Apple CFO talks Apple TV, iPhone, Leopard and retail [transcript]

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Speaking at the Morgan Stanley Technology Conference in San Francisco on Tuesday, Apple chief financial officer Peter Oppenheimer fielded questions on the company's upcoming launch of Apple TV and iPhone, while also talking at length about Mac OS X 10.5 Leopard and strategies in the retail segment. A full transcript the near 40 minute session follows.

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Questions from Morgan Stanley Systems and PC hardware analyst Katy Huberty

Q: As a starting point, start with Apple TV. The potential to change the way customers gather and purchase their video content. And we've seen some cable providers — and the most recent I've read about is Time Warner in San Diego — and those trials to hook PCs and the Internet to the TV to distribute video just haven't worked. So why is Apple's strategy different?

A: Over the past several years Apple has made significant improvements in how customers manage and enjoy their digital lifestyle, including the iLife suite of software. We develop technology as we integrate into our products, such as AirPort Express, AirTunes and Bonjour. And now with Apple TV, we believe we are providing a new and better way for people to seamlessly and wireless enjoy their digital lifestyles. The Apple TV interface is simple, yet elegant, and the picture quality is excellent. I think Steve [Jobs] said it really well when he said Apple TV, as he described it, is the DVD of the 21st century.

Q: So part of that solution is the content. Clearly Apple does a great job with the hardware and the peripherals and what have you, but the content is important. How many movies and TV shows does Apple have on iTunes today and where do you think that goes over the next 12 months?

A: We are very pleased to have recently added Paramount and Lionsgate. And as a results, we have over 400 movies and on the iTunes Store today, up from 75 in September. And if I can think back to when we first launched iTunes, we started with 200,000 songs in our catalog and today we have over 4 million. When we launched with the fifth-generation iPod in October of 2005, um TV shows, we started with five. And today we have over 350. And as the end of last quarter, we downloaded more than 50 million TV shows. And we're confident that we'll add more studios over time. And as we discussed with Apple TV, we'll provide customers with a great seamless way to enjoy this content that they have on iTunes either from their Mac or PC to their big screen TV.

Q: So, have you done any work to figure out where the point of indifference is in terms of how much content you have to have in your system to create this indifference between traditional cable cable boxes and Apple solutions.

A: Well, our sales through iTunes are growing at very strong levels. We're very happy with it. We got some indication of that in the December quarter. We think we're giving customers a great experience. And we will continue to bring more video over time to the store.

Q: Since we're talking about iTunes — Steve was vocal over the last couple of months on the idea of abolishing DRM from [inaudible]. What would that do to the financial model if Apple didn't have to pay the DRM licensing fees?

A: Steve recently wrote his thoughts on this topic, summarizing how we got to where we are in the industry with DRM. The fact is DRM is required by the big four labels in order for us to protect [inaudible] from being illegally downloaded. We believe that consumers would be best served in a marketplace where any player can play music purchased from any store, and any store could sell music that would be playable on any player. We think this is the best result for consumers and Apple would embrace it wholeheartedly. In terms of the financial impact, that remains to be seen. We've sold over 2 billion songs, 50 million TV shows, 1.3 million movies. We've provided a great experience to customers, and we think we have the best solution out there. We're going to continue to invest in the iPod and in iTunes, and we stand ready to compete.

Q: We'll get to iPhone in a minute. But talking about Apple TV and iPhone, can you help us understand the go-to-market strategy of Apple as you introduce an entirely new product segment? Is it a situation where you roll it out broadly across distribution investments you've made? Or is it a targeted roll out over time?

A: Well, beginning with Apple TV — we plan on shipping it this month to all resellers who want to carry it. I personally believe that Apple TV is the kind of product where the features really need to be seen to be appreciated, and we certainly will do that in our stores and I think our channel partners will as well. In terms of the iPhone, Apple and Cingular will sell the iPhone online and in our retail stores. So we think they'll be many places for customers to come and see it. We chose to partner with Cingular for a number of reasons. First of all, we think Cingular is the best quality carrier. They're the largest with over 61 million subscribers here in the U.S. We were able to form a relationship with Cingular that will allow Apple to be Apple and do it what it does best, and Cingular to be Cingular to do what it does best. And finally, we think that GSM is the best global standard for customers, and Cingular's network is based on this standard.

Q: So that's the go-to-market strategy. But as you evolve the product portfolios, how do you think about rolling out accessories, potentially introducing more mainstream price-points, taking those products international over time. How do you evolve the new product portfolios.

A: Seems to be the question of the day. As you know we don't talk about future products, so I can't give you a specific answer to that. But you can look at what we've done in the past with Mac and iPod to get some idea. As an innovator, we are focused on delivering value by providing solutions that are meaningful to customers. With our Macs, this has meant bundling our iLife suit and adding such things as iSights cameras, AirPort cards and other technologies. With iPods, we have included photo viewing and video, and frequent updates to the iTunes Music Store. And today I think our products are as competitive as they have ever been since I've been with Apple in the last 10 years, and we're providing great value to customers. Regarding accessories, we work with thousands of developers to provide a great array of hardware and software accessories to our customers. With iPod, there are over 3000 accessories that you can buy, and with the Mac there are over 23,000 developer products that you can buy. We have been focusing on international markets. For example, we are very happy with the results we saw in December with the iPod. What Tim Cook and his team have done to focus on the point-of-sale — and our marketing teams have done for our marketing program — have caused our share to double in most western, european and asian countries this past December over last December; other than the UK, Japan and Australia, which it eclipsed 50 percent. So I think those programs are really working and you'll see us continue to work on the point-of-sale and open stores internationally.

Q: So lets shift focus to the iPhone. Morgan Stanley published or survey results last week, and that pointed to very high level of demand. But from Apple's perspective, what are the barriers to adoption for the iPhone?

A: We believe the iPhone is a breakthrough product with outstanding features that years ahead of anything in the market today. We don't think there is another product like the iPhone and we think the iPhone will redefine the cell phone market. The iPhone combines three products into one — a beautiful, light, handheld device. We think it's a revolutionary phone with visual voicemail. It's the best iPod that we've ever done. And we think it's breakthrough internet device with desktop class email, searching and web browsing. As an innovator, we don't look at traditional market methodologies to think about how to develop products. Before we introduced the first iPod in 2001, we didn't really ask ourselves what was the potential for the MP3 player market by looking at products that were over $399. We believe that people really love music and would appreciate a product like the iPod to listen to music while on the go. Though we're new to the mobile phone market, we believe the addressable market will grow quickly for a product that delivers so much value and uncompromising functionality to customers.

Q: What we found is half the demand is coming from your traditional high-end handset market, half the demand is coming from Apple's customer base. Can you help us understand how you do... you don't really have to size the market, but you have to test for elasticity and customer preferences and which functionality to put into the phone. Can you talk about what type of market testing you do do, and then how you take that and evolve it into the product portfolio over time?

A: I think this is what Apple really does so well. We get feedback from customers and others sources, and we have very talented people at the company who really think through how to deliver great solutions to customers, in some cases they never thought they would want. Again, the iPod was a great example of that. Back when we shipped the first iPod in 2001, did anyone really think you could have your whole music library in your pocket with such a wonderful and seamless experience? I think not. But that's just a great example of how Apple brings hardware and software and other capabilities together to create great solutions for customers.

Q: So shifting focus over to the retail store strategy, because I very much believe that this is under-appreciated by investors today: You've built out 165, roughly, retail stores thus far, and as you introduce new products — that don't frankly take up that much floor space — but increase returns within those stores, why wouldn't we see the operating margins within the retail store base accelerate?

A: We don't give financial projections at a segment level, and I have to say that I'm very, very happy with the financial performance of the retail stores. Our December quarter, we sold more Macs in total and on a per-store basis than we did the year before. Our iPod sales were down a bit year over year as a result of the broader channel we had and our ability to better stock it this past year. But again, I'm very happy with the experience customers are getting at the stores and the returns. We're going to continue to open stores at a measured and controlled pace. We expect to open 35 to 40 this year, with a little over 10 coming outside the United States.

Q: So if you think about it historically though, operating margins in the stores have accelerated as you've increased revenues... And so you don't have to carry that to a forward-looking statement, but you haven't had to put all of your margin incremental back into investing in the stores, historically?

A: In this last year, we did invest in the stores. And I continue to want to do that just to make them a great place for customers. Ron will not compromise on the service in the stores. We're keeping the payroll up, and we're remodeling some of the first stores we opened to take advantage of some of the new innovations we have in our more current stores, and to prepare them to sell our new products.

Q: So you mentioned 10 essentially stores internationally. If you look historically, the store build-out has largely U.S.-centric with some [inaudible] stores around the world, in Japan and Canada, and some in Europe. Are there any structural or behavioral limitations that limit your growth internationally? Or is it just a matter of having seen the growth in the U.S. and staging it over time and we'll see the international strategy play out?

A: Today we've got about 175 stores open and roughly 20 of them our outside the United States. About 10 of those we've opened in the last year. So we're beginning to increase our international stores openings. Today we're in Canada, Japan and the UK. You'll see us open in some additional countries in the note too distant future. In terms of international it is a little bit harder than it is here in the U.S., because there are fewer malls, the turnover in a good site is slower than what we see here in the U.S., and as a result you're typically dealing with more individual landlords. So it just takes a bit more time. We continue to be very careful about real estate. We're very selective and won't take a bad site. And I see us opening 35 to 40 stores this year and I think over 10 would be international.

Q: So I'll cover a couple of near-term questions then we'll open it up to Q&A. I want to start with gross margins because there is a big debate if you go back four or five years ago when we first started hearing and thinking about the iPod, and Wall Street's belief was your margins would be pressured as you sold lower price, potentially lower-margin products. And yet this past quarter, a lot of the upside came from the iPod portfolio, and yet both your operating and gross margins hit record levels. And so, as you think about the next couple of quarters, what are the headwinds on margin front that get you to guidance that assume margins come down?

A: As you know we don't provide guidance beyond the current quarter. But in terms of the March quarter, I did guide are gross margins to 29.5 percent, and on the call I said don't get used to 18.5 percent operating margins. The expanded gross margin that we've observed over the last few quarters is mostly attributable to a favorable commodity environment that we're in. And it's been very good. But these tend to run in cycles and these cycles come to an end. As regards this quarter for gross margin, I can't give you a mid-quarter update but I can discuss with you what we said at the time in January. The reason we saw margins coming down were really four areas. The first is we expect revenues to be down sequentially in the March quarter because the holiday season comes around once a year. So we have less leverage on fixed costs. Secondly, a different product mix, including having a full-quarter availability of the shuffle which we are now shipping in 5 colors. We also sold a lot of iTunes gift cards in the December quarter. We'd expect to see redemption of those, and as we told you we run the music store at just a little over break-even. And lastly, I expect software sales to be down as we get closer the Leopard release. As regards operating expenses, we continue to be very confident in our business and strategy, and we're going to continue to invest in engineering and marketing and distribution to grow our top and bottom line.

Q: So mentioned the OS launch. Can you update us? Is the Leopard OS launch on time, and historically, what impact do you see on both hardware and software sales before the launch and after the launch.

A: OK. Our next release of Mac OS X is called Leopard. We've previously announced that it will ship this Spring. With past OS release, we did not incur any significant slow down in Mac sales coming into the release. And we've simplified the installation process in such a way that we don't think it's a deterrent to sales. In terms of the last release we did, Tiger, in its first quarter we had $100 million of OS sales in that quarter.

Q: So it can be pretty significant right off the bat?

A: Usually your first quarter is the best one in the software business.

Q: Vista received a lot of media attention over the past month, post launch. Does it create an opportunity or any risk for Apple in the market?

A: Well in the time that it took Microsoft to develop Vista we've come out with 5 releases of Mac OS X, delivering great features. We think we have the gold standard in operating systems. We believe that we have the superior OS on the market today and the Leopard release will only extend that. With the features and functionality and stability and security of Mac OS X, I don't really see Vista as a threat. In terms of opportunity, since the hardware requirements of Vista require much of the install base to buy a new PC — and to the extent this occurs — it gives Macs an opportunity to be considered. And I think that could be a good thing, so we'll have to see.

Questions from the audience

Q: On the topic of Vista and Leopard — you made Windows available on the Mac, what would it take for you to make Leopard available on PCs?

A: You mean to license Mac OS X to somebody else?

Q: Yes.

A: Uh, no plans to do so.

Q: What was the reason for the delay in Apple TV?

A: Um, we're taking a little bit more time to finish Apple TV, and um expect to begin to ship it in mid-March.

Q: [inaudible] manage to get into gaming?

A: Our developer relations team works with a lot of the great game developers to be sure that we have a great gaming experience on the Mac platform. And we're thrilled to have the developer community behind us.

Q: Can you maybe comment on your cash balance sheet? Why do you need so much cash on your balance sheet at this time?

A: Admittedly we've been conservative with wanting to maintain cash for flexibility. We do discuss buybacks and other forms of returning cash to the shareholders with the board, but we've not changed our philosophy at this point in time.

Q: Can you talk about iTunes and Vista? From what I understand, it doesn't run on it at this point. How did that occur and how does that get fixed in the future?

A: "I've heard that question several times this morning. And I believe that we put something out recently that solves that."

Q: We know that the iPhone will be sold at the Apple Store as well as Cingular stores. That means Apple will have to spend incremental overhead in expenses in getting the phones activated and etc. How does Apple get paid for that extra services and why not share the services revenue with Cingular?

A: Um, I'm not able to discuss any financial projections today on the iPhone. I may do that closer to shipping. I'm sorry I can't answer that question.

Q: Is iPhone on track to be launched on June 1st?

A: Um, at Macworld Steve said that we expect to ship iPhone in June and we've not provided any further update.

Q: Peter, how do you look at margins and how it relates to commodities? In other-words, NAND pricing collapsing right now. That can obviously change. Do you kinda look at that and say, 'Our margins are pretty high. We can get more share invested in other stuff?' Or do you not price around what is happening on the component side, necessarily, as much as you have certain schedules you're trying to hit and certain price points?

A: When we launch a new product, we certainly take into consideration what we think commodities will cost and in some cases we may lean into that a bit. So we consider commodity costs in terms of the configs we'll do and our pricing, and append it to change that when we launch new products.

Q: With respect to the iPhone you said that you felt GSM was the best option for consumers. And obviously the data rates are somewhat limited relative to some other technologies coming into the market now. How are you thinking about enabling a better experience in the future years with the iPhone in terms of data rates and air interface?

A: I can't speak to future products, but with iPhone, we believe that customers will have a great experience using the GSM network that Cingular has here in the U.S. along with Edge... And we also enabled the iPhone for Wi-Fi, which people can use in hot-spots as well.

Q: As you think about future generations of the iPhone, would you consider a sort private labeled service which offered maybe more features, besides [inaudible] wimax, sprint CDMA? Would you ever covert that [inaudible] branded telecom provider service to an Apple phone service?

A: I think today we are very focused on getting a great iPhone shipped in June. We haven't really thought about that. Our focus is really on June and then, as Steve said at Macworld, wanting to get to Europe before the end of the calendar year.

Q: Uh, I think you guys still make computers. [laughter] Can you talk about what is going on in that side of the business and what leads you to continue to take share in the portable segments?

A: OK. We make great computers. Looking at the December quarter, unit shipment growth was 28 percent over last year, which was 4 times the market rate of growth... really driven by portable as you indicated. I think our portable shipments have done so well because we have really a great MacBook and MacBook Pro... ships with great software such as iLife. We are very competitive in the price bands that we are choosing to compete in. And we've got good presence in our own direct distribution. Tim and his team have worked to improve the point-of-sale around the world. Last quarter as an example, Europe grew for us at the company rate of growth and Asia-Pacific actually grew faster. So I really think that we doing all the right things from our product perspective and a distribution perspective, and it's certainly playing out in share gains.

Q: Any specifics on current shares and goals there?

A: Want to continue to increase market share. For example here in the U.S. in the home portable market, our share was about 10 percent. In the overall education market, we're at 15 [percent]. We're gaining share in most of the markets that we're competing in around the world, particularly in consumer and then education. Our enterprise sales continue to grow. Here in the United States, for example, we have 150 who are calling on enterprise customers and government customers and our sales are growing at or above our company rates of growth. I think that's a result of a) Mac OS X being very secure and stable and plugging well into corporate networks, and b) I think the Intel microprocessor has helped us as well. And we are tending to do well with mobile professionals who want to carry our MacBook and MacBook Pro for their design and multimedia, and also doing quite well for areas of these enterprises that have intense computing needs. Particularly in bio-science, oil and gas, and Internet.

Q: How is the uptake of Boot Camp downloaded onto the Mac?

A: We've downloaded over 1.5 million copies of Boot Camp, which is in beta. We look forward to shipping the 1.0 release in Leopard. And I also believe that Parallels is a great choice for customers and people seem to be happy with that too.

Q: Could you tell us a little bit about marketing and advertising plans around the iPhone? We saw some advertisements during this year's Oscars. What else is coming?

A: Again, I'm sorry. That's not a question I think I can answer. Um, Steve and the team have some great plans but I can't share those with you in advance. I'm sorry.

Q: To what degree do you think the iPhone might cannibalize your iPod sales?

A: Honestly, I don't think we know. We haven't shipped the iPhone yet, and I think we'll learn when we do. That being said, I think they are really two different products. One being a great phone and the other being a great way to view your video and listen to your content. They come with different commitments as well.

Q: Now that you're partners with Intel on the chip, have there been any glitches with these Centrino-based laptops and these off-the-shelf Wi-Fi NIC cards with the Apple TV. Is that fully flushed out in terms of PCs integrating with Apple TV — are they just going to be able to turn it on?

A: Apple TV uses industry standard technology such as 802.11. But I don't think I'm the right person to answer the very technical parts of your question. I don't know the reason why it wouldn't. But, again, I want to be clear — I'm probably not the right person to answer that. Apple TV, by the way, works with a Mac or a PC. It would be a great way for you to be able to view your iTunes content on a widescreen TV, whether it came from a Mac or PC.

Q: Is the content that is coming down to you iTunes, is that full HD content or is it similar to the chopped music, not fully analog TV equivalent? When you download "Pirates," is it the full equivalent to buying the DVD at your local Costco?

A: It is near DVD quality. I've seen it running in our labs, and I can't tell the difference. It's an excellent experience from my point of view.

Q: Can you speak about your vision for integrating the iPhone and Mac PC experience, and how you plan to get the synergized experience across all Apple products?

A: Well. I think when we think of developing new products, ease-of-use and customer experience are at the forefront of our minds. If you look at iPhone, it's really three fantastic products in one — the best iPod we've ever made, so it will sync to your computer, music and video content; it's a revolutionary phone with great features such as visual voicemail; and it will truly deliver desktop applications such as e-mail, web browsing and search. So I think those are some good examples of how we've really tried to make the iPhone just a breakthrough revolutionary product like we've done with the iPod and like I think we've done with the Mac.

Q: What's the current availability of the Mac at Best Buy retail stores?

A: Today we have a pilot that's in a little over 50 stores. About half have Apple-badged employees in them and the other half don't. We've expanded the pilot from where we had originally started, and both Apple and Best Buy continue to monitor the results and consider further expansion.

Q: You've split the stock at these levels before. Is that something that's under consideration?

A: Um. Don't have anything to announce today.

Q: We talked about whether there are barriers to adoption. And you obviously have to look at the market much differently to ultimately know what the iPhone can do. But from a limiting standpoint, you have a 175 stores, Cingular has a little over 2000 stores. Is that infrastructure a limiting factor in terms of how many iPhones you can sell this year?

A: Well, and both Apple and Cingular operate online stores as well. So I think there is many places for people to come in and look at and buy the iPhone.


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