – Citigroup

Maynard Um – UBS

Brian Marshall – Broadpoint Amtech

Mike Abramsky - RBC Capital Markets

Katie Huberty – Morgan Stanley

Keith Bachman – BMO Capital Markets

Yair Reiner – Oppenheimer

Mark Moskowitz – JP Morgan

Operator

Welcome to the Apple Incorporated second quarter fiscal year 2010 earnings release conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Ms. Nancy Paxton, Senior Director of Investor Relations. Please go ahead, ma’am.

Nancy Paxton

Thank you. Good afternoon and thanks to everyone for joining us. Speaking today is Apple CFO, Peter Oppenheimer, and he will be joined by Apple COO, Tim Cook and Treasurer, Gary Wipfler for the Q&A session with analysts.

Please note that some of the information you will hear during our discussion today will consist of forward-looking statements including without limitation those regarding revenue, gross margin, operating expenses, other income and expense, stock-based compensation expense, taxes, earnings per share and future products. Actual results or trends could differ materially from our forecasts. For more information, please refer to the risk factors discussed in Apple's Form 10-K for 2009 as amended, the Form 10-Q for the first quarter of fiscal 2010 and the form 8-K filed with the SEC today along with the attached press release. Apple assumes no obligation to update any forward-looking statements or information which speak as of their respective dates.

With that, I would like to turn the call over to Peter Oppenheimer for introductory remarks.

Peter Oppenheimer

Thank you, Nancy. Thank you for joining us. We are thrilled to report outstanding March quarter results that exceeded our expectations. The strong momentum we experienced in the holiday quarter continued in the March quarter. As a result, we are reporting our best non-holiday quarter revenue and earnings ever, the highest quarterly iPhone sales ever and a new record for Mac sales in the March quarter. We are delivering the best products in Apple’s history and our customers are responding enthusiastically.

Revenue was $13.5 billion, a 49% increase over the prior March quarter’s results. This very strong performance was due primarily to the more than doubling of iPhone sales and the strong momentum of our Mac products. This resulted in a much smaller sequential revenue decline from the December to March quarters than we normally experience. Operating margin was $4 billion representing 29.5% of revenue. Net income was $3.1 billion up 90% over the year-ago quarter and earnings per share were $3.33.

Turning to the details of our results I would like to begin with our Mac products and services. We generated record March quarter sales of 2.94 million Macs. This represents 33% year-over-year growth compared to IDCs latest published estimate of 24% growth for the market overall in the March quarter. We were very pleased with Mac sales growth in each of our geographic segments and we experienced strong, double digit growth for both desktop and portable categories.

We made our portable lineup even stronger last week by introducing an updated MacBook Pro line with faster processors, more powerful next generation NVIDIA graphics and even longer battery life. We began and ended the quarter with between 3-4 weeks of Mac channel inventory.

Moving onto our music products we sold 10.9 million iPods, about equal to the 11 million we sold in the year-ago quarter. iPod Touch continued to be very strong with units growing 63% year-over-year. The strong mix of iPod Touch resulted in overall iPod revenue growth of 12%, the strongest iPod revenue growth rate in the last two years. Our share of the U.S. market for MP3 players remains at over 70% based on the latest monthly data published by NPD. iPod was also the top selling MP3 player and continues to gain share internationally year-over-year in nearly every country we track including high market share countries such as Australia, the U.K., Canada and Japan based on the latest data published by GFK.

The iTunes store delivered its best quarter ever with sales of $1.1 billion due to continued strong demand for music, video and apps. iTunes has the world’s largest online music catalog with a selection of over 12 million songs and in February we crossed the 10 billion mark for songs purchased and downloaded. The App Store continues to be a phenomenal success with more than 185,000 apps and well over 4 billion downloads to date by iPhone and iPod Touch users in 90 countries. We are very excited to have launched the iBook store as well as over 3,500 new apps designed for iPad. We ended the quarter within our target range of 4-6 weeks of iPod channel inventory.

I would now like to turn to the iPhone. We are thrilled to have sold 8.75 million iPhones during the quarter, an all-time high exceeding the previous record set in the most recent holiday quarter. This represents 131% year-over-year growth over the previous March quarter’s results and is more than three times the IDCs published estimate of 41% growth for the Smart Phone market overall in the March quarter. Recognized revenue from iPhone handset sales, accessory sales and carrier payments was $5.45 billion during the quarter compared to $2.43 billion in the year-ago quarter. The sales value of iPhones alone was about $5.3 billion and dividing this by the 8.75 million units yields an ASP of about $600.

We have continued to expand iPhone’s reach by adding both carriers and countries and we now have iPhone distribution with 151 carriers in 88 countries. We experienced very strong year-over-year growth in each of our geographic segments and particularly in Asia, Australia, Japan and Europe. We were very pleased with the significant sales growth in both existing and new carrier partners. We were also very pleased that customers once again ranked iPhone first in JD Power and Associates’ 2010 U.S. Wireless Smart Phone Customer Satisfaction study.

We are also very excited about the release of the iPhone OS4 this summer. Developer response to the beta release and new SDK has been very positive and we believe customers and developers will really enjoy the over 100 new features including multitasking for third-party apps, folders, enhanced enterprise support, the iAd mobile advertising programs and much more.

Turning to the iPad we are extremely pleased with sales results during the past couple of weeks and the critical reviews and customer feedback has been outstanding. Customers are loving the iPad and its revolutionary multi-touch user interface that lets them browse the web, read and send email, enjoy and share photos, watch HD videos, listen to music, play games, read eBooks and much more. We are on track to begin shipping the 3G version of the iPad in the U.S. on April 30th and to begin shipping both versions of the iPad in nine additional countries at the end of May.

I would now like to turn to the Apple Retail Stores. Revenue in the quarter was $1.68 billion compared to $1.38 billion in the year-ago quarter, an increase of 22%. Our stores sold 606,000 Macs compared to 438,000 Macs in the year-ago quarter, an increase of 38%. About half the Macs sold in our stores during the March quarter were to customers who have never owned a Mac before. We opened two new stores in the U.K. during the quarter as well as a new store in Germany to end with 286 stores. With an average of 284 stores open during the March quarter average revenue per store was $5.9 million compared to $5.5 million in the year-ago quarter.

Retail segment margin was $373 million or 22.2% compared to $317 million or 23% in the year-ago quarter. We hosted 47 million visitors in our stores during the quarter compared to 39.1 million visitors in the year-ago quarter, an increase of 20%. We also conducted over 700,000 personal training sessions and we ended the quarter with 607,000 members in our One to One program. We remain on track to open 40-50 new stores in total during fiscal 2010 with over half being in international locations including London, Paris and Shanghai.

Total company gross margin was 41.7% which was 270 basis points above our guidance. This difference was primarily driven by several categories of positive factors compared to our forecast. In order of relative impact these were; first, a stronger product mix including more iPhones and accessories. Second, lower cost. Third, fixed cost leverage from the higher than expected revenue in the March quarter as well as a few other small items.

Operating expenses were $1.65 billion and included $194 million in stock based compensation expense. OI&E was $50 million and the tax rate for the quarter was 24%. We have previously forecasted a 29% tax rate for the full-year but have revised our forecast to about 27% based on a higher mix of foreign earnings. The 24% tax rate for the March quarter was required to true up year-to-date provisions to 27%.

Turning to cash, our cash plus short-term and long-term marketable securities totaled $41.7 billion at the end of the March quarter compared to $39.8 billion at the end of the December quarter, an increase of $1.9 billion. Cash flow from operations was over $2.3 billion. Our investment priorities for cash continues to be preservation of capital which has served us well in the current environment. We are continuing to focus on short-dated, high quality investments and remain comfortable with our investment portfolio.

Looking ahead to the June quarter I would like to review our outlook which includes the types of forward-looking information Nancy referred to at the beginning of the call. We expect revenue to be between about $13-13.4 billion compared to $9.7 billion in the June quarter last year. We expect gross margin to be about 36% down from 41.7% in the March quarter and reflecting approximately $36 million related to stock based compensation expense. We expect about 25% of the sequential gross margin decline to be driven by the first quarter of iPad sales.

As we said in January when we announced the iPad we have been very aggressive with pricing and are delivering tremendous value to customers. We think the market for the iPad will be large and we want to capitalize on our first-mover advantage. We expect the remaining three quarters of the margin decline to be due to four factors of roughly equal impact including; a stronger U.S. dollar, our Mac portable transition, the beginning of the education buying season and future product transitions.

We expect OpEx to be about $1.83 billion including $185 million related to stock based compensation. We expect OI&E to be about $45 million reflective of the short-term interest rate environment and we expect the tax rate to be about 27%. We are targeting EPS in a range of $2.28 to $2.39 compared to $2.01 in the year-ago quarter.

In closing, we are thrilled with our record March quarter results and the momentum of our business. We are very pleased with the market share gains for our iPhone, Mac and iPod products and with the tremendous customer response to iPad. We are looking forward to the release of both iPad versions in nine international countries at the end of May and we are very enthusiastic about iPhone OS4 arriving this summer. We are very confident in our new product pipeline and are excited about the months ahead.

With that I would like to open the call to questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Gene Munster – Piper Jaffray.

Gene Munster – Piper Jaffray

It is clear the iPad is off to a fast start. Based on our work it looks like it has the potential to become the Mac of the masses, if you will. My question is what insight did you gain in the last three weeks in the U.S. market in terms of gauging what the impact of the iPad has been on the demand for the overall Mac and has there been any cannibalization? I would guess there is some data somewhere that would give us some insight into answering that question.

Timothy Cook

If you look at last quarter we made the announcement as you know of the iPad in January. In our view the last quarter there was no obvious impact on either the Mac or the iPod but you can look at the numbers we are reporting and judge that for yourself. Going forward now that we are selling into April we really don’t have enough experience to come to a judgment yet. We will see how it goes. We are obviously thrilled with the sales of the iPad. They have far exceeded our expectations and it has been a relative great start.

Gene Munster – Piper Jaffray

Throughout the March quarter if you were to look on a month-to-month basis based on some of the third-party data we saw a deceleration in the growth rate of Mac in the month of March. Do you think any of that could have been attributed to people holding off on buying a Mac for an iPad and what would you attribute that step down in the month of March to?

Timothy Cook

If you look at the previous March, the base quarter you are comparing to, we announced a new iMac and a new Mac Mini. So our compare point was to a month we announced two new products versus a month we didn’t announce any new Macs. I wouldn’t think you could really judge the Mac business on a month-by-month basis. I think looking at a longer period of time is correct. Certainly, our internal expectation was that the comparable would come down through the quarters and begin to comp against those products.

Gene Munster – Piper Jaffray

On the mix between 3G versus WiFi any sort of flavor you can give us on how to model that out.

Timothy Cook

Honestly it is too early to tell. We have only been selling WiFi other than the pre-orders and we feel we really need to be selling both models side by side in an unconstrained environment before we are able really to know what the mix will be.

Operator

The next question comes from the line of Benjamin Reitzes – Barclays Capital.

Benjamin Reitzes – Barclays Capital

I wonder if you could talk about your guidance and a follow-up. You talked about the many margin hits sequentially. Can you talk about revenue? For example you have the iPad which you have never had before which should help sequentially. Usually Mac is up in the June quarter sequentially and obviously the iPod are usually maybe down a little. Can you talk about the puts and takes sequentially? Is there something going on with the iPhone where there is a transition that hits that sequentially and that is why you are guiding down revenue sequentially?

Peter Oppenheimer

We are thrilled with the performance of our business and to be providing guidance year-over-year for growth of 34-38% for the June quarter. In coming up with that we factored several points into the guidance including sequentially lower ASPs from the beginning of the education buying season, a stronger U.S. dollar and product transition. We have also factored in sequentially lower iTunes which is typical as holiday gift cards are used in the March quarter and also sequentially lower accessory and software sales. For Mac we would expect to see a sequential increase in Mac unit sales as a result of the beginning of the education buying season and a recent refresh we just did in the Mac Pro line.

For iPod our in-stock in the March quarter was better than last year which helped us achieve the 10.9 million units. This year we would expect to see a bigger sequential decline in the June quarter than the 7% we saw last year. For iPhone we don’t have much experience with seasonality with our current country and carrier distribution. We are very confident in our product but we will see what occurs and we will report to you in July. For iPad we are thrilled with customer response to the iPad and we will begin shipping both the WiFi and WiFi 3G versions in the U.S. by the end of April and 9 additional countries by the end of May.

We feel very, very good about the start of iPad.

Benjamin Reitzes – Barclays Capital

I wanted to hear more about iPhones. Why was it so good? The number was actually frankly staggering due to the expectations in my opinion. There seems to be good strength overseas. Can you talk about why, what happened there and how was China and also channel inventory?

Timothy Cook

That is a lot. On the channel inventory our channel inventory was essentially flat from the beginning of this quarter compared to the end of the quarter. If you look in terms of geography we had some staggering growth rates as you mentioned. If you look at Asia Pacific as an example the iPhone units in Asia Pacific grew 474% year-over-year. Japan grew 183%. Europe grew 133% and so these are some fabulous numbers we are seeing just incredible demand for iPhones. Some of this was led by adding eight carriers in some key countries.

For example Vodafone in the U.K. and Ireland as well as some other carriers in key countries in Asia. We also had very strong performance from existing carrier partners really around the world. It was widespread and just generally terrific results.

Benjamin Reitzes – Barclays Capital

Did China meet your expectations?

Timothy Cook

China has been interesting. If you look at greater China which we define as mainland China, Hong Kong and Taiwan, the iPhone units were up year-over-year over 9 times. We added another 800 points of distribution in China. The revenue, we have never released this number before but I will do this in this particular case, through the first half of the fiscal year that we just completed for the six month period our revenue from greater China was almost $1.3 billion and this is up over 200% year-over-year. So we are well pleased with how the company is positioned to take advantage of the growth in greater China.

Operator

The next question comes from the line of Shannon Cross - Cross Research.

Shannon Cross - Cross Research

Could you talk a little bit about data points for the success of the App store? And how you are thinking about the App Store with the addition of the higher ASP apps related to the iPad?

Timothy Cook

We are thrilled with the App store and customers are loving it. It has seen well over 4 billion downloads from the App store and have over 185,000 apps and now over 3,500 for the iPad alone. We have just begun shipping the iPad. Early in the first week we released some data about customer downloads related to the iPad. They are clearly loving it and I think it is a very strong part of the overall product offering to customers.

Shannon Cross - Cross Research

Can you talk a little bit about your production capacity on the iPad side? Clearly you pushed out, because of demand in the U.S., you pushed out your international launch. How are you feeling about your ability to produce there? How quickly can you ramp up production? Are there any [gating] factors with any commodity components or anything like that?

Timothy Cook

We have done very well versus our planned capacity. There is not a production problem. It is sort of a good kind of issue to have that the demand in the U.S. was much, much stronger than we predicted and so regrettably we had to push out the international launch to be able to launch the 3G unit in the U.S. and to get the WiFi units into the United States. We are adding capabilities. We will see where this thing goes but it has shocked us the level of demand at least initially. We will see what happens from here.

Operator

The next question comes from the line of Bill Shope – Credit Suisse.

Bill Shope – Credit Suisse

I may have missed it but I didn’t hear you comment on component pricing in your gross margin outlook. Can you give us a sense of what you are seeing in terms of the component pricing trends and where you are seeing any signs of pressure or easing?

Timothy Cook

The DRAM market is constrained. We do expect higher pricing sequentially as a result of that. The bulk of the other commodities including the key commodities of [demand] and LCD and HD we see generally in-supply demand balance. Other components we expect to decline consistent with historical trends.

Bill Shope – Credit Suisse

I know it is still early stage here or actually pre-stage but can you help us understand how we should think about the economics of the iAd business. Is it a potential profit center or are you looking at it as a break-even type of business like iTunes and the App Store?

Peter Oppenheimer

We are putting our toes in the water but don’t expect much from us this calendar year. We think we will learn a lot and build a foundation for the future.

Bill Shope – Credit Suisse

Can you give us an update on where you think AT&T is with its network improvement plans and are you still comfortable that the performance of the network will be up to par this year?

Peter Oppenheimer

I think they continue to work very, very hard and we look forward to continued improvement. They clearly made big strides in some areas with some of the recent surveys have pointed out and I think it will continue.

Operator

The next question comes from the line of Toni Sacconaghi - Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

You kind of alluded to the growth from new carriers versus existing carriers. I don’t know if it might be possible for you to quantify how much of the year-over-year growth came from new carriers or what percentage of the units were contributed by carriers you did not have one year ago?

Timothy Cook

We don’t break it out at that level of detail. I would tell you both were very important to us. Both the additions and the existing carriers. You can look at the number of carriers we added which was eight as I had mentioned, and out of the 151 carriers at the country level it is a good number but not a significant number. Obviously the existing carriers performed very well in addition to the adds.

Toni Sacconaghi - Sanford Bernstein

Taking that one step further, can you update us on your thinking about incremental distribution for the iPhone? A couple of calls ago you talked about not really believing in exclusive distribution and really trying to broaden distribution as quickly as possible. I think on the last earnings call it almost seemed like you had softened that and said look there may be regions where we actually don’t care to operate beyond one carrier at our choice. Can you update us on your thinking about incremental distribution? How important is it? Is it available to any carrier in any country? How are you thinking about pricing the device for incremental distribution?

Timothy Cook

Let me see if I can word it like this. There are three main countries where iPhones have a contractual exclusive relationship. That is the United States, Germany and Spain. There are a few smaller countries where we have an exclusive or co-exclusive but those three are the ones that are the major markets. Over the past year we have moved a number of markets from exclusive to non-exclusive. In each case as we have done that we have seen our unit growth accelerate and our market share improve. But that doesn’t mean we view that formula works in every single case. I would just sort of reiterate what I did last time that this is how we are learning so far. That is the result we have seen so far. We think very carefully about each of these at the country level to conclude what is in our best interest.

Toni Sacconaghi - Sanford Bernstein

Let me just switch to one other topic if I may and Peter I think this is probably for you. Bear with me, I am going to just plug through some numbers. You said gross margin is going to decline 600 basis points sequentially in the quarter that would be due to the iPad. So that is 150 basis point negative impact from the iPad. If you assume the iPad is 10 points lower gross margin than the company average which is way, way lower than most third-party tear-down services which it would suggest it basically means for that contribution to be true for your guidance iPad would need to be 15% of your revenue or $2 billion. So either iPad is going to be more than $2 billion in terms of revenue per your guidance for next quarter and have a gross margin that is less than 10 points less than the company average or the gross margins of the iPad are more than 10 points lower than the company average.

Can you comment? The math I think is pretty self-evident. Can you comment on whether we should be thinking about this device as having dramatically lower margins than the company average or should we be thinking about this as something that has perhaps a bit more volume than many investors are thinking about?

Timothy Cook

Let me comment on the iPad margin first. As you know we don’t give out specific margins for products but really refer to the company gross margin. That said I would point out when we priced iPad we priced it very aggressively in order to deliver tremendous value to our customers. We think the market size for the iPad is very large and we want to capitalize on our first mover advantage. As we have done in other products, although I am not forecasting it, you can see we have a good track record of writing down the costs per with value engineering and volume manufacturing or at least that has certainly been our experience with other products. Those are the things I would point out. Peter do you want to add something to that?

Peter Oppenheimer

No, that is definitely our view.

Toni Sacconaghi - Sanford Bernstein

But the implication of writing down the costs would be unless you pass that on in the form of much lower prices your margins are going to get better. I gather that statement suggests to the degree you want to drive volume you are going to be open minded about price changes?

Peter Oppenheimer

We have nothing to announce relative to those things today. I am just saying that we have a great product. We have seen great demand. We have priced this extremely aggressively and we did that because we believe there is a huge market for it and certainly the initial results suggest that is the case.

Operator

The next question comes from the line of Richard Gardner – Citigroup.

Richard Gardner – Citigroup

You talked about the headwinds on gross margin going into the second calendar quarter. In the spirit of balance I was hoping you might be able to talk about what you might consider tailwinds on gross margin going into June? In particular whether you would consider component pricing overall to be a headwind or a tailwind in the June quarter sequentially?

Peter Oppenheimer

I don’t really consider component pricing to be a headwind or a tailwind. Tim I think answered in Bill’s question his view on what we were going to see in the June quarter. So [costs] are by themselves necessarily a big factor. I think what we think is going to occur in the June quarter is we have introduced a new product that we couldn’t be more excited about. We have been very aggressive and we will take advantage of our first-mover opportunity here.

Then we have some other transitions. We have a stronger dollar and we are heading into the Ed buying season which we anticipate being competitive this year. So that is really what has gone into our thinking on gross margin.

Richard Gardner – Citigroup

I wanted to ask you about the accounting treatment for the iPad. Whether you could give us a sense of whether you are going to be deferring a portion of the revenue associated with iPad software upgrades or whether you are going to be charging for those upgrades?

Peter Oppenheimer

We will discuss that with you on our July conference call when we report the June quarter results which will include our first shipments of iPad.

Richard Gardner – Citigroup

Could you talk about the performance of your China stores in particular and your plans for additional store openings in China this year?

Peter Oppenheimer

Sure. We are very excited about China not only for retail but for Apple. Tim talked about the success we have had in greater China to date with revenue being up about two time’s year-over-year. With regard to retail stores we will open two stores in Shanghai this summer and with targets of having about 25 stores open in China by the end of calendar 2011.

Operator

The next question comes from the line of Maynard Um – UBS.

Maynard Um – UBS

If I look at your iPhone units across your 151 operators it is roughly about 58,000 units per operator. Understanding some operators are smaller and others larger, can you talk about the dynamic there and how you drive those units up more materially on a per operator basis?

Peter Oppenheimer

The 58,000 to be honest with you is not a very meaningful number because the variance is from one particular carrier that does a few million to some that do very, very low numbers. So the average itself isn’t very meaningful. The things we do to drive overall iPhone demand is focus on product innovation. That is software that hopefully you saw with the preview we gave with new iPhones that will be coming this summer is new hardware and new products. It is new distribution points. It is additional carriers and geographic expansion which we will continue to do. It is really all of those things and great marketing.

Maynard Um – UBS

Apple has been a little bit more aggressive defending its patent portfolio against infringement. It doesn’t look like we are really seeing an impact here to OpEx. I am curious how we should think about legal expenses relative to your operating expenses?

Peter Oppenheimer

We have certainly factored into the guidance we have given you for the June quarter and results we have reported for March our legal and other expenses. Whatever we are incurring in that area is included.

Operator

The next question comes from the line of Brian Marshall – Broadpoint Amtech.

Brian Marshall – Broadpoint Amtech

I guess some of the iPhone upset I was expecting last quarter actually happened this quarter and based on my calculations your international carrier partners probably represented roughly 75% of the mix for iPhone shipments in the quarter. And taking that one step further I think there was roughly 100 basis points penetrated of that international carrier base, call it post-paid sub base of those total carriers, roughly half a billion units. The question is have you learned any lessons with regard to how the international markets have ramped up relative to what you have experienced in the U.S. over the past 2.5 years?

Timothy Cook

I think the key thing is the smart phone category specifically is a great market to be in. It has very high growth rates from a market point of view and Apple with the iPhone unit growth of 131% outgrew the market by three times. So we feel great about that. Those numbers were even better outside of the U.S. than inside the U.S. We have learned a number of things and we are trying every day to take everything we have learned and do something better from a product point of view and do something better for distribution and our carrier relationships and so on and so forth. I don’t want to go into each of those on here because I don’t want anybody to copy those.

Brian Marshall – Broadpoint Amtech

With regard to the Apple TV clearly it seems as though you have been very successful attracting additional media content on the iTunes and the App Store platform. I was wondering if we could get an update on ambitions with regard to Apple TV? Clearly broadband is still somewhat lagging in terms of quality of the service I think and cell phone areas need to get better. I wanted to get your thoughts there.

Timothy Cook

The units were up for the quarter 34% year-over-year but the absolute number of units are still small and we still classify the product as a hobby for the company. I would just repeat what I have probably said before. If you look at the other markets that Apple is in, the Macintosh competes in a market of 300 million or so units a year. The iPhone competes in a market if you look at all phones of maybe 1.2 billion a year. The iPod competes in a market that has 100 million plus or minus units per year.

So these are enormous sized markets and clearly the market that AppleTV is in is not in our view nearly that large as yet. That is the reason we classify it as a hobby so that no one gets the wrong impression that we have a vision that it is anywhere close to the size of the other businesses. However, a number of us love the product, use the product and we continue to think there is something is something interesting there and we continue to invest in it.

Brian Marshall – Broadpoint Amtech

A final question with regard to the iAds. Do you think this could be a significant source of potential incremental earnings down the road as I think what you offer advertisers is a pretty compelling demographic user base with the information and emotion you are able to convey?

Peter Oppenheimer

I think I commented on a prior question, at this point we are putting our toes in the water so we don’t expect much this calendar year. We think we are going to learn a lot and we will work to build a foundation for the future.

Operator

The next question comes from the line of Mike Abramsky - RBC Capital Markets.

Mike Abramsky - RBC Capital Markets

Just wondering why you didn’t see, or whether you expect any touch cannibalization from the iPad and what is your sense for do you think iPad is cannibalizing maybe competitive netbooks?

Timothy Cook

I can only tell you in the quarter we finished, Q2 we finished in March, although we announced the iPad in January there was nothing obvious in the iPod number or the Mac number to suggest cannibalization. There is an obvious announcing and people know it is coming and it is starting to sell. So that part of the equation we don’t know yet. We will find out. We are thrilled with how the iPad is selling and the enormous response that we have received. We also announced net MacBook Pro that you probably saw last week and the whole line change. So we are also happy about how the Mac business is positioned and the level of product innovation in those notebooks. It is enormous. It is taking battery life up to 10 hours. That is absolutely amazing.

In terms of the iPad competing for customers who are considering a netbook, you know I am the wrong person to ask that. To be it is a no-brainer. iPad/Netbook, it is sort of 100 to zero. I can’t think of a single thing the netbook does well. iPad does so many things very, very well. I am already personally addicted to mine and couldn’t live without it. So I am probably not the right person to ask that question.

Mike Abramsky - RBC Capital Markets

You talked about you see it as a huge independent category and given all the public debate over its positioning which you obviously have some strong views on can you elaborate on why it you see it as a huge independent category given it is a new market, you just sort of listed off a lot of markets that are pre-existing. But you stated in this case you also feel [inaudible]. Why do you think Apple’s approach will outpace of that of big competitor tablets or vertical devices like ebooks?

Peter Oppenheimer

I think we did extremely well as usually in positioning the product in the January announcement when he talked about if a product category were to exist between the notebook and Smart Phone then it would need to do something better than either of those. I am just saying from my personal use there is a variety of things I would put on that list and I love notebooks personally but I would put email on it. I would put browsing on it. Listening to music. Watching videos. Watching TV shows of any type. Reading books. The list goes on. Of course you have the entire App store and the ecosystem built around that and so people that like to play games now they have that larger handbook to play games on and other apps from serious apps to less serious apps the larger handbook provides the artist a lot more room to do things that are very cool.

I think it is a new category and certainly it is early but we really, really like what we see right now. We had what we thought were high hopes and it exceeded those. That is all I can offer for now. I would love to talk to you in July and tell you how the quarter went for the June quarter.

Operator

The next question comes from the line of Katie Huberty – Morgan Stanley.

Katie Huberty – Morgan Stanley

In a previous question you walked through some of the incremental demand drivers for the iPhone. The one you left out was price because Apple along with the carriers has done a good job lowering the price of the hardware over the last couple of years. But with the low end at $99 it seems the incremental demand from here would come from more affordable monthly service plans. So I guess my question is whether Apple has any influence via the carriers to get more aggressive on the total cost of ownership for the iPhone?

Peter Oppenheimer

We do everything we can to try to get the best deal possible for the consumer. By the way I feel like each of the carrier partners we have worked want to do the same. I think everybody is focused on that. When we dropped the subsidized price of the phone to $99 last year we were actually surprised that the mix to the 3G was very, very high. As you know, that was at $199. I think it is important. I think that price is important on the device but I think there are other things people really want like an extremely innovative product and all the apps and the ecosystem and the great OS and incredible hardware we have got. I think it is one of the factors.

Katie Huberty – Morgan Stanley

As a follow-up on the discussion around margin for iPad, either one of the upside drivers of revenue and margin for the iPhone has been the aftermarket sale of things like accessories. What have you considered about attach rates to the iPad relative to what you have seen on iPod and iPhone and could that maybe be an upside driver to gross margins for that portfolio over time?

Peter Oppenheimer

The accessory portfolio is good for us. Over 5,000 accessories that work for the iPhone and iPod largely work for the iPad. We have come out with some great accessories for the iPad in the first weeks and the developer community has rallied around it as well. Let’s give it a little time and presumably some great things will happen there just like it has for iPhone and iPod.

Operator

The next question comes from the line of Keith Bachman – BMO Capital Markets.

Keith Bachman – BMO Capital Markets

I wanted to ask about retail. In your same store sales comments I think retail on same store sales were up about 7% and total retail was up about 22% in terms of revenue. Therefore, as investors look out is the retail number really driven by new store openings or is there something unusual that was going on? If you could give a little bit of color of the drivers of the retail business that would be great.

Peter Oppenheimer

Sure. Our retail stores had a great March quarter. The average increase of revenue per store was actually up 8% and this was the best we had seen in six quarters. The Mac did incredibly well in the stores, up 38% overall. Same store Mac sales were up over 20%. Phone did well. I think the stores are really going to be a great place for customers to come in, look at and buy iPads. We are very confident in our retail stores. The experience it is giving customers and finally just after 10 years of retailing we are just ecstatic about the fact that roughly half of the Mac sales that occur each quarter are to people that have never owned a Mac before.

Keith Bachman – BMO Capital Markets

Right but the data has been fairly consistent that the revenue growth in retail at least that category is dependent upon new store openings.

Peter Oppenheimer

Again, the average store was up 8% and in the quarter our average revenue was $5.9 million. So if you annualize it that is incredibly high by retail standards particularly for the size of store we have. I would say good growth coming not only from new stores that we open but the stores that we have had open for a number of years are performing very, very well for us and cash flow from those stores is quite strong.

Keith Bachman – BMO Capital Markets

I wanted to ask one follow-up if I could. I know Rich had asked about the iPad. Could you at least let us know where that will be categorized as a line item? Will it be independent or included in something else?

Peter Oppenheimer

Sure. We are going to report the iPad very similar as we do iPhones. It will be a line item on our data summary and the revenue we report will be for the iPad units and the iPad specific accessories. Again, similar to what we do for iPhones.

Operator

The next question comes from the line of Yair Reiner – Oppenheimer.

Yair Reiner – Oppenheimer

Recognizing the iPad is still in very much in early days but have you been able to pick out anything about the apps performing? Are consumers buying different kinds of apps than they typically have for the iPhone and is the ASP panning out to be different than the types of apps people bought for the phone to this point?

Peter Oppenheimer

It is very early days. We put out some information after the first couple of days. Customers are loving the iPad. They are going to the App Store and getting apps, getting books. It has been really a great thing for customers but we will talk more in the future about how that goes. I would say we are not focused on trying to make a lot of money on the App Store as we haven’t on the iTunes store. We have run the store just over break-even and we just want to offer tremendous value to customers.

Yair Reiner – Oppenheimer

Europe appears to be performing exceptionally well. Can we finally say you are seeing a halo effect from the iPhone there? To what extent has that been playing out at the stores? Are more than 50% of Mac buyers in European stores new to Mac?

Peter Oppenheimer

We tend to not break it down by country but I can tell you we are thrilled with our new to Mac all over the world.

Yair Reiner – Oppenheimer

You mentioned $600 ASP for the iPhone. Does that include the ratable revenue from software or is that purely for the hardware?

Peter Oppenheimer

It is based on the sales value of the iPhone so it doesn’t include anything from carrier payments, any of the deferral or accessories. So it is the sales value in the quarter of the handset sales.

Operator

The next question comes from the line of Mark Moskowitz – JP Morgan.

Mark Moskowitz – JP Morgan

Earlier you mentioned that Apple was shocked about the reception in the U.S. for the iPad. Can you talk about how you are shocked in terms of customer penetration? Are there any customers in the early days that are taking the iPad that are completely new to Apple?

Peter Oppenheimer

Of course. The numbers right now are so preliminary and based on such a small amount of time we don’t read a lot into those. So they are not something we would disclose at this point.

Mark Moskowitz – JP Morgan

Not too far beyond the iPad but in the prepared release you said there are other extraordinary products in the pipeline for this year. Are those incremental categories similar to the iPad or are they just enhancements of existing products?

Peter Oppenheimer

We are just not going to help our competitors so that is not a question I can specifically answer for you. Let me reiterate we are very confident in our new product pipeline and are very excited about the coming months.

Mark Moskowitz – JP Morgan

In terms of the education vertical as far as the commentary around the margin hit for June, how much of that is driven by competitive dynamics versus maybe just your own ability here to try to cough up demand because of the troubles facing some of the school districts out there?

Peter Oppenheimer

You read the same things we do about the state budget situations and the school districts are under a lot of pressure in pretty much every state around the country. I have seen no evidence we are losing market share in education and so I think it is really just a budget issue. We have now entered in the June quarter the education buying season. June tends to be more dominated by K-12 and then September will be more dominated typically by higher ed. This year we expect it to be competitive but we are going to put on our uniforms, suit up and we look forward to competing.

Nancy Paxton

Thank you Mark. Thanks to everyone for joining us. A replay of today’s call will be available for two weeks as a podcast on the iTunes store, as a webcast on Apple.com/Investor and by telephone. The numbers for the telephone replay are 888-203-1112 or 719-457-0820. Please enter the confirmation code 5473920. These replays should be available beginning at approximately 5:00 p.m. PT today.

Members of the press that have additional questions can contact Steve Dowling at 408-974-1896. Financial Analysts can contact Joan Hoover or me with additional questions. Joan is at 408-974-4570. I am at 408-974-5420. Thanks again for joining us.

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Source: Apple Inc. F2Q10 (Qtr end 03/27/10) Earnings Call Transcript
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