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Thursday, July 26, 2007, 12:40 pm PT (03:40 pm ET)

Apple execs talk product transitions, iPhone expansion, more...

With most of the attention surrounding Apple's third quarter earnings on Wednesday focusing on iPhone metrics, several interesting revelations by members of the company's executive team have gone largely undocumented.

During a 60-minute conference call with analysts and members of the media, Apple chief operating officer Tim Cook and chief financial officer Peter Oppenheimer discussed changes to the way the company will measure its retail performance, upcoming product transitions, and a plan to grow its iPhone business "model by model."

Excerpts from the relevant sections of the call have been transcribed for reader appreciation.

Apple Retail Performance

During his opening comments, Oppenheimer spoke at some length about Apple's ongoing retail story and how recent changes will alter the way it measures the segments performance:

Oppenheimer: "The stores offer customers a great experience for buying Macs, iPods and now iPhones. As we compensate iPhones sales through our stores that will result in significant amount of deferred revenue and cost of goods sold, we revisited how we measure our stores performance. Since the stores inception, operating income for our retail segment reflected cost of sales for Apple products at the amount normally charged for the same product to Apples’ major US channel partners operating retail stores, less the cost of sales program and incentives to those partners."

"We believe this enables us to measure the stores performance in way that would allow comparability to the performance of those results. Today and with more than six years of retail operating history and given the subscription accounting for the iPhones, we have determined that this is the right time to begin measuring our retail segment operating performance in a manner that is generally consistent with the way we measure Apples’ other operating segments. Therefore, beginning with the June quarter, we are using cost of sales for Apple’s products sold through our retail stores that are similar to those used for Apple’s other operating segments."

Similarly, Oppenheimer added, the company has altered the way it records revenue for time-oriented services such as .Mac and AppleCare.

Oppenheimer: "We are also changing the way we measure AppleCare and Mac sales through our retail stores. Historically, revenue and cost of sales were recognized by the retail segment at the time of sale for AppleCare and .Mac. We are now recognizing revenues in cost reduced products over the life of their respective agreements consistent with the accounting treatment in our other segments. We believe all those changes will allow greater comparability of results between our various operating segments."

Upcoming Product Transitions

During an ensuing question and answer session, Oppenheimer was asked by UBS analyst Ben Reitzes why he was again providing extremely conservative guidance for Apple's current fiscal quarter, to which Oppenheimer responded with some intriguing remarks.

Reitzes: "Good afternoon. Thanks a lot. Couple of questions if I may. Peter... I guess with regard to guidance, you just guided $0.66 and came up with $0.92. Why should we believe that this is $0.66 — $0.65 this time when you have been so conservative. Are you really that worried about the component costs, or is there something else going on with regard to our coming price cut for product?"

Oppenheimer: "Ben we gave you guidance that have reasonable confidence in achieving. Regarding gross margin, I have guided down to 29.5%. As a result primarily of these factors. We’re going to run the back-to-school promotion for most of the quarter, great promotions for the company and bring us each year many new customers, but it is an expensive one. We do expect to see higher commodity costs and I will let Tim comment on that in a moment, and we got some product transitions, but I can’t get into it."

iPhone Expansion

Reitzes: "Well, I am sure someone will ask the component question. I guess can you give us any more flavor on the iPhones — perhaps how many have been sold to date. What do you think of just various reports and chatter out there, I mean this is a new frontier for us as analysts and we’re trying to navigate all the headwinds and tailwinds etc? Can you give us any more commentary as to what you think demand is like right now as you see it and how it should build into year-end and how we fight this battle as investors and trying to match the hike?"

Cook: "Hi Ben, it's Tim."

Reitzes: "Hi, Tim."

Cook: "Let me take this one. As Peter said in his opening comments, we sold 270,000 units in the first 30 hours. And AT&T said that more iPhones were sold in the first week than they have sold in the first month of any other wireless device in their entire history. More important than this our customers looked at iPhone as Peter mentioned in this opening comments with a recent survey finding that a stunning 90 percent of iPhone owners were extremely very satisfied with the iPhone. And so, our view is the starting gun has been fired and we have gotten off to a great start.

However our primary focus is not initial sale. We are focused on building a third great business for Apple over the long-term, alongside our Mac and iPod businesses both of which you can see from the results reported today are doing very well.

It won’t be easy to build the third business because the competitors are at large entrenched and it will not be done overnight. Our perspective is measured in years not months. But the rewards we believe are huge for Apple. And Apple clearly has the skills including world-class hardware and software engineering that make us confident that we can succeed.

As Peter mentioned earlier, our next step is to begin selling the iPhone in Europe next quarter starting with the few major countries and then expand over the whole of 2008. We hope to as a result of this and other things, we hope to grow our sales step by step, year by year and model my model. Just like we have done in the prior product lines. And I do think it’s interesting to note that it took Apple seven quarters — almost 2 years — to sell our one millionth iPod. We hoped to sell our one millionth iPhone in the first full quarter of sale."

Reitzes: "Okay."

Cook: "What we think so far, it gives us a lot of confidence to reiterate our goal to sell 10 million units before [the end of] 2008."

iPhone Royalty Payments?

At one point, David Bailey from Goldman Sachs asked Oppenheimer whether Apple received any royalty payments from companies such as Google who have their services linked promptly from the iPhones home screen.

Bailey: "Great, good afternoon. In addition to the payment that you’re getting from AT&T, are you receiving any fees from the other vendors that have placement for their services on the main screen of the iPhone?"

Oppenheimer: "David, we don’t discuss the terms of various agreements that we have with vendors and suppliers. I am sorry, we can’t answer that question.

Bailey: "You can’t even answer if you are or if you are not?"

Oppenheimer: "No."

Best Buy and Component Pricing

Richard Gardner from Citigroup then asked for an update on Best Buy and component pricing.

Gardner: "Thank you very much. I was wondering Tim, if you could give us an update on the Best Buy roll out and how that’s coming and how many stores you are in at the beginning of the quarter or how many stores exiting the quarter and whether that was a contributor — a material contributed to the Mac unit shipment number in the quarter?"

Cook: "Richard the beginning of the quarter we were around 15, by the end of the quarter we were around 75. By the end of this quarter we will be over 200 and we expect to be almost 300 by the end of the calendar year. So it’s going very well, both parties are very happy about it and that’s the reason we are expanding."

Gardner: "Okay. And then I guess I will ask the component question, Tim. I was just hoping maybe you could give us a sense of what was better than expected in the second quarter and how you see component prices trending for the categories in the third quarter?"

Cook: "Yes, sure. Component prices particularly DRAM, which bottomed in the quarter later than we predicted and lower than the predicted. Both of those were led component prices in general will be more favorable than the predicted. And this contributed to the higher than expected gross margins as Peter talked about product plans going forward, as you know historically in the second half of the year, the commodity markets tighten as the industry heads into a seasonally stronger demand period, and I don’t envision this year being fundamentally different.Specifically, we see the NAND flash market tightening, we expect DRAM to stabilize from its recent oversupply state, and on LCDs, our fundamental lack of new capacity investment combined with flat-panel TV demand is creating a greater than typical imbalance between supply-demand. For other commodities, we expect them to follow more historic trends."

Gardner: "Tim, if I could follow up. Was — did pre-buys or forward purchases on NAND during the first calendar quarter contribute meaningfully to the gross margin upside in the second quarter?"

Cook: "Rich, I don’t want to go into that level of detail."

Gardner: "Okay. All right. Thank you."

Cheaper iPhones and iPhones for Business

Two final questions of interest came from Merrill Lynch analyst Richard Farmer, who asked about the potential for cheaper iPhone models, and from Bear Stearns analyst Andy Neff, who questioned how Apple planned to address the corporate market with iPhone.

Farmer: "Okay. Thanks. And then just a broader question about the iPhone price points overtime. If you look at the history of your iPod business, you started at higher price points and ultimately had a broad line all the way down to $79, obviously the first iPhone is at $500 or $600. Should we reasonably assume that over time we will have a broader line and lower price points and kind of a family of phones to choose from?"

Oppenheimer: "We don’t really comment on that. We believe the iPhone offers tremendous value that customers couldn’t even have imagined before. As you know, this is really three product in one, it’s a revolutionary mobile phone, a wide screen iPod, and Internet in your pocket with the best desktop class e-mail Web browsing and Map application ever on a mobile phone before. And we think, customers are clearly seeing as witnessed by the customer satisfaction ratings that we talked about."

Farmer: "Okay, thank you."

Neff: "Great. Two things I guess, one just one of the comments, you seen a lot of issue about corporate e-mail, are there thoughts about relative to the phone about trying to address that market began discussions with some of the major provider’s corporate e-mail along those lines or thought about how you guys try to address that corporate market? The second was just again to clarify in terms of the accounting treatment, just relative to what are you going to recognize in the deferred revenues going forward, can you clarify for us what you are going to put in there?"

Oppenheimer: "Andy in terms of the corporate market, we think the iPhone is a breakthrough product for all customers including business customers. It’s a great Internet device that includes the best e-mail client out there with the best Web-browser ever on a mobile device. And with a very little bit of help from the corporate IT department that can be set up to work with corporate e-mail. We already have a number of corporate customers that are piloting the iPhone in their enterprises and they have told us that they are very happy with the results so far."

Gary Wipler:" Andy with regard to your deferred revenue question, we provided to you the deferred revenue scheduled this quarter for iPhone and Apple TV, it has 180 million of total deferred revenue which again related only to the hardware from the iPhone and from Apple TV, so there was no accessories revenue included in this or payments from AT&T. We will provide a similar schedule to you in October to the September quarter and I will walk you through then how the various revenue streams impacted the financials."