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December 23rd, 1999

[12:00 PM] Apple's Annual Report: A Careful Analysis, Part 1
by Wes George

Yesterday Apple, as required by the Security and Exchange Commission (SEC), released its annual report. The long version called a 10-K is a yearly summation of Apple's operations, as well as its balance sheets and income statement. In the past this document was only available to shareholders, now thanks to the Internet all 108 pages are posted for the world to behold.

How to read an annual report

Annual reports are the epic sagas of the corporate world written primarily by lawyers and accountants with guidance from the executive chieftains. They often contain some rather stern language that can be misinterpreted as a stormy forecast by those unfamiliar with stoic corporate language.

For instance, when Apple warns in the 1999 annual report that:

"It is uncertain whether Mac OS X will gain developer support and market acceptance. Inability to successfully develop and make timely delivery of a substantially backward-compatible Mac OS X or of planned enhancements to the current Mac OS, or to gain developer support and market acceptance for those operating systems, may have an adverse impact on the Company's operating results and financial condition."

Do you really think Apple believes that OS X may fail? I don't think so. With language like this, Apple's legal department is hermetically sealing Apple from accusations of exacerbating naïve investors into any undue 'irrational exuberance' about the company's future potential profits.

Nevertheless, it is a clue. If Apple cannot meet its delivery schedule for OS X, (whatever that may come to be) and the stock price stumbles, you can't say Apple didn't alert you. Perhaps Apple is even anticipating a delay in the release of OS X? The arcane language of annual reports often contain subtleties that would make any poet proud.

It is important to note that annual reports, like epic sagas, are about the past, although they contain some "forwarding looking statements" these are usually of the cautionary type quoted above. In many ways financial information from before September 25 1999 doesn't illuminate the year 2000 and beyond. Investors are at least vaguely aware of the data contained in the report since this information is already largely reflected or "discounted" in the stock's recent price action. The future is all investors are really interested in.

Apple's annual report tells us nothing about iBook or G4 sales. It sheds no light on how this Christmas season is going for Apple and cannot predict whether the iMac will remain a top-selling computer for the current fiscal year. All it really can say about the future is how well management has executed their business plan for the last year and just where in the business cycle the company finds itself.

Apple's management scored high grades in this report and Apple's product cycle is still in the early stages of accelerating sales, except for the PowerBooks.

Just the highlights, thank you.

In the Annual report's first paragraph, labeled "Overview", you'll find the condensed version of what Apple did in 1999. They sold lots of iMacs, 1.8 million of the fruit colored computers to be exact. Because of the huge iMac sales Apple experienced a healthy 25% rise in the number of computers sold over 1998. That is insanely great, if old, news!

Since unit sales in 1998 showed a 4% decline from 1997, a 25% increase in unit sales in 1999 over 1998 indicates that Apple led by iCEO Jobs has turned this battleship around.

The unit sales numbers for Japan and Pacific Asia are of special interest. Most analysts expect Asian economies to take off in a big way during next few years, creating more new information technology consumers than other part of the globe. And they seem to love their Macs. 1999 unit sales for Asia showed about a 35% increase over 1998.

Meanwhile, net sales, which is the total amount of cash actually received from customers for computers Apple sold (less returns, freight, allowances and cash discounts), grew by 3% over 1998. This is hardly a surprise because computers are much cheaper today than in 1998. Computer hardware has been in a deflationary spiral for years now (largely because of Moore's Law) and all the PC vendors are experiencing the same decline in net sales while actually selling more units.

According to the annual report: "The decline during 1999 in the average revenue per Macintosh system is attributable to lower pricing for both iMac and Power Macintosh products, which reflects the continuing overall industry trend towards lower pricing. The decline is also attributable to the shift in the Company's unit mix toward lower-priced consumer products such that iMac units and comparable products comprised 52% of total Macintosh unit sales in 1999 versus 39% in 1998."

Gross Margins are up!

The declining price of computers has hurt every PC vendor's gross margins, except Apple. Gross margins are net sales less the cost of goods sold and are an indication of how efficient a company is. The PC vendors are struggling to maintain margins while racing to see who can make the cheapest PC. Already IBM and Packard Bell have been largely eliminated from the PC market by this trend.

Apple's gross margin is the highest in the computer industry and amazingly rose in 1999 to 28% from 25% in 1998, which is the opposite direction one might expect the gross margins to move as computer prices fall below a $1,000 per unit. Captain Jobs runs a tight ship!

However, in one of those dire forward looking statements the annual report admonishes investors to expect gross margins to decline in 2000 as "lower priced consumer products become a larger share of net sales…" There is only so much pricing inefficiency that can be wrung out of the system before lower computer prices put downward pressure on margins.

Also, rather disturbing is the fact that PowerBook G3 sales lagged in 1999. Apple sold only 344,000 PowerBooks in 1999 as compared to 427,000 units in 1998. Is this fall off in sales due to consumer anticipation of the iBook "pre-cannibalizing" PowerBook sales even before the iBook was released? If so the iBook may add less to Apple's bottom line in 2000 than hoped for.

To be continued….

There's much more to be revealed in Apple's annual report, but it will take me a couple of hours to wring out the secrets lodged in the 108 pages of arcane phraseology. So stay tuned for tomorrow's second installment when we will get to the down to the nitty gritty bottom line.

We have an Apple Stock Watch Special Report with all of our coverage on Apple's stock and financial news.


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