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Apple Computer, Inc. (NASDAQ:AAPL)

Q1 2006 Financial Results Conference Call

January 18th 2006, 5:00 PM.

Executives:

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Peter Oppenheimer, Chief Financial Officer

Timothy (Tim) Cook, Chief Operating Officer

Gary Whistler, Corporate Treasurer

Analysts:

Keith Bachman Banc of America Securities.

Benjamin Reitzes, UBS.

Robert Semple, Credit Suisse First Boston

Gene Munster, Piper Jaffray.

Rebecca Runkle, Morgan Stanley.

Bill Shope, J.P.Morgan.

Charles Wolf, Needham & Company.

Joel Wagonfeld, First Albany Capital.

Richard Chu, Sg. Cowen & Co.

Steve Lidberg, Pacific Crest Securities.

Shaw Wu, American Technology.

Steven Fortuna, Prudential Equity Group

David Bailey, Goldman Sachs.

Shannon Cross, Cross Research

Richard Gardner, Citigroup.

Presentation:

Operator

Good day and welcome to the Apple Computer's First Quarter Financial Results Conference Call. Today’s call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to Ms. Nancy Paxton, Senior Director, Investor Relations and Corporate Finance. Please go ahead Ms. Paxton.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Good afternoon. Thanks for everyone for joining us. Speaking today is Apple’s CFO Peter Oppenheimer and he will be joined by Apple’s COO Timothy (Tim) Cook and corporate treasurer Gary Whistler for Q&A session with analyst. Please note that some of the information you will here during this call consists of forward looking statements regarding revenue gross margin, operating expenses, other income and expense, taxes earnings per share, Apple’s retail initiative, iPod shipments, future products including Intel based Mac, component prepayments and non-cash stock based compensation expense. Actual results and trends could differ materially from our forecast. For more information please refer to the risk factors contained in the company’s Form 10-K for 2005. Please also note that any non-GAAP financial measures included in today’s call should be viewed in addition to and not in lue of Apple’s GAAP results. A reconciliation of any GAAP and non-GAAP measures discussed will be posted on Apple’s website at www.apple.com/investor. I would like to remind you that the second quarter of Apple’s fiscal 2006 will end on April 1st and will span 13 weeks rather the 14 weeks spanned by the first fiscal quarter. In connection with SEC rules on corporate disclosure Apple is making this analyst call open to the media and general public by broadcasting the call live over the internet. With that i would like to turn the call over to Peter Oppenheimer for introductory remarks.

Peter Oppenheimer, CFO

Thank for joining us. We are extremely proud to report a tremendous first quarter for Apple. Revenue of $5.75 billion increased over $2 billion from last quarter’s record revenue and was up 65% year-over-year. This quarterly results also exceeded Apple’s revenue for all of fiscal 2002. The quarter’s revenue was fueled by record shattering iPod sales, solid Mac sales and 14th week of business during the quarter. Quarterly net income nearly doubled on a year-over-year basis and also widely eclipsed the previous record established in the September quarter. Based on an unusually strong operating margin of 13% net income was $565 million or $0.65 per diluted share on a GAAP basis. Excluding the impact of non-cash stock based compensation operating margin was 13.8%, net income was $595 million and diluted earnings per shares was $0.68. I will now provide highlights of our two businesses, Mac and Music. Our Mac business generated 41% of total revenue which was up 12% from the year-ago quarter. Mac shipments increased 20% year-over-year to $1.254 million the highest quarterly total in six years.

We continued to experience strong portable system sales. We shipped the combined total of 587,000 iBooks and PowerBooks representing 39% year-over-year growth. We shipped 667,000 Desktops systems representing 7% year-over-year growth. Mac unit sales exceeded our internal expectations despite of what we believe was a positive sale associated with the Intel transition. Reflecting on the September and December quarters, we were pleased with the lower than expected impact at the Intel transition on sales and with the moment of our Mac business. Our ending channel inventory remain below our target of 4-5 weeks as planned due to our Intel based Macintosh announced at Mac World.

Our Music business generated 59% of total Apple revenue in the quarter and was up 145% compared to the year-ago quarter. We sold over 14 million iPods during the quarter, more than three times the number we sold in the year-ago quarter and more than double the previous record number of iPods we sold in the September quarter. We are particularly proud of our execution given that we replaced two of our three iPod lines including the highest volume iPod Mini line as we entered the holiday season. Customer reactions about the iPod Nano and the 5th generation iPod.

IPod channel inventories were lower than we would have liked during the quarter. At the end of the quarter including units in transit our channel inventory levels were within our 4-6 weeks target range based on our current US demand for the seasonally lower March quarter. It was a landmark quarter for the iTunes music store with the addition of television, music video and short term content to the store’s vast and growing library of music and audio books. The iTunes music store continues to be the world’s leading online music service and currently operates in 21 countries that represent over 90% of the global music market. We have sold over 850 million songs and 8 million videos to date. And according to Nielsen Sound Scan Apple accounted for 83% share of the US market of legally purchased and downloaded music during the month of December.

The Apple Retail stores reached a significant new milestone in the December quarter by generating $1.072 billion in revenue compared to $561 million in the year-ago quarter. We opened 11 new stores during the quarter exiting with a 135. With an average of 129 stores opened during the quarter average quarterly revenue per store was $8.3 million up 41% from the year-ago quarter. Retail segments profits grew sharply to $90 million from $45 million in the year-ago quarter. And associated manufacturing margin not reflected in retail segment profit with a $199 million up from $99 million in the year-ago quarter. We are particularly proud of the moment we have realized in our stores. With fiscal 2004 after 3 years of operation we generated $1.185 billion in annual revenue through the stores. In fiscal 2005 we nearly doubled that number $2.35 billion. Now in a single quarter we have surpassed $1 billion in revenue. We will continue to add new stores at a measured pace and expect to open a total of 40 new stores during fiscal of ’06.

In terms of geographic results including sales from our retail stores quarterly revenue in Japan, the Americas and Europe was up year-over-year by 92%, 70% and 51% respectively. Gross margin was 27.2% on a GAAP basis and included $5 million in expense related to non-cash stock based compensation. Without this expense non-GAAP gross margin would have been 27.3%. GAAP operating expenses were $814 million including $39 million in expense related to stock based compensation.

Non-GAAP Opex was $775 million $55 million higher than our guidance primarily due to variable expenses associated with the higher revenue level, a greater than expected mix of direct sales and investments we made in our business. OYME (ph) was $81 million and the tax rate was 32%. Cash grew by $446 million during the quarter to $8.707 billion. We made prepayment of $750 million related to previously announced agreements for future supply of NAND Flash memory components. Without these prepayments cash would have increased by about $1.2 billion. The cash generation was primarily a function of strong earnings, excellent working capital management and employee stock option exercises.

Cash flow from operations during the quarter was about $283 million which includes the impact of a $750 million prepayments. Capital expenditures in the quarter were $82 million including $40 million for our retail initiative. Looking ahead for the March quarter i would like to review our outlook which includes the types of forward-looking information that Nancy referred to at the beginning of the call. Quarter-to-quarter which will span a fiscal 13 rather than 14 weeks we are targeting the second best quarter in the company’s history second only to the last quarter with revenues of about $4.3 billion. This target represents 33% year-over-year growth and an increase of over $1 billion year-over-year. We are factoring into our guidance a seasonal decline in iPods in the beginning of our transition of Intel based Mac. We expect the total quarterly cost of non-cash stock based compensation to be approximately $49 million. We expect GAAP gross margins to be about 27.8% reflecting approximately $5 million related to stock based compensation expense. Without that expense we expect non-GAAP gross margins to be about 27.9%. We expect GAAP Opex to be about $774 million including about $44 million related to stock based compensation. We expect non-GAAP Opex to be about $730 million. We expect OYME (ph) to be $72 million and we expect the tax rate to be 32%. We expect to generate GAAP EPS of about $0.38 which includes an anticipated $0.4 per share related to non-cash share based compensation expense. We expect non-GAAP EPS to be about $0.42.

During the March quarter, we expect to pay the remaining the $500 million of the $1.25 billion NAND Flash repayment. We just completed the best quarter in Apple’s history, and fiscal ’06 is off to a great start. Our new Intel based Mac announced at Mac World has been very well received. We remain extremely enthusiastic about our innovative product pipeline and we are confident in our strategy. With that I would like to open the call for questions.

Questions And Answers

Operator

Thank you Operator Instructions Our first question comes from Benjamin Reitzes of UBS.

Q - Benjamin Reitzes

A couple of things, Peter do you – are you able to quantify the impact of the extra week, I believe last year you did not have the week after Christmas, this year you did, and so was this year’s extra week extra big or is it really hard to say and then I just wanted to ask more about your guidance, so it would be great if you can just answer.

A - Peter Oppenheimer

Let me answer your first question. Yes, the 14th week this year, did span between Christmas day and New Year’s day and that is traditionally and it is was year, a very strong shopping week, and our earnings expenses and revenue were all higher as a result.

Q - Benjamin Reitzes

Okay. I mean is it possible to say like it added a million or 2 million iPods or is it just too hard to say?

A - Peter Oppenheimer

Ben, I would characterize it as a big week.

Q - Benjamin Reitzes

Then with regard to your outlook, I mean can you just tell us a little more about what you are expecting with the Intel transition, I mean, you are coming off a quarter where you guided 4.7, you are coming in at 5.75, I mean, now you are at 4.3, shouldn’t we assume, why are being so conservative, a little more detail on this exact Intel transition issue, would be helpful, may be even if you can go back to the weeks of inventory and what you might expect further drain or anything else.

A - Peter Oppenheimer

Let me, I’ll let Tim address, our channel inventory. But let me just speak to you in a little broader term about our guidance. We factored a number of considerations into developing our guidance. Our first, then, this really was your first question, Q1 spanned 14 weeks, and Q2 will span a normal 13 weeks. And again the 14th week that we had this quarter was the week between Christmas and New Year which is a very strong, sharp shopping week. Second, for our Mac business, we have factored in the very strong response that we’ve received for the new Intel-based Mac that we announced at Mac World, the limited number of shipping weeks that we will have on the MacBook Pro and the positives that we saw in customer demand for Q1. For the iPods we have factored the extraordinary demand in Q1 which was fueled by iPods being one of the top holiday gifts of the season, some channel fill that we had and the seasonal drop in demand as we go from holiday quarter to the March quarter.

Q - Benjamin Reitzes

Did you say channel inventory for iPods were within the range or even at the low end?

A - Peter Oppenheimer

They were within the range but maybe i’ll let Tim make some comments on both Mac and iPod inventory.

A - Timothy Cook

On iPod channel inventory, as it has been widely reported in number places, our channel inventories were lower than we would have liked, for most of the quarter. Shipments did improve on iPod across the quarter, in particular in the second half of December, the shipments were very strong. With the strong shipments, the total channel inventory which included a significant amount of inventory that was in transit at the end of the quarter increased by approximately 550,000 units as compared to the channel inventory at the beginning of the quarter. Despite that the ending channel inventory was still below the target range of 4-6 weeks based December sales. However we believe that the channel inventory is within our targeted range of 4-6 weeks, based on our current view of demand for the seasonally lower March quarter. In terms of the Mac channel inventory, we began the quarter below the targeted range of 4-5 weeks, and as we had planned we ended the quarter below the targeted range in preparation for the Mac World announcements that we made last week.

Q - Benjamin Reitzes

Okay. Tim, i am going speed it for one more, the – just, i see a situation where you still may have some lower than expected channel inventory but, may be now are you seeing anything out there that is giving you any pause in the economy or in the consumer markets other than some of these Apple related events that you are talking about?

A - Timothy Cook

What we are seeing is, we had extraordinary response last week to our announcements at Mac World, we are thrilled with the reactions that we’ve got including the bookings on the new iMac and the PowerBook, our MacBook Pro, the last quarter we did see a pause as some customers began to speculate about the upcoming announcements at Mac World however, the Mac beat our internal expectations as Peter just said, we obviously factored some level of pause into our guidance and we were able to beat that number and we are happy with that and the overall moment of the Mac business.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Ben, could we have the next question please.

Operator

Robert Semple from Credit Suisse First Boston is our next question.

Q - Robert Semple

Just kindly of looking at the Opex guidance, it is now basically inline with your sales guidance, i know you don’t give a target model anymore but historically you used to try to keep that tracking at about 50% of the growth of sales, how should we be thinking about that, do you need to be spending this much if top line growth is going to be slowing like this?

A - Peter Oppenheimer

We, as I said we are very confident in our business, in our strategy and we are continuing to invest for long term growth, both in revenue and in earnings. I’ve provided very strong guidance for the March quarter with revenue growing at 33% and double digit operating margin.

Q - Robert Semple

I guess one follow up on the Mac question. Obviously you have had a strong response for the new product, does this mean you are very scared about iBook and PowerBook sales really deteriorating until those two new products are launched as well?

A - Timothy Cook

We did see a pause quarter as Peter has said we have factored what we saw last quarter, end of the quarters guidance, we are thrilled with the response that we got last week and as we said we started shipments of the iMac already and given that we’ve got an entire to ship it, we believe we can, we are hopeful that we can meet the demand on the iMac. But also as we announced last week, the MacBook Pro will begin shipping in February and therefore has a limited number of weeks to ship during the quarter, given that and the very strong response that we saw, we may not be able to meet the demand on the MacBook Pro.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Rob, could we have the next question please.

Operator

Rebecca Runkle of Morgan Stanley.

Q – Rebecca Runkle

Obviously phenomenal quarter, just wanted to dig down a little bit more on the CPU side of the equation, you have reported several times the fact that you saw a pause, since that was the one area where some people could say, they were disappointed on the December results. Can you just provide a little bit more specificity in terms of what you saw that gives you a confident that this is purely a pause in front of the product cycle as compared to any disconnect on the “Halo Effect�? that many people have?

A - Timothy Cook

Let me make some comments. First of all the Mac business grew 20% year-over-year and it did exceed our internal expectations which had factored again at a level upon. We did see a pause, we’ve received reports from a number of customer from different markets that they were postponing purchases tending Mac World announcements, however in our results last week that we saw in the reaction last week is extraordinary and that gives us tremendous optimism about the customer reaction and on the Intel based Macintosh. It is very difficult to predict how customers will react this quarter. And so obviously factored in a that kind of thinking into our guidance. A year ago we had a situation as you recall the comparison of the quarter where we had, a significant shortage of G5 chip in the September quarter and then we began to fill the channel and serve the pent-up demand as we entered the December quarter. And so the comparison frankly is also a difficult comparison. That has to be taken to consideration as well and looking at the year-over-year results.

Q – Rebecca Runkle

You specifically like to talk about specific products anymore but would you atleast confirm that more of the slowdown happened on the professional side of the equation as opposed to the consumer side of the equation? Or is there another trend that you saw?

A - Timothy Cook

We had some level of reports from customers in different markets, i wouldn’t want to pin it on one market above the other.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Rebecca, could we have the next question please.

Operator

The next question comes from Bill Shope of J.P.Morgan.

Q - Bill Shope

First of all, on your website you are still offering the iMac G5, obviously the PowerMac G4. They are at the same price as the new Intel based Mac, that you highlighted at Mac World. Can you give us an idea of how much inventory you are still need to work through for the legacy products and also help us understand how you work through that inventory without discounting?

A - Peter Oppenheimer

We don’t Bill, talk about future products or future pricing but we certainly factored our thinking into our guidance and we will continue to ship the iMac G5 and the PowerBook 15 inch wealth of iBook.

Q - Bill Shope

Okay. Just a clarification on the in-transit inventory that you included in your channel inventory number, that is not recognized as revenue yet. You don’t recognize until it actually arrived at the retailer or is that incorrect?

A - Peter Oppenheimer

We recognize shipment of our products in most cases, when they are shipped from our factories.

Q - Bill Shope

One final question. Can you give us read on margins for the iPod business for the quarter?

A - Peter Oppenheimer

Sure. As you know i don’t want to be, for competitive reasons specific in what we want to talk about, specific iPod sales, but i will tell you that the iPod gross margins in the December quarter were above 20%.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Bill, could we have the next question please.

Operator

Charles Wolf of Needham & Company.

Q - Charles Wolf

Yes. I have few questions. What was expressed on Apple Store Mac sales between Windows and Mac users?

A - Peter Oppenheimer

Charlie, i am sorry, i don’t have that.

Q - Charles Wolf

Okay. What was the split between iPod sales, domestic versus international?

A - Peter Oppenheimer

Charlie, as i have indicated in Bill’s question, we don’t want to talk about iPod sales by model or geography. I can tell you that with 14 million sold last quarter, we were thrilled with that result and there were points in the quarter where we were too low in our many of our channels.

Q - Charles Wolf

Okay. Let me ask the final question then. At the Mac World keynote last week, Steve indicated that music downloads were running at 3 million per week, i believe, i assume that that level was reached through a lot of redemption’s of gift certificates, is that a reasonable assumption?

A - Peter Oppenheimer

Yes. In the december quarter we sold a lot of iTunes Music gift cards and certificates over the store but we were also having people purchase directly as well, and we couldn’t have been happier with the sales of iTunes in the December quarter.

A - Timothy Cook

Yeah. Charlie that is 3 million per day, not 3 million per week for clarity.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Charlie, could we have the next question please.

Operator

Shannon Cross of Cross Research

Q – Shannon Cross

Can you give us an idea in terms of availability of components from Intel and specifically is that leading to any delays in terms of getting the MacBook Pro out? Just specifics, you said February, it is earlier rather than later in the month?

A - Timothy Cook

Let me answer the question broadly about the supply of the iMac and the MacBook Pro. We’ve begin to ship the iMac, we are very happy with how the production ramp is going. We are extremely happy with the response we had last week as i’ve said before, and we are hopeful that we could meet the demand for the quarter. On the MacBook Pro as planned we are beginning to ship that in February and given the number of weeks that would remain in the quarter to ship and the extraordinary response that we’ve seen with our customers we may not be able to meet demand on that product.

Q – Shannon Cross

And with regard to any product constraints in the last quarter, any thoughts on air freighting, any incremental cost that were associated with any shortages?

A - Timothy Cook

In the current quarter, that factored into our guidance we would be airfreighting the Intel based iMac in order to get those into customers hands very quickly. We are also in the results in our Q1 that has Peter has talked to airfreighted some number of iMacs as we had rose the multiple line up in October.

Q – Shannon Cross

Okay. And then finally, can you give us an idea of how many outlets, you are now selling iPods in?

A - Timothy Cook

We are over 35000 at this point although we do not sell all models in all outlets.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Shannon, could we have the next question please.

Operator

Joel Wagonfeld of First Albany Capital.

Q - Joel Wagonfeld

Two part question, if i could. 1) is there any chance the new iMac and the PowerBook have better gross margins given the scale of the Intel Eco system for other parts of the component. 2) is it accurate of the impact of any price protection that you may have incorporated for plan discounts of the legacy G5 and G4 Mac, with that already be incorporated in the December quarter and hence that would negatively impact this March quarter and finally i just wanted to be clear, are you saying that with your comments on the inventory that the supply and demand are now in balance for all of the iPods includes the NANO 4gig?

A - Peter Oppenheimer

Let is answer your first two questions and Tim can address your third. As regards the Intel based Mac gross margins we don’t to provide specific gross margins for any of our products, i have given you pretty detailed guidance for the December quarter. And i am sorry what was your second question?

Q - Joel Wagonfeld

The impact of any price protection, that would have already been incorporated last quarter?

A - Peter Oppenheimer

As i had earlier mentioned we are not going to talk about product plans or pricing actions that we have not already have announced but i can tell you that any price protection that would effect our channel inventory that contemplate, we provided for in our December quarter and in future action beyond that, would not affect the channel inventory but March quarter is down in, we have factored into our guidance for the March quarter.

A - Timothy Cook

Relative to the channel inventory on iPod on an aggregate basis, we believe that we are within our targeted range of 4-6 weeks based on our current of view of demand for the quarter however, there are stock out in different places on different models and also some countries are leaner than others. We are working very very hard right now, to alleviate this situation.

Q - Joel Wagonfeld

is the 4gig still the key bottleneck?

A - Timothy Cook

The 4gig is lean in places that we are working very hard to get those gigs NANOs out there.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Joel, could we have the next question please.

Operator

Gene Munster of Piper Jaffray.

Q - Gene Munster

Just in terms of the big picture here, conceptually where you are going with the market share plan here, do you see yourself being a little bit more aggressive 2006, in terms of your efforts to gain market share, maybe just in terms of breadth of distribution and other ways that you could gain market share?

A - Timothy Cook

Gene, is your question on the Macintosh or the iPods?

Q - Gene Munster

On the Mac side.

A - Timothy Cook

We are very confident that we have selected the right course where the future of the Macintosh, we reviewed the roadmap, from many different sources, we believe Intel has the best one by far. We’ve got the launch underway, we were happy that we were able to do that 5 or 6 months before the expectations doing it, and we will have the transition completed much earlier than the market anticipated by pulling again until the end of 2006. And so we are very very optimistic about the future of the Mac and the way we are headed.

Q - Gene Munster

But there are also just of couple of, doing the product side which i would say is they are important but there is also, the distribution side and the pricing side, and you guys can probably have an opportunity to really put the hammer down in terms of picking up market share in 2006. So just conceptually, obviously you guys like to talk about pricing, but conceptually do you see Apple being more aggressive, trying to gain market share in 2006 or kind of continue to the status quo of creating the best products, happen –to be more selective in terms of distribution, more selective in terms of price.

A - Timothy Cook

We are going to continue to make the best products on the face of the earth, that is reason that we are here. On a distribution basis, we continue to open stores, we also continue to look at different alternatives to the channel, and when responding that we like and we would obviously view that, they are beneficial, i wouldn’t want to comment on the price question.

Q - Gene Munster

And just last question is, outside of the extra week in the December quarter, and outside of people postponing their purchases in anticipation of the Intel based, is there any reason to think that the seasonality between December March should be any different than previous years?

A - Timothy Cook

On the Macintosh or the iPod?

Q - Gene Munster

Just the overall business, the overall seasonality between December and March.

A - Timothy Cook

Yes. There is a reason to think that seasonality of the total company would be different because the music business with a much higher percentage of our business in the December quarter than it had previously been and so obviously the iPod would have a different seasonal curve than the Macintosh to have.

Q - Gene Munster

Okay. That makes sense. Great thank you.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Gene, could we have the next question please.

Operator

Richard Chu of Sg. Cowen & Co.

Q – Richard Chu

I just wanted to repeat this but, three questions, seasonality on the guidance, you are assuming this similar, i have seen a stronger seasonal decline in the resent systems, is that impromptu to comment?

A - Peter Oppenheimer

Richard, we didn’t hear you, would you repeat?

Q – Richard Chu

The impact of the Tim’s response to the prior question was, effectively that you are assuming a larger seasonal decline in music business than the Mac business?

A - Timothy Cook

What i am saying specifically is that if you look at previous years for Apple, and the Q1 results, and just look at the total revenue, we would not expect the total revenue to look the same sequentially that had in the past, because we were operating at a much higher music content in the Q1 in the holiday period.

Q – Richard Chu

If i can follow on the second question, you kept, as you said, the old product pricing is unchanged, can i fundamentally ask why, just that you assume users perceive the things, your performance for what they need. Could you comment on that?

A - Timothy Cook

We are selling the iMac G5 and the PowerBook G4 15H product while supplies last. And we factored our thinking into our guidance.

Q – Richard Chu

So effectively you are saying, so you see no need to reduce prices, in spite of the perceived difference in value?

A - Timothy Cook

I am saying that anything that we are planning on doing we factored into our guidance. And that we are only selling these while supplies last.

Q – Richard Chu

And finally, if upon rough calculations on the implied music and video downloads are revenue streams, are correct, excluding that downloads at iPod, the remainder of the music revenue streams look like they are non-iPod non-download music revenues increased dramatically Q4 to Q1 and could you comment on that and comment on the seasonality and dynamic associated with that business.

A - Peter Oppenheimer

Richard this is Peter. There are now over 2000 different accessories that you can buy with your iPod and fundamentally those are the revenue streams that i think that you are referring to. We did very well with our sales with these in the quarter, both the Apple branded and our third party developers that we sold directly. We expect to have a good quarter in March and honestly we are going to learn more about the seasonality of this part of the business because it is bigger, it is growing, i have said this before and believe it to be the case that many people will buy and iPod and then later come back to add accessories to it. And this seems to be a part of our business that has more of a recurring revenue stream, much like the iTunes music stores and we are very pleased with what we are seeing and we are learning more about it.

Q – Richard Chu

Can you update us on profitability of the music store?

A - Peter Oppenheimer

The music store in the December did operate above break even.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Richard Chu, could we have the next question please.

Operator

Next question comes from Richard Gardner of Citigroup.

Q - Richard Gardner

Tim, i was hoping if you could just give us standard pitch on component pricing and availability during the first and second fiscal quarters for the major commodities that you buy and then also i was hoping if you could give us the mix of web direct sales in the quarter please.

A - Timothy Cook

On a component basis, Rich what we saw last quarter was that the, we have a favorable component environment, both in terms of LCDs and memory, both of those were most stabilize than we had predicted, as we enter into this quarter, we continue to see the LCDs being a favorable environment, because supply is greater than demand, we do expect the DRAM market stabilizes on as more of the manufacturing capacity is converted to NAND Flash. Hard drive prices continue to decline but they are declining at a lower than attributable rate due to some underlying components.

Q - Richard Gardner

And any comments on flash?

A - Timothy Cook

I would tell not to continue to expect price reductions in the flash area as more and more and people convert their DRAM capacity to NAND in short term, but overall as you can tell by the amount of prepay that we’ve elected to do, we view that particular market as not having as many down turns as some of the other commodity markets then, we believe that it is very important to lock supplies for the long term.

Q - Richard Gardner

And then web direct sales in the quarter.

A - Timothy Cook

We don’t release the exact numbers but i would tell you that the web sales was significant in the quarter.

A - Peter Oppenheimer

Rich, i will add with overall our direct sales which include the web sales that Tim referred to, sales through our retail stores, and direct sales to US education and enterprise and music stores comprised of 49% of total Apple revenue and that was up from 44% in the year ago quarter.

Q - Richard Gardner

And then may be Peter, just one more simple one for you. Can you talk about the location of the 14 new store openings that you talked about fiscal 2006. How many of those are domestic versus international?

A - Peter Oppenheimer

We expect most of those to be domestically but we will continue to open stores in Canada, the UK and Japan as well.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Richard Gardner, could we have the next question please.

Operator

And our next question will come from Steven Fortuna of Prudential Equity Group.

Q - Steven Fortuna

In terms of the seasonality of the iPod, it seems which you are baking into your guidance, in terms of my model, at least so much of your earnings power for the quarter and for the year for that matter, depends upon what assumptions one makes for seasonality in the March quarter end, looks like your guiding, if i am doing it quickly, it perhaps not accurate, looks about 45% sequential decline in iPod, it looks may be bacon in that kind of a decline to get to the numbers that you guiding to, i think first of all, i am in the ballpark with that and secondly if you don’t comment on the iPod things specifically, how do you think about the broader CE market in terms of the typical March seasonality.

A - Peter Oppenheimer

Steve, it is Peter, I’ll address that. I am not going to provide specific product level guidance, to think you thought i would, but let me make some comments what was last year and related little bit to this year. Last year we did see a seasonal drop off, in the combination of our iPod and the iPod Mini line which was more than offset by the introduction of the iPod shuffle. And as was widely reported and we’ve commented, the iPod was one of the top holiday gifts this season and it is natural to think that they will be decrease in demand in the March quarter from this exceptional holiday result which again included a 14th week. And you can go out get some primary research on what you would see for various CE products.

Q - Steven Fortuna

And then, in terms of okay, I’ll leave that alone and then go on to my last question, can you walk through, Tim commented on what you expect for component in the March quarter, go through, because of the kind of puts and stakes that you factored into your gross margin guidance?

A - Peter Oppenheimer

Basically, i am a factory man, a different product mix which would include fewer iPods and a lower component cost.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Steven Fortuna, could we have the next question please.

Operator

Keith Bachman Banc of America Securities.

Q -Keith Bachman

Two questions if i could. Tim i just wanted to clarify, i think what you said was you started the quarter with some low inventory in the CPU side and you ended a bit low too, so it didn’t sound like inventory played a big role in the December quarter in the CPU side can you just clarify that if i could for the first question?

A - Timothy Cook

We started below our range, we ended below our range, and we had planned that Keith because of the announcements that we made at Mac World.

Q -Keith Bachman

The second questions, is there anyway to conceptually think about your CPU business may split in terms of the units at all between the Intel side and the Mac side in this quarter, is there any kind of general plan that you could think since there is the vast majority of the platform is still on the IBM processor side or the G processor side. Is that 80-20 or any kind of color you could give us there?

A - Timothy Cook

We are producing the best Macintosh that has ever been produced and there are great products that have Power PC processors in them and incredible products that have Intel processors in them and we just have to see how the customers vote in terms of the percentage of each.

Q -Keith Bachman

Well let me ask the software part of the question and Tim, At least at Mac World, the Cox coming natively, and then the Apple software suite is running natively in sounds like Rezatto and emulation is still, going to be a part of the software side of the equation, so you still have the emulation. Do you think that is going to cause people to pause it off in terms of the performance that you didn’t get?

A - Timothy Cook

What we are seeing is that Rezatto runs very well with products like Microsoft Office as an example and as you commented we have already reported the iLight suite and it is shifting on the new iMac, new MacBook Pro. We’ve already ported iWare. Obviously the OS is native and all of the applications embedded in the OS that is just mail, iChat etc., are also ported. We’ve also announced as you refer, that our, the bulk of our Pro application will be available in March natively. It is just includes final product and logic and aperture expenses. There are a lot of things that are already native and in fact as we’ve announced last week, the website has recorded over 200 native ads already, and well over 1500 witches. And so we are seeing great moment for our developer community and i think by making the announcement, obviously people are even more anxious than they already were to complete the work and we are very confident that we’ll continue to see great momentum in that area.

Q -Keith Bachman

Any idea when Microsoft and Adobe might be needed.

A - Timothy Cook

I think that is a question for them, however, we worked closely with Microsoft with running Rezatto and if you, i would invite you to try that yourself and we certainly believe that users will be very satisfied with that experience.

Q -Keith Bachman

Okay. Fair enough, thanks very much guys.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Keith Bachman, could we have the next question please.

Operator

David Bailey of Goldman Sachs.

Q – David Bailey

You mentioned that iPod margins were about above 20% in the quarter, is that from lower component cost, or a better mix and how sustainable is that?

A - Peter Oppenheimer

David, i don’t want to be specific any of those parts of your question and just we said that they were above 20% in the quarter, and i will report to you in April what they were for the March quarter.

Q – David Bailey

Okay. Let me try something on the Mac side. Do you expect to end the March quarter within your targeted channel inventory range. And if so how much build you think you will have in the quarter, how much you have included in your target?

A - Timothy Cook

We don’t project channel inventory, David, we guide to a total revenue number and Peter has provided that guidance.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks David, could we have the next question please.

Operator

Shaw Wu of American Technology.

Q – Shaw Wu

Yes. Two questions. Europe looked like there was very very strong, just wanted if you could give more color in terms of what happened there in terms of i guess the Mac business versus the music business and then the second question R&D, looks like it took a big of spike in terms of the absolute dollars, but certainly not so on the percentage of the revenue, just wondering how should we think of R&D spending, should we think remaining at these levels, or could it turn down?

A - Peter Oppenheimer

Shaw, let me address your R&D question and Tim can talk a bit about Europe. As i mentioned earlier we are very confident in our business and we are investing in the business for long term growth and both revenue and earnings and a big part of that is our investment in engineering and you have seen it go up, each quarter for the last many quarters and just expect it continue to invest not only in engineering but in opening more retail stores and more advertising and marketing program to grow the business.

A - Timothy Cook

Shaw, on the Europe side the Mac shipments were up 49% sequentially from September, but as you probably know that the September quarter in Europe is the traditionally weak quarter because the summer vacation that happen across most of Europe. In terms of revenue Europe with retail stores was up over 50% and frankly there were many countries in Europe that had more relatively more iPods constraints so that revenue number was held down iPods a bit more than some of the other geographies.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Shaw, could we have the next question please.

Operator

Steve Lidberg of Pacific Crest Securities.

Q - Steve Lidberg

I was hoping first with regards to iPod if you kind of outline how you see the opportunity for the iPod in terms of units or other market comparisons and on the total opportunity available and also with regards to creative professional can you comment with regards to the health of that market both from a video perspective as well as publishing?

A - Timothy Cook

On your second question, on the creative professional we saw good growth in the video market on a year-over-year basis, we were very pleased with it, DNP was weak and if it is as you know the DNP market itself is not a hugely growing market, it is just that not out of our expectation though by any means. In terms of opportunities on the iPod, we see iPod as the absolute best player in the market. We only recently announced the iPod Nano and the iPod, there is more video content on the way with the iPod and so i think there continues to be significant opportunity for the iPod in the overall music business.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Steve, could we have the next question please.

Operator

We have a follow-up question from Benjamin Reitzes of UBS.

Q - Benjamin Reitzes

Good afternoon again and couple of things, just caught me a little off guard, it was pretty quick. With regards to other music at 491 much better than expected. I am just wondering, was there anything in there, that that particularly helpful meaning you are seeing a lot of extra shells now iPod accessories in many retailers, maybe if you are able to kind of talk to how much iPod accessories were in that number and what is going on with the iPod Eco system going forward so that we can model that line a little better.

A - Peter Oppenheimer

Ben, the two largest component of the other music related products and services are first the iTunes music store and then the iPod accessories, both the Apple branded that we sell both directly and indirectly and the developer iPod accessories that we sell through the Apple online and retail stores. Both had significant growth year-over-year and sequentially the music store, we couldn’t be happier with it’s performance as indicated earlier, we are serving customers in 21 countries, where over 90% of music is purchased. And we saw just strong growth both year-over-year and sequentially not only in music but with the addition of video and we look forward to bringing more content both here in the United States and in other places before too long. The accessories business continues to grow for us both in terms of the Apple branded and our developers support. We are now have over 2000 accessories that you can buy with your iPod, the vast majority that Apple doesn’t make. And as i said we are beginning to see a bit more of a recurring revenue stream there where people are coming and adding back, that next accessory to their iPod family.

Q - Benjamin Reitzes

Well, will that line where we see the new radio tuner, i believe?

A - Peter Oppenheimer

Yes. Announced at Mac World. Yes.

Q - Benjamin Reitzes

That radio tuner, any early indications on how that is doing.

A - Peter Oppenheimer

Well.

Q - Benjamin Reitzes

Okay. And you can meet demand.

A - Timothy Cook

We are very pleased with the response on it Ben, and we are working very hard to get units out. We are currently not meeting demand but we are working really hard to try to do it. I am not projecting whether we can or not, for the full quarter at this point.

Q - Benjamin Reitzes

I mean, is that like million of units, tracking type of device in the future, that kind of subset of iPod sales, is that the potential where we are looking at. Like a higher attach rate?

A - Timothy Cook

We don’t give unit level guidance on the product.

Q - Benjamin Reitzes

I guess, you are helping. Okay thanks a lot.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Thanks Ben, could we have the next question please.

Operator

We have follow-up question from Rebecca Runkle. Please go ahead.

Q - Rebecca Runkle

Mine has been answered. Thanks a lot.

Operator

And a follow-up from Gene Munster of Piper Jaffray.

Q - Piper Jaffray

Mine has been answered as well. Thank you.

Nancy Paxton, Senior Director, Investor Relations and Corporate Finance

Okay. Thanks. Gene and thanks to everyone for joining us. A recording of today’s call will be available for replay via telephone for seven days beginning at 5:00 PM pacific time today. The number for the replay is 719-457-0820 and the confirmation code is 1699046. A replay of the audio webcast of this call also will be available beginning at approximately 5:00 PM pacific time today at www.apple.com/investor. Members of the press with additional questions can contact Steve Dowling at 408-974-1896. Financial analysts can contact John Hoover or me with additional questions, Dowling is at 408-974-4570 and i am at 408-974-5420. Thanks again.

Operator

Ladies and gentlemen, that does conclude our presentations for today.

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