Apple's diluted earnings per share for the 2004 fiscal year would have been 27 cents less, if it used the fair-market value when expensing the cost of employee stock options.

When it reported its financial results in October, Apple said its 2004 earnings per share was 71 cents a share. In the company's SEC Form 10-K, Annual Report, issued on Friday, it admits earnings per share would have been 44 cents if it used the different method to figure the cost for employee stock options.

Apple says it measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (page 70-72 of the 10-K).

This method accounts for options by taking the difference between the market price of the stock and the exercise price at which the employee may buy that stock. Some view this accounting procedure as controversial because compensation expenses are not recognized in Apple's consolidated statements of operations.

Not developed

Apple says it follows the APB method because: "The alternative fair value accounting provided for under SFAS No. 123 requires use of option valuation models that were not developed for use in valuing employee stock options and employee stock purchase plan shares. Under APB Opinion No. 25, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized."

Alternative option valuation models "require the input of highly subjective assumptions including the expected life of options and the Company’s expected stock price volatility", claims Apple.

"Because the Company’s employee stock options and employee stock purchase plan shares have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not provide a reliable measure of the fair value of the Company’s employee stock options and employee stock purchase plan shares," it explains.

Retail strategy

The 10-K report also includes details of Apple's retail strategy, education sales, legal proceedings, property holdings, and Mac and iPod sales.

Regarding the retail stores Apple says: "One of the goals of the retail initiative is to bring new customers to the Company and expand its installed base through sales to both first time personal computer buyers and those switching to the Macintosh platform from competing operating system platforms.

"Apple believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware, software and peripheral integration, demonstrate the unique digital lifestyle solutions that are available only on Macintosh computers, and demonstrate the seamless compatibility of the Macintosh with the Windows platform and networks."

"The Company believes a high quality buying experience with knowledgeable salespersons, who can convey the value of the Company’s products and services, is critical to attracting and retaining customers."

Mac sales

Apple offers some explanation of the decline experienced in its iMac line. According to the report: "The decrease in iMac net sales and unit sales was largely due to the delay in the introduction of the new iMac, based on the PowerPC G5 processor, primarily as a result of manufacturing problems experienced by IBM. The delays in the new iMac resulted in the depletion of inventory of the old iMac flat panel prior to availability of the new iMac G5.

"The old flat panel iMac form factor which was available during most of fiscal 2004, was nearly 3 years old by the time the new iMac G5 began shipping in September 2004 and had experienced declines in sales as a result of the age of this product. The Company believes that sales of iMac systems have also declined due to a shift in consumer preference to portable systems and competitor desktop models with price points below $1,000."

Apple also suggests that interest in desktops was less than it would have been because of weak economic conditions affecting its key markets, and a perception that the machines are not as fast as the PC alternatives – proof that the megahertz myth has not disappeared.

Weak economy

The report states: "The Company believes that weak economic conditions over the past several years are having a pronounced negative impact on its professional and creative customers who are significant users of its professional systems.

"Also, it is likely that many of the Company’s current and potential professional, creative, and small business customers, who are most likely to utilize professional systems, believe that the relatively slower MHz rating or clock speed of the microprocessors the Company utilizes in its Macintosh systems compares unfavorably to those utilized by other computer manufacturers and translates to slower overall system performance."

However, the company did experience increased interest in laptops. "Unit sales of portable systems accounted for 51 per cent of all Macintosh systems sold during fiscal 2004 compared to only 42 per cent during 2003. The Company believes that these results reflect an overall trend in the industry towards portable systems."

Music maestros

Apple experienced "strong demand" for the iPod, "driven by enhancements to the iPod, the introduction of the iPod mini, increased expansion of the Company's iPod distribution network, and continued success of the iTunes Music Store due largely to making it available to both Macintosh and Windows users in the US, UK, France and Germany".

However, Apple does add a note of caution, predicting the competition "will intensify" in this growing market, saying: "The Company anticipates that competition will intensify requiring the Company to respond as hardware, software and content providers work more collaboratively to offer integrated products that compete against the Company’s offerings. The Company believes it maintains a competitive advantage by more effectively integrating the entire end-to-end music solution, including the hardware (iPod), software (iTunes) and distribution of third-party music content (iTunes Music Store).

Apple also notes the competition in the PC industry, saying: "The Company has a significant number of competitors, many of whom have greater financial, marketing, manufacturing, and technological resources, as well as broader product lines and larger installed customer bases than those of the Company. Additionally, there has been a trend towards consolidation in the personal computer industry that has resulted in larger and potentially stronger competitors in the Company’s markets."


Other highlights of the report include news that Apple has increased research and development by $28M. "The Company's research and development expenditures totalled $489 million, $471 million, and $446 million in 2004, 2003, and 2002, respectively."

The report also indicates that Panther drives software sales. According to Apple: "Net sales of software rose $140 million or 39 per cent during fiscal 2004 compared to 2003 due primarily to higher net sales of the Company's Apple-branded software and in particular, higher net sales of the Company's operating system software, Mac OS X version 10.3 Panther, which was released in October 2003. Net sales of Panther accounted for approximately $74 million or over 50 per cent of the increase in software net sales for fiscal 2004 compared to 2003."