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APPLE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[April 24, 2014]

APPLE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) This section and other parts of this Form 10-Q contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements also can be identified by words such as "future," "anticipates," "believes," "estimates," "expects," "intends," "will," "would," "could," "can," "may," and similar terms. Forward-looking statements are not guarantees of future performance and the Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part II, Item 1A of this Form 10-Q under the heading "Risk Factors," which are incorporated herein by reference. The following discussion should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended September 28, 2013 (the "2013 Form 10-K") filed with the U.S. Securities and Exchange Commission (the "SEC") and the condensed consolidated financial statements and notes thereto included elsewhere in this Form 10-Q. All information presented herein is based on the Company's fiscal calendar. Unless otherwise stated, references in this report to particular years, quarters, months or periods refer to the Company's fiscal years ended in September and the associated quarters, months, or periods of those fiscal years. Each of the terms the "Company" and "Apple" as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law.



Available Information The Company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), are filed with the SEC. The Company is subject to the informational requirements of the Exchange Act and files or furnishes reports, proxy statements, and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge on the Company's website at investor.apple.com/sec.cfm when such reports are available on the SEC's website. The public may read and copy any materials filed by the Company with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov. The contents of these websites are not incorporated into this filing. Further, the Company's references to the URLs for these websites are intended to be inactive textual references only.

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


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

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

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

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

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

24 -------------------------------------------------------------------------------- Table of Contents Sales Data The following table shows net sales by operating segment and net sales and unit sales by product during the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions and units in thousands): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net Sales by Operating Segment: Americas $ 14,310 $ 14,052 2% $ 34,408 $ 34,393 0% Europe 10,230 9,800 4% 23,303 22,264 5% Greater China (a) 9,289 8,213 13% 18,133 15,043 21% Japan 3,963 3,135 26% 8,911 7,578 18% Rest of Asia Pacific 2,627 3,162 (17)% 6,260 7,155 (13)% Retail 5,227 5,241 0% 12,225 11,682 5% Total net sales $ 45,646 $ 43,603 5% $ 103,240 $ 98,115 5% Net Sales by Product: iPhone (b) $ 26,064 $ 22,955 14% $ 58,562 $ 53,615 9% iPad (b) 7,610 8,746 (13)% 19,078 19,420 (2)% Mac (b) 5,519 5,447 1% 11,914 10,966 9% iPod (b) 461 962 (52)% 1,434 3,105 (54)% iTunes, Software and Services (c) 4,573 4,114 11% 8,970 7,801 15% Accessories (d) 1,419 1,379 3% 3,282 3,208 2% Total net sales $ 45,646 $ 43,603 5% $ 103,240 $ 98,115 5% Unit Sales by Product: iPhone 43,719 37,430 17% 94,744 85,219 11% iPad 16,350 19,477 (16)% 42,385 42,337 0% Mac 4,136 3,952 5% 8,973 8,013 12% iPod 2,761 5,633 (51)% 8,810 18,312 (52)% (a) Greater China includes China, Hong Kong and Taiwan.

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

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

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

25 -------------------------------------------------------------------------------- Table of Contents Product Performance iPhone The following table presents iPhone net sales and unit sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions and units in thousands): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 26,064 $ 22,955 14% $ 58,562 $ 53,615 9% Percentage of total net sales 57% 53% 57% 55% Unit sales 43,719 37,430 17% 94,744 85,219 11% The year-over-year growth in iPhone net sales and unit sales in the second quarter and first six months of 2014 resulted from strong customer acceptance of iPhone 5s and 5c, continued demand for the Company's entry-priced iPhone and expanded distribution. iPhone net sales and unit sales growth were particularly strong in the Greater China and Japan segments. Overall average selling prices ("ASPs") for iPhone were down slightly during the second quarter and first six months of 2014 compared to the same periods in 2013.

iPad The following table presents iPad net sales and unit sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions and units in thousands): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 7,610 $ 8,746 (13)% $ 19,078 $ 19,420 (2)% Percentage of total net sales 17% 20% 18% 20% Unit sales 16,350 19,477 (16)% 42,385 42,337 0% Net sales and unit sales for iPad declined in the second quarter of 2014 and were relatively flat in the first six months of 2014 compared to the same periods in 2013. The decline in iPad net sales and unit sales in the second quarter of 2014 was primarily due to changes in iPad channel inventory, and also reflects a slight decline in iPad unit sell-through to end users. iPad channel inventory increased from the beginning to the end of the second quarter of 2013 as the Company met pent-up demand for new iPads introduced in the first quarter of 2013 and supplied distribution channels to achieve appropriate channel inventory levels. In contrast, the Company entered the second quarter of 2014 near supply and demand balance for iPad, and channel inventory declined from the beginning to the end of the quarter to achieve appropriate channel inventory levels based on anticipated future demand. Partially offsetting these factors, iPad ASPs increased approximately 4% during the second quarter of 2014 compared to the second quarter of 2013 primarily as a result of a shift in mix towards iPad mini with Retina display and iPad Air. iPad ASPs were down slightly for the first six months of 2014 compared to the same period in 2013.

Mac The following table presents Mac net sales and unit sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions and units in thousands): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 5,519 $ 5,447 1% $ 11,914 $ 10,966 9% Percentage of total net sales 12% 12% 12% 11% Unit sales 4,136 3,952 5% 8,973 8,013 12% The year-over-year growth in Mac net sales and unit sales for the second quarter and first six months of 2014 was driven by increased sales of MacBook Pro® and MacBook Air®. Mac ASPs decreased during the second quarter of 2014 and first six months of 2014 compared to the same periods in 2013 primarily due to price reductions on certain Mac models and the shift in mix towards Mac portable systems.

26 -------------------------------------------------------------------------------- Table of Contents iTunes, Software and Services The following table presents net sales information of iTunes, Software and Services for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 4,573 $ 4,114 11% $ 8,970 $ 7,801 15% Percentage of total net sales 10% 9% 9% 8% The increase in net sales of iTunes, Software and Services in the second quarter and first six months of 2014 compared to the same periods in 2013 was due to growth in net sales from the iTunes Store, AppleCare and licensing. The iTunes Store generated a total of $2.6 billion and $5.1 billion in net sales during the second quarter and first six months of 2014, respectively, compared to $2.4 billion and $4.6 billion during the second quarter and first six months of 2013, respectively. Growth in net sales from the iTunes Store, which includes the App Store, the Mac App Store and the iBooks Store, was driven by increases in revenue from App sales reflecting continued growth in the installed base of iOS devices and the expansion in the number of third-party iOS Apps available. This was partially offset by a decline in sales of digital music.

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

Americas The following table presents Americas net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 14,310 $ 14,052 2% $ 34,408 $ 34,393 0% Percentage of total net sales 31% 32% 33% 35% Americas experienced increases in net sales of iPhone and iTunes, Software and Services in the second quarter and first six months of 2014 compared to the same periods in 2013. This growth was largely offset by a decline in net sales of both iPod and iPad, and weakness in foreign currencies relative to the U.S.

dollar. The decline in iPad sales was due in part to channel inventory changes.

iPad channel inventory increased from the beginning to the end of the second quarter and first six months of 2013 as the Company met pent-up demand for new iPads introduced in the first quarter of 2013 and supplied distribution channels to achieve appropriate channel inventory levels. In contrast, channel inventory declined from the beginning to the end of the second quarter of 2014 and increased much less significantly from the beginning to the end of the first six months of 2014 compared to the same periods in 2013 to achieve appropriate channel inventory levels based on anticipated future demand.

27-------------------------------------------------------------------------------- Table of Contents Europe The following table presents Europe net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 10,230 $ 9,800 4% $ 23,303 $ 22,264 5% Percentage of total net sales 22% 23% 23% 23% The increase in Europe net sales during the second quarter and first six months of 2014 compared to the same periods of 2013 reflects increases in net sales of iPhone, Mac and iTunes, Software and Services, partially offset by a decline in net sales of iPod and iPad. Net sales growth in the second quarter of 2014 was experienced in both developed and emerging markets within Europe, while net sales growth in the first six months of 2014 was driven primarily by increased demand in emerging markets.

Greater China The following table presents Greater China net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 9,289 $ 8,213 13% $ 18,133 $ 15,043 21% Percentage of total net sales 20% 19% 18% 15% During the second quarter and first six months of 2014, Greater China experienced year-over-year increases in net sales that were significantly higher than those experienced by the Company overall. The second quarter growth compared to the same period in 2013 was driven by higher net sales and unit sales of iPhone and Mac and higher net sales of iTunes, Software and Services, partially offset by lower net sales and unit sales of iPad and iPod. The growth in the first six months of 2014 was driven by higher net sales and unit sales of all major product categories except iPod. Higher iPhone net sales and unit sales resulted from the launch of new iPhones in Greater China at the end of 2013, increased demand for the Company's entry-priced iPhone, and the addition of a significant new carrier in the second quarter of 2014. Net sales and unit sales of iPad grew year-over-year in the first six months of 2014 due to strong demand for iPad Air and iPad mini with Retina display which were launched in China during the first quarter of 2014. Net sales and unit sales of iPad declined year-over-year in the second quarter of 2014 due to differences in timing of new product launches in 2014 versus 2013. iPad channel inventory increased significantly from the beginning to the end of the second quarter of 2013 to support demand for new iPads launched in China near the end of the first quarter of 2013. In contrast, new iPads were launched in China in the early part of the first quarter of 2014 and channel inventory declined from the beginning to the end of the second quarter of 2014 to achieve appropriate channel inventory levels based on anticipated demand.

Japan The following table presents Japan net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 3,963 $ 3,135 26% $ 8,911 $ 7,578 18% Percentage of total net sales 9% 7% 9% 8% Japan generated strong year-over-year increases in net sales that were significantly higher than those experienced by the Company overall. The growth reflects higher net sales of every major product category except iPod and growth in net sales of iTunes, Software and Service. iPhone net sales and unit sales were particularly strong in Japan following the launch of new iPhones and the addition of a significant new carrier in the fourth quarter of 2013. iPad unit sales were down slightly in the second quarter of 2014 and relatively flat in the first six months of 2014 due in part to changes in channel inventory year-over-year. iPhone channel inventory declined from the beginning to the end of the second quarter and first six months of 2014 and iPad channel inventory was relatively flat in the second quarter of 2014 but increased from the beginning to the end of the first six months of 2014 to achieve appropriate channel inventory levels based on anticipated demand. The increases in overall product net sales were partially offset by weakness in the Japanese Yen relative to the U.S. dollar.

28 -------------------------------------------------------------------------------- Table of Contents Rest of Asia Pacific The following table presents Rest of Asia Pacific net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 2,627 $ 3,162 (17)% $ 6,260 $ 7,155 (13)% Percentage of total net sales 6% 7% 6% 7% During the second quarter and first six months of 2014, Rest of Asia Pacific experienced year-over-year declines in net sales and unit sales in all major product categories except Mac, and experienced declines in net sales in most countries included in the segment. Net sales were negatively affected by several factors including the impact of weakness in several currencies relative to the U.S. dollar, including the Australian dollar. Net sales were also negatively impacted by changes in iPhone channel inventory, which grew from the beginning to the end of the second quarter and first six months of 2013 following the launch of new iPhones but declined from the beginning to the end of second quarter of 2014 and increased much less significantly from the beginning to the end of the first six months of 2014 compared to the same periods in 2013. iPad channel inventory increased less significantly from the beginning to the end of the second quarter of 2014 compared to the second quarter of 2013, but iPad channel inventory increased more significantly from the beginning to the end of the first six months of 2014 than from the beginning to the end of the first six months of 2013.

Retail The following tables present Retail net sales information for the three- and six-month periods ended March 29, 2014 and March 30, 2013 and Retail store and headcount information as of March 29, 2014 and March 30, 2013 (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Net sales $ 5,227 $ 5,241 0% $ 12,225 $ 11,682 5% Percentage of total net sales 11% 12% 12% 12% March 29, 2014 March 30, 2013 U.S. stores 254 251 International stores 169 151 Total store count 423 402 Headcount 42,400 42,600 Growth in Retail net sales and unit sales of iPhone and Mac in the second quarter and first six months of 2014 were offset in the second quarter and first six months of 2014 by declines in net sales and unit sales of iPad. With an average of 422 and 401 stores open during the second quarters of 2014 and 2013, respectively, average revenue per store declined to $12.4 million in the second quarter of 2014 from $13.1 million in the second quarter of 2013. Average revenue per store declined to $29.1 million in the first six months of 2014 from $29.4 million in the first six months of 2013.

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

29-------------------------------------------------------------------------------- Table of Contents Gross Margin Gross margin for the three- and six-month periods ended March 29, 2014 and March 30, 2013 was as follows (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 2014 2013 Net sales $ 45,646 $ 43,603 $ 103,240 $ 98,115 Cost of sales 27,699 27,254 63,447 60,706 Gross margin $ 17,947 $ 16,349 $ 39,793 $ 37,409 Gross margin percentage 39.3% 37.5% 38.5% 38.1% The increase in the gross margin percentage during the second quarter and first six months of 2014 compared to the same periods in 2013 was driven by multiple factors including a favorable shift in mix to products with higher margins, lower commodity costs, and improved leverage on fixed costs from higher net sales. The impact of these factors was partially offset by higher cost structures on new products and by changes in some foreign currency exchange rates.

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

Operating Expenses Operating expenses for the three- and six-month periods ended March 29, 2014 and March 30, 2013 were as follows (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 2014 2013 Research and development expense $ 1,422 $ 1,119 $ 2,752 $ 2,129 Percentage of net sales 3.1% 2.6% 2.7% 2.2% Selling, general and administrative expense $ 2,932 $ 2,672 $ 5,985 $ 5,512 Percentage of net sales 6.4% 6.1% 5.8% 5.6% Total operating expenses $ 4,354 $ 3,791 $ 8,737 $ 7,641 Percentage of net sales 9.5% 8.7% 8.5% 7.8% Research and Development ("R&D") Expense The growth in R&D expense during the second quarter and the first six months of 2014 compared to the same periods in 2013 was driven primarily by an increase in headcount and related expenses to support expanded R&D activities. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the Company's core business strategy. As such, the Company expects to make further investments in R&D to remain competitive.

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

30-------------------------------------------------------------------------------- Table of Contents Other Income and Expense Other income and expense for the three- and six-month periods ended March 29, 2014 and March 30, 2013 was as follows (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 Change 2014 2013 Change Interest and dividend income $ 410 $ 420 $ 837 $ 841 Interest expense (85 ) 0 (169 ) 0 Other expense, net (100 ) (73 ) (197 ) (32 ) Total other income/(expense), net $ 225 $ 347 (35)% $ 471 $ 809 (42)% The decrease in other income and expense during the second quarter and first six months of 2014 compared to the same periods in 2013 was due primarily to interest expense on debt, higher expenses associated with foreign exchange rate movements, and lower realized gains from investment sales, partially offset by lower premium expenses on foreign exchange contracts. The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.04% and 1.05% in the second quarter of 2014 and 2013, respectively, and 1.03% and 1.06% in the first six months of 2014 and 2013, respectively.

Provision for Income Taxes Provision for income taxes and effective tax rates for the three- and six-month periods ended March 29, 2014 and March 30, 2013 was as follows (dollars in millions): Three Months Ended Six Months Ended March 29, March 30, March 29, March 30, 2014 2013 2014 2013 Provision for income taxes $ 3,595 $ 3,358 $ 8,232 $ 7,952 Effective tax rate 26.0% 26.0% 26.1% 26.0% The Company's effective tax rates for both periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S.

The Internal Revenue Service (the "IRS") is currently examining the years 2007 through 2012. All IRS audit issues for years prior to 2007 have been resolved.

In addition, the Company is subject to audits by state, local, and foreign tax authorities. Management believes that adequate provisions have been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company's tax audits are resolved in a manner not consistent with management's expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs.

31-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources The following tables present selected financial information and statistics as of March 29, 2014 and September 28, 2013 and during the first six months of 2014 and 2013 (in millions): March 29, 2014 September 28, 2013 Cash, cash equivalents and marketable securities $ 150,589 $ 146,761 Property, plant and equipment, net $ 15,120 $ 16,597 Long-term debt $ 16,962 $ 16,960 Working capital $ 27,333 $ 29,628 Six Months Ended March 29, 2014 March 30, 2013 Cash generated by operating activities $ 36,208 $ 35,930 Cash used in investing activities $ (3,362 ) $ (27,878 ) Cash used in financing activities $ (28,156 ) $ (6,745 ) The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to satisfy its working capital needs, capital asset purchases, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months. To provide additional flexibility in managing liquidity, the Company plans to access the commercial paper markets beginning in 2014. The Company currently anticipates the cash used for future dividends and the share repurchase program will come from its current domestic cash, cash generated from on-going U.S.

operating activities and from borrowings.

As of March 29, 2014 and September 28, 2013, $132.2 billion and $111.3 billion, respectively, of the Company's cash, cash equivalents and marketable securities were held by foreign subsidiaries and generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are typically subject to U.S.

income taxation on repatriation to the U.S. The Company's marketable securities investment portfolio is invested primarily in highly-rated securities and its investment policy limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade with the objective of minimizing the potential risk of principal loss.

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

Cash used in financing activities during the six months ended March 29, 2014 consisted primarily of cash used to repurchase common stock of $23.0 billion and cash used to pay dividends and dividend equivalents of $5.4 billion.

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

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

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

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

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

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

The following table presents the Company's dividends, dividend equivalents, share repurchases and net share settlement activity from the start of the capital return program in August 2012 through the second quarter of 2014 (in millions): Dividends Taxes and Open Related to Dividend Accelerated Market Settlement Equivalents Share Share of Equity Paid Repurchases Repurchases Awards Total 2012 $ 2,488 $ 0 $ 0 $ 56 $ 2,544 2013 10,564 13,950 9,000 1,082 34,596 Q1 2014 2,769 0 5,000 365 8,134 Q2 2014 2,661 12,000 6,000 65 20,726 Total $ 18,482 $ 25,950 $ 20,000 $ 1,568 $ 66,000 On April 23, 2014, the Company announced that the Board of Directors raised the cash dividend by approximately 8% to $3.29 per common share, beginning with the dividend to be paid during the third quarter of 2014. The Company expects to pay approximately $2.8 billion in quarterly dividends to common shareholders during the third quarter of 2014. The Company also plans to increase its dividend on an annual basis, subject to declaration by the Board of Directors.

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

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

Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the Company.

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

33-------------------------------------------------------------------------------- Table of Contents Purchase Commitments with Outsourcing Partners and Component Suppliers The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company's products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. Where appropriate, the purchases are applied to inventory component prepayments that are outstanding with the respective supplier. As of March 29, 2014, the Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $12.6 billion.

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

The Company's other non-current liabilities in the Condensed Consolidated Balance Sheets consist primarily of deferred tax liabilities, gross unrecognized tax benefits and the related gross interest and penalties. As of March 29, 2014, the Company had non-current deferred tax liabilities of $19.5 billion.

Additionally, as of March 29, 2014, the Company had gross unrecognized tax benefits of $3.0 billion and an additional $590 million for gross interest and penalties classified as non-current liabilities. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes.

Indemnification The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or application software for infringement of third-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of March 29, 2014 or September 28, 2013.

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

Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles ("GAAP") and the Company's discussion and analysis of its financial condition and operating results require the Company's management to make judgments, assumptions, and estimates that affect the amounts reported in its condensed consolidated financial statements and accompanying notes. Note 1, "Summary of Significant Accounting Policies" of this Form 10-Q and in the Notes to Consolidated Financial Statements in Part II, Item 8 of the Company's 2013 Form 10-K describes the significant accounting policies and methods used in the preparation of the Company's condensed consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates and such differences may be material.

Management believes the Company's critical accounting policies and estimates are those related to revenue recognition, valuation and impairment of marketable securities, inventory valuation and valuation of manufacturing-related assets and estimated purchase commitment cancellation fees, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company's financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company's senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company's Board of Directors.

34 -------------------------------------------------------------------------------- Table of Contents Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, peripherals, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company's product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware, and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware.

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

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

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

The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company's policy requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company's other customer incentive programs, the estimated cost is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company's historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs that could result in reductions to future revenue. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive. Management's estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeems such incentives, the Company would be required to record additional reductions to revenue, which would have an adverse impact on the Company's results of operations.

35-------------------------------------------------------------------------------- Table of Contents Valuation and Impairment of Marketable Securities The Company's investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated other comprehensive income, net of tax, in the Company's Condensed Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities impact the Company's net income only when such securities are sold or an other-than-temporary impairment is recognized.

Realized gains and losses on the sale of securities are determined by specific identification of each security's cost basis. The Company regularly reviews its investment portfolio to determine if any security is other-than-temporarily impaired, which would require the Company to record an impairment charge in the period any such determination is made. In making this judgment, the Company evaluates, among other things, the duration and extent to which the fair value of a security is less than its cost; the financial condition of the issuer and any changes thereto; and the Company's intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. The Company's assessment on whether a security is other-than-temporarily impaired could change in the future due to new developments or changes in assumptions related to any particular security.

Inventory Valuation and Valuation of Manufacturing-Related Assets and Estimated Purchase Commitment Cancellation Fees The Company must order components for its products and build inventory in advance of product shipments and has invested in manufacturing process equipment, including capital assets held at its suppliers' facilities. In addition, the Company has made prepayments to certain of its suppliers associated with long-term supply agreements to secure supply of inventory components. The Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The Company also reviews its manufacturing-related capital assets and inventory prepayments for impairment whenever events or circumstances indicate the carrying amount of such assets may not be recoverable. If the Company determines that an asset is not recoverable, it records an impairment loss equal to the amount by which the carrying value of such an asset exceeds its fair value.

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

The Company records accruals for estimated cancellation fees related to component orders that have been cancelled or are expected to be cancelled.

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

Warranty Costs The Company provides for the estimated cost of warranties at the time the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company's typical experience. Each quarter, the Company reevaluates these estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to warranty protection and adjusts the amounts as necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required and could materially affect the Company's results of operations.

36-------------------------------------------------------------------------------- Table of Contents Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized.

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

Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. In the event that the Company determines all or part of the net deferred tax assets are not realizable in the future, the Company will make an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management's expectations could have a material impact on the Company's financial condition and operating results.

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

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