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During Q2, despite some startup difficulties at the factory and component delays, Apple managed to blow through the iMac unit shipment estimates, shipping 220k iMacs when the highest analyst estimate was 200k units. Apple accomplished this feat at a price. By At the same time, profit margins on the iMac took a hit from increased production, component, and shipping cost.

"aggressive pricing on the new iMac introduced during the second quarter; temporary incremental production and air freight costs associated with the new iMac; and relatively lower margin iMac systems comprising a higher mix of second quarter net sales than of first quarter net sales. " (page 27)

To guard itself from another harrying month like March, Apple has made provisions to assure itself of component supply.

"In April 2002, the Company made a $100 million prepayment to an Asian supplier for the future purchase of components. In return for this deposit, the supplier has agreed to supply the Company with a specified level of components in each of the fiscal three quarters ended December 28, 2002. If the supplier fails to supply the agreed upon level of components in any of those three fiscal quarters, the Company may cancel the arrangement and receive any unutilized deposit plus a penalty. " (page 17)

Apple had previously invested $100M in Samsung at a time when it was suffering from an LCD-crunch for its laptop lines. That investment was ended in Q2 2001, when LCD prices hit a historic low. While the prepayment is more risky, being essentially an unsecured loan, it also has more definite returns.


On the investment front, Apple did something very unusual in Q2. No equity stake sales at all. First time in at least 3 years that Apple didn't sell a single share of any of its equity stakes.

That's because the higher-than-anticipated revenue on the LCD-iMac means Apple can hit the profit estimates without needing to record any investment income. As such, the investment income will be saved for quarters where operational income fail to meet expectations. This is one of the many tools a CFO in a public corporation can use to manage profits.

There is a small landmine in the investment front, in the form of Earthlink.

"The Company holds a significant investment in EarthLink Network, Inc. (EarthLink) in the form of approximately 6.54 million EarthLink common shares with a basis of $12.13 per share. .... As of March 30, 2002, the fair value of the Company's investment in EarthLink was $10.15 per share or approximately $66 million versus the Company's basis in this investment of approximately $79 million. Based on the relatively short time this investment's basis has exceeded its fair value and the financial condition and near-term prospects of EarthLink, the Company believes this decline in fair value is temporary" (page 29)

ELNK has been trading below $12 for about 5 months now. If share prices continue to linger at the ~$8, Apple will eventually have to take a write-down. But Apple still has more than enough ARM shares to cover this shortfall, so the only real problem is if ELNK tanks at the same time Apple needs investment income to meet the profit estimate.

In anticipation of that possibility, Apple has shifted more of its resources from cash/equivalents into short-term securities. The net change is ~$1.2B, as Fred Anderson seeks greater returns on Apple's capital. Interest income has declined by over 50% in the last year, and it's crimping Apple's income statement.


On the education channel, there are definite clouds on Apple's horizon.

"the Company continues to see weakness in its U.S. education channel. Total net sales in this channel have fallen approximately 18% during the first six months of 2002 compared to the same period in 2001. The Company believes this weakness has been caused by multiple factors including some educational institutions delaying technology purchases due to concerns about the overall impact of the weaker economy on their available funding." (page 25)

In the last 6 months, we've had iBook updates, price cuts on the CRT-iMac, and the LCD-iMac. Total net sales is still lower than 2001, despite the fact that the year-over-year comparison includes the abysmal Q1 2001. So educational channel sales must be even worse than expected. Ironically, we have this explanation in the very next paragraph

"Comparison of total net sales for the first six months of 2002 to the same period in 2001 is not particularly meaningful. Net sales during the first quarter of 2001 were unusually low."

If Q1 '01 was unusually low, and the last 6 months of '02 is worse than '01, what does that say about the performance of education sales in 2002?

The eMac is a step in the right direction. Education institutions with tight budgets won't be able to afford the LCD-iMac, and buying the 15" CRT-iMac would not be an attractive option. The aggressively priced eMac should be a significant factor in bridging the gap.


In a strange twist, the Apple Retail stores may already be profitable.

"To assess the operating performance of the Retail segment, cost of sales for this segment includes a mark-up above standard cost to approximate the price normally charged to the Company's major channel partners in the United States. For the six month period ended March 30, 2002, this resulted in the Retail segment recognizing additional cost of sales above standard cost and an offsetting benefit to corporate expenses of approximately $21 million. (page 15)"

Apple is treating inventory shipped to the retail stores as if they were shipping to a channel partner, and putting the "profit" into a different segment. If Apple had chosen to charge a COGS consistent with the fact that they own the Apple Retail Stores the same way they own Apple Online Store, the retail segment should have been profitable to the tune of $9M over the last 6 months.

Why did Apple make this revenue recognition change? Probably because they absorb the store operating expenses into SG&A. By doing an accounting markup, Apple is defraying the expense of staffing the Retail segment.

It also means that by changing the accounting model, Apple can boost the Retail segment to profitability at a time of its choosing by simply treating the inventory the same way it does Apple Online Store sales.

On a side note, the Retail segments seem to be selling a high mix of peripherals/software. That's generally a good thing, since peripherals/software usually has higher margins.

"During the three and six month periods ended March 30, 2002, approximately 33% and 38%, respectively, of the Retail segment's net sales came from the sale of peripherals and software. This compares to 19% and 21%, respectively, for the Company as a whole. (page 26)"


Finally, Apple is making headway on trimming its operational costs to more properly reflect the lower annual revenues in 2001/2002 compared to 1999/2000

"The general trend of decreasing selling, general and administrative expenses is primarily the result of lower discretionary spending on marketing and advertising and benefits from reductions in infrastructure as a result of the restructuring plan implemented in the first quarter of 2002. " (page 28)

Even the R&D budget has received a small cut of $2M form Q1 to Q2. That's a good sign that Apple will put a greater focus on cutting costs in order to realize greater net margins.
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