Apr 25, 2007
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Executives
Nancy Paxton - Senior Director, Investor Relations and Corporate Finance Peter Oppenheimer - Chief Financial Officer, Senior Vice President Tim Cook - Chief Operating Officer
Analysts
Andrew Neff - Bear Stearns Shannon Cross - Cross Research Rob Semple - Credit Suisse Gene Munster - Piper Jaffray Harry Blount - Lehman Brothers David Bailey - Goldman Sachs Ben Reitzes - UBS Tony Sakanagi - Sanford Bernstein Richard Gardner - Citigroup Richard Farmer - Merrill Lynch Bill Shope - JP Morgan Bill Fearnley - FTN Midwest Kevin Hunt - Thomas Weisel Ingrid Ebeling - JMP Securities Ben Boland - Cleveland Research Shaw Wu - American Technology Research Chris Whitmore - Deutsche Bank Operator Good day, everyone and welcome to this Apple Inc. second quarter 2007 quarterly results conference call.
As a reminder, today's call is being recorded. At this time, for opening remarks and introductions I would like to turn the call over to Nancy Paxton, Senior Director of Investor Relations and Corporate Finance.
Please go ahead, ma'am.
Nancy Paxton
Thank you. Good afternoon and thanks for joining us.
Speaking today is Apple CFO Peter Oppenheimer. He'll be joined by Apple COO Tim Cook and Treasurer Gary Wipfler for the Q&A session with analysts.
Please note that some of the information you'll hear during our discussion today may consist of forward-looking statements regarding revenue, gross margin, operating expenses, other income and expense, taxes, earnings per share, future products and non-cash, stock-based compensation expense. Actual results or trends could differ materially from our forecast.
For more information, please refer to the risk factors discussed in Apple's Form 10-K for 2006, the Form 10-Q for the first quarter of 2007, and the Form 8-K filed with the SEC today and the attached press release. Apple assumes no obligation to update any forward-looking statements or information which speak of their respective dates.
With that, I'd like to turn the call over to Peter Oppenheimer for introductory remarks.
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Peter Oppenheimer
Thank you, Nancy. Thank you for joining us.
We are pleased to report strong financial results and the best March quarter in Apple's history. The quarter's revenue was $5.26 billion, representing 21% growth over the prior March quarter's results.
The revenue growth was driven by very strong demand for Macs and another great quarter for iPod sales. Operating margin for the quarter was very strong at 18.7%, resulting from stronger than expected revenue and an extremely favorable commodity cost environment.
We generated net income of $770 million, which was up 88% over the prior March quarter's results, and translated to earnings per share of $0.87. I'd like to first talk about our Mac products and services which represented 56% of our total quarterly revenue.
We shipped a total of 1.52 million Macs, representing 36% growth over the year-ago quarter. We continue to be very pleased with our Mac sales growth, which was ahead of our expectations, and represented more than three times IDC's latest published industry growth rate estimate for the March quarter.
Demand for our Mac Books and Mac Book Pros continued to be very strong. Sales of Mac Notebooks grew 79% year over year during the quarter and accounted for 59% of total Macs sold.
We began and ended the quarter with between three and four weeks of Mac channel inventory. Now I'd like to turn to our music products and services, which accounted for 44% of total revenue during the quarter.
We sold 10.55 million iPods, representing 24% growth over the year-ago quarter. The iPod Shuffle was especially popular, with the addition of four brilliant new colors beginning in late January.
The number of iPods in the channel at quarter end was essentially flat sequentially and we ended the quarter comfortably within our target range of four to six weeks of iPod channel inventory. Other music revenue grew 35% year over year, fueled by very strong sales through the iTunes store.
This store's growing catalog now includes over 5 million songs, 350 television shows, and 500 movies. We're very pleased to have added titles from Paramount Pictures, Lions Gate, and MGM to our movie library.
iTunes continues to lead the market for songs purchased and downloaded, accounting for over 85% of the U.S. market, based on the latest data from Nielsen SoundScan.
Sales from our Apple retail stores were $855 million, representing 34% year-over-year growth. The stores generated $32 million in segment margin, in addition to $174 million of associated manufacturing profit.
We opened seven new stores during the quarter, ending with 177 stores. With an average of 172 stores open during the quarter, average revenue per store was $5 million.
We now have 21 stores outside the U.S., including our new store in Rome that opened last month. As we previously announced, we plan to open high profile stores in Sydney, Australia and Glasgow, Scotland later this calendar year.
We're also pleased to announce plans for our third store in Manhattan at 14th Street and 9th Avenue, in the meat packing district. The stores sold 275,000 Macs during the quarter, representing 79% year-over-year growth.
As we've been reporting for some time now, over 50% of the customers buying Macs in our stores were new to the Mac. Over 21.5 million people visited our stores during the quarter, representing almost 10,000 customers per store per week.
We've continued to invest in our stores to enhance the customer experience. They are a great place to view the Apple TV experience today and they are preparing for their biggest launch of all time, the iPhone in late June.
Gross margin was 35.1%, considerably higher than our guidance, primarily due to the very favorable commodity pricing environment, better product mix, lower service costs and leverage on higher revenues. Operating expenses were $863 million including $54 million in expense related to stock-based compensation.
We capitalized $27 million of software development expense during the quarter. OI&E was $148 million and the tax rate for the quarter was 32%.
We had strong cash generation during the quarter, increasing our cash balance by over $700 million to end with $12.6 billion. Before I talk about the outlook for the June quarter, I'd like to provide a little more information about our strategy for the iPhone and Apple TV and how we plan to account for them.
We believe the iPhone is a revolutionary device that is years ahead of the competition. At Macworld, we demonstrated a number of the iPhone's breakthrough features, including its pioneering multi-touch display and user interface, visual voicemail, desktop class e-mail and web browsing, and of course, the best iPod ever.
We plan to build on this incredible foundation by continuing to develop new software features as well as entirely new applications and incorporate them into the iPhone. Since iPhone customers will likely be our best advocates for the product, we want to get them many of these new features and applications at no additional charge as they become available.
Since we will be periodically providing new software features to iPhone customers free of charge, we will use subscription accounting and recognize the revenue and product cost of goods sold associated with iPhone handset sales on a straight line basis over 24 months. So while the cash from iPhone sales will be collected at the time of sale, we will be recording deferred revenue and costs of goods sold on our balance sheet, and amortizing both of them into our earnings on a straight line basis over 24 months.
We will continue to expense our iPhone engineering, sales and marketing costs as we incur them. This accounting policy will have no impact on cash flow or the economics of our business.
Apple's proven capability to create innovative software gives us a tremendous competitive advantage in the consumer electronics industry. We are taking this bold step to leverage what we do best.
We hope the result will be to surprise and delight our iPhone customers, which should result in happier customers and more customers as we enter this billion unit per year mobile phone market. We also plan to recognize payments from AT&T Cingular as revenue over time, as earned.
We will report iPhone results each quarter that will include unit sales, and recognize revenue for iPhones, iPhone accessories and payments from AT&T Cingular. Similar to iPhone, we plan to periodically provide new software features and enhancements at no charge to our Apple TV customers.
We will also recognize the revenue and product cost of goods sold associated with Apple TV on a straight line basis over 24 months. This will be included in the other music-related products and services in the data summary we provide you each quarter.
Additionally, we will provide you with a schedule each quarter in our earnings release that indicates the total deferred revenue, including the combined amounts related to the iPhone and Apple TV. Looking ahead to the June quarter, I'd like to review our outlook which includes the types of forward-looking information that Nancy referred to at the beginning of the call.
For the quarter, we are targeting revenue of about $5.1 billion. We expect the total quarterly cost of non-cash stock-based compensation to be approximately $65 million.
We expect gross margin to be about 32%, reflecting approximately $9 million related to stock-based compensation expense. We expect OpEx to be about $915 million, including about $56 million related to stock-based compensation.
This includes increased marketing expenses related to the launch of the iPhone. We expect OI&E to be about $150 million and we expect the tax rate to be about 32%.
We expect to generate EPS of about $0.66 including an anticipated $0.05 per share related to non-cash stock-based compensation expense. In closing, we are very pleased with our results.
In the first half of fiscal 2007, we generated $12.4 billion in revenue and $1.8 billion in earnings. Our Mac shipments were up 32% over the first half of 2006 and iPod shipments grew 40%.
We're also very proud to have recently shipped our hundred millionth iPod. We're extremely excited about the launch of the iPhone in late June, and we continue to be very confident about the other innovative products in our pipeline.
With that, I'd like to open the call to questions.
Operator
(Operator Instructions) Your first question comes from Andrew Neff – Bear Stearns.
Andrew Neff – Bear Stearns
I wanted to follow-up on a statement you put out separately I guess from the board, talking about the situation related to the options. Can you give color as to rationale for that?
Just give us your commentary on what appears to be discrepancies between two statements? Another question, can you give us the Apple TV numbers at this point?
Peter Oppenheimer
I will answer your first question and Tim can take your second. The board, put out its statement today, to express confidence in what we have said and done.
The board said that Steve cooperated fully with Apple's independent investigation and with the government's investigation of stock option grants at Apple. The SEC investigated the matter thoroughly and its complaint speaks for itself in terms of what it says.
What it does not say -- who it charges and who it does not charge – and the board has expressed its complete confidence in the conclusion of Apple's independent investigation and in Steve's integrity and his ability to lead the company.
Tim Cook
In regard to Apple TV, we've gotten some incredible reviews from many different sources. As you know, we just started shipping on the third week in March.
We're off to a very good start and we're going to continue investing in this area. We're very, very excited about the long-term potential of the product.
Andrew Neff – Bear Stearns
Any shipment figures at this point, you said you were going to go with them going forward?
Tim Cook
We're not releasing the exact unit shipments.
Operator
Your next question comes from Shannon Cross – Cross Research.
Shannon Cross – Cross Research
Peter, if you could explain again the subscription model for the Apple TV and what the rationale is behind that?
Peter Oppenheimer
We have a proven capability to create innovative software that gives us a tremendous competitive advantage in the consumer electronic industry. We are taking this step so that we can leverage what we do best.
We believe that the results of this will be that we can surprise and delight our iPhone customers. We think they will be happier as a result and believe we'll have more of them as we enter this billion unit per year market.
Shannon Cross – Cross Research
Just a question with regard to staffing, since there was a bit of a delay on Leopard. How do you feel right now about your current staffing levels?
Ability to hire employees, was this sort of a one-time thing or are you looking to staff up at this point?
Tim Cook
We have no issue at all in hiring really great people. This is simply a matter of iPod is a very revolutionary product, it uses Mac OS as you know.
So we have always planned on using Mac OS resources to complete the iPhone. It's taking us a little more time or resources than we thought, so we made a choice and delayed Leopard.
We think it's the right choice.
Operator
Your next question comes from Rob Semple – Credit Suisse.
Rob Semple – Credit Suisse
Peter and Tim, can you walk us through the puts and takes behind the sequential decline in gross margin? The component environment outlook would probably be the most important factor to hear about.
Peter Oppenheimer
Rob, I'll make a few comments and then Tim can add on. I'm guiding gross margin down sequentially, largely as a result of the commodity pricing beginning to trend up but also, the beginning of our education buying season which we will see higher K to 12 purchases this quarter, typically at lower price points.
A couple weeks ago, we completely repriced our display line and that had an impact as well.
Rob Semple – Credit Suisse
If I could just follow-up, maybe a clarification: you talked about payments, Cingular AT&T. Are you guys getting subsidies for the phone or a percentage of the monthly service contracts that customers enter in to?
How is that relationship going to work?
Peter Oppenheimer
Rob, I'm not able to comment specifically and beyond what I said, which is that we will recognize payments from AT&T Cingular as revenue over time as earned. Tim, did you want to comment?
Tim Cook
The commodity environment last quarter was favorable as we thought it would be when we spoke in January. However, it was even more favorable than we had predicted, particularly in the memory area.
This quarter we see some commodities moving from an oversupply condition to more of a supply/demand balanced position, particularly NAND Flash and memory in general.
Rob Semple – Credit Suisse
Lastly, could I get the Cap Ex for the quarter?
Peter Oppenheimer
We had $105 million in capital for the March quarter.
Operator
Your next question comes from Gene Munster - Piper Jaffray.
Gene Munster - Piper Jaffray
Good afternoon. Back to the component pricing question, obviously you guys don't really have a history of really passing on significant benefits of the price environment to the customers and obviously the price environment might even increase a little bit for the component side.
Is it safe to say if you essentially maintain your pricing of your products that you should be having margins consistent? I know mix is in there too, but gross margins consistent with the 35% level.
Peter Oppenheimer
Gene, for the June quarter I've guided gross margins to 32%. While I'm doing that for June, I would continue to target gross margin in the 27% to 28% range on a longer term basis, despite our recent results which have benefitted from a number of factors, including a very favorable commodity environment.
Now looking forward, we are likely to see other factors which will drive gross margin down, such as a different commodity environment or product mix. We do not see the current gross margin levels as sustainable and don’t want you to count on them.
Gene Munster - Piper Jaffray
I understand you don't want us to count on them, but from a theory basis, if the pricing does stay relatively low and you guys basically maintain the pricing of your products, I know you typically lower the price of the iPods once or twice a year; but just generally maintain the price of the products, could we draw the conclusion, let’s say those factors happen, that the margins should be higher than 32%?
Peter Oppenheimer
Well again, as I commented and Tim can add on, we see commodity pricing trending up in June. We are now entering our education buying season.
The June quarter tends to be more dominated by K-12 which tends to buy our lower ASP products and we have, in fact, repriced our display line.
Gene Munster - Piper Jaffray
Historically, you guys have a phenomenon of introducing a product and there being supply constraints. Do you have any idea, I know the iPhone will come out in June, but do you think it be widely available in June or is it going to be relatively few units in June?
Any color on that front?
Tim Cook
It's very difficult to tell what the demand is until you're actually shipping the product. I think all of us have many anecdotal stories to tell, but there seems to be an enormous amount of people waiting for it and talking about it.
We really need to start shipping and make the product available for sale before we can do a reasonable job of predicting demand.
Gene Munster - Piper Jaffray
Did AT&T say they have a million orders for the iPhone?
Tim Cook
AT&T is not taking orders. They have a million people who are interested that have signed up on the website.
Gene Munster - Piper Jaffray
Do you think you could fulfill a million in the June quarter?
Tim Cook
I haven't started ramp yet so I don't want to predict what our supply would be.
Operator
Your next question comes from Harry Blount – Lehman Brothers.
Harry Blount – Lehman Brothers
Peter, I want to circle back on the subscription accounting again. At a high level, if we take the price points you guys have initially indicated of about $500 and take the 24-month straight line, if you guys were to receive the entire hardware value of that, that would be about $21 a month.
First of all, is that roughly the right number to assume per unit? Or $60 a quarter?
Or how much higher or lower in general should we be assuming for the hardware and the software? Hardware and the service, I should say.
Peter Oppenheimer
On the iPhone hand set the factors will relate to we're going to ship two models, one at $499, one at $599. We're going to sell some direct and we will sell some indirect.
Those are variables that you would want to think about. We also will sell accessories, as I indicated and I expect to receive payments from AT&T Cingular.
We will report those to you each quarter on our data summary.
Harry Blount – Lehman Brothers
The accessories will be accounted for on a period basis rather than a subscription basis, is that fair?
Peter Oppenheimer
Yes.
Harry Blount – Lehman Brothers
Peter, just in terms of attach rate on the hardware, is there a good number to use? Should we assume an incremental $5 or so for the services?
Peter Oppenheimer
Harry I'm not able to make any comments beyond what I've said about the relationship with AT&T and we also plan to sell accessories with the iPhone as we do with our iPods.
Harry Blount – Lehman Brothers
On the cash balance of $15 billion, from a shareholder perspective, it isn't a good use of capital as you well know to have that level of cash with low returns. So one of the things we've started to see with other tech companies is some leveraging the balance sheet to buy back stock.
Any plans to do anything with the cash at this point?
Peter Oppenheimer
First of all, we ended the March quarter with $12.6 billion in cash. I don't have a change in our position to share with you today.
We continue to retain our cash for our flexibility to invest in the business and we do discuss share buyback and other forms of returning cash to the shareholders with the board from time to time.
Harry Blount – Lehman Brothers
Sorry, I meant $15. Lastly back on the Apple TV subscription agreement, is this a prelude to actually moving to a subscription model to the end user?
Is that where you're setting the stage for subscription accounting on the TV product at this point?
Peter Oppenheimer
The reason that we are going to also account for Apple TV on a subscription basis is we want to provide periodically to our customers, software updates. We have a number of ideas for Apple TV.
We'll provide those to customers as they become available. That's why we're doing this.
This is a relatively new market, much like the iPod was a number of years ago. We're very excited about it over the future, and have a number of ideas.
Harry Blount – Lehman Brothers
Sure, but you don't charge for the iPod on a subscription basis, so anyway.
Operator
Your next question comes from David Bailey - Goldman Sachs.
David Bailey - Goldman Sachs
Two questions please. How should we think about the potential for a push out of iPod in front of the iPhone launch as people try to decide between one product or the other?
In the same vein, how are you thinking about the impact, the delay in Leopard might have on Mac sales in the June and September quarters?
Tim Cook
On the iPod question, the only thing I can say for certain is that in the data last quarter there was no obvious effect from iPhone on iPod. We'll just have to see how this quarter goes.
In terms of Leopard, we are shipping the best Macs we've ever shipped. The upgrade to Leopard is very simple and straightforward to do, but I am really not sure whether customers will delay or not.
David Bailey - Goldman Sachs
Given the amount of time between the iPhone announcement and the launch, does that give you any advantage as far as being able to ramp in volume before the end of June?
Tim Cook
We've been focusing very heavily on the production capability of iPhone and as you know, we bring a lot of experience into this. We did 21 million iPods in the first fiscal quarter and so we've got that same level of expertise that we're putting in place for iPhone, but I wouldn't want to predict the ramp at this point.
Operator
Your next question comes from Ben Reitzes – UBS.
Ben Reitzes – UBS
Are you going to take preorders for iPhone? Do you know yet, Peter or Tim?
Peter Oppenheimer
We're currently not taking them. We will announce later the date at which we'll begin taking orders.
Ben Reitzes – UBS
Typically your retail staff are waiting for new products much like we are, they don't know what's coming. With regard to the iPhone, is it different and are they going through training right now and/or soon to learn how to sell this whole new phone and whole new offering from Apple?
Is there an investment on your part so they're ready on day one? That’s kind of unprecedented.
Anything you can talk about there would be helpful.
Peter Oppenheimer
There's a number of things that are different. Generally speaking, as you know, we keep products very secret until they're announced.
Sometimes that limits the amount of planning that can take place on the product. iPhone is uniquely different there in that we announced it in January, and so the retail store personnel are putting a lot of energy into planning for the launch right now.
Ben Reitzes – UBS
So they'll be fully trained and aware of the all features and everything right off day one and have it all ready to go is what you're saying, basically?
Peter Oppenheimer
They're putting a lot of energy in getting ready for the launch.
Ben Reitzes – UBS
What about customer support on the back end? Is there a significant investment that you guys are making right now?
Do you think you'll have fully staffed support for the product on your end?
Peter Oppenheimer
We have award winning support that we provide today on the Mac and iPod and we're going at the iPhone with the same rigor.
Ben Reitzes – UBS
Lastly on Mac distribution, any updates with regard to the Best Buy relationship? They said it was going up to 200.
You were at 10 with Circuit City. Any more distribution partners you’d like to talk about or any progress you'd like to update us on?
Peter Oppenheimer
As you pointed out, we started with Best Buy with a half dozen or so stores; we then took it to over 50 and we have just announced taking it over to 200 which will take place by the fall. We're very, very excited to do that.
We'll be doing some unique merchandising things with them that we're excited about. I don't have an update on Circuit City pilot.
We are evaluating right now the results of it, and I believe we will be making a decision on that this quarter. In terms of overall Mac point of sales, we've been working on this worldwide and the Mac point of sales have moved from 5,800 to 8,000 on a year-over-year basis.
Ben Reitzes – UBS
Lastly, have you seen any uptick in the Creative Professional segment yet from Adobe CS3, or is that still coming?
Tim Cook
We do believe that our Pro customers have been stalling and delaying purchase. One key reason is the Creative Suite.
It has just started shipping, as you know. Generally speaking, what we've seen in the past in this area is that people, companies will buy a few units and test those and then subsequently do rollouts.
It's really too early to tell what occurs in here. However, with the Creative Suite shipping and the announcements that we made last week at NAD with Final Cut Studio and the announcements we made just a few weeks with the 8-core Mac Pro we believe that we have got an incredible lineup for our Pro customers and believe they will be very excited to get their hands on them.
Operator
Your next question comes from Tony Sakanagi - Sanford Bernstein.
Tony Sakanagi - Sanford Bernstein
Typically your revenues from Q2 to Q3 are flat to slightly up. You're guiding for them to be down, despite tremendous enthusiasm for the iPhone, for your Mac lineup which you just mentioned on the aforementioned question, and your confidence in the iPod line.
Can you talk about some of the puts and takes for revenue in your revenue guidance for next quarter?
Peter Oppenheimer
We are guiding revenue down slightly sequentially as a result of a couple factors. First last year, iPod sales declined sequentially from the March to June quarters despite supply being constrained at the beginning of the March quarter.
This year, we were in a good supply and demand balance in the March quarter, so we would expect to see a bigger sequential decline. We see this as a market seasonality issue and not an iPod specific issue.
We are very pleased with our market share. Second, it's the beginning of the education buying season, which typically sees higher K-12 purchases in the June quarter and at lower ASPs.
Tony Sakanagi - Sanford Bernstein
Is the second point any different from normal seasonality though? In the sense that don't you always see that and accordingly, if we're comparing this quarter versus previous quarters, why would that be any notably different?
Peter Oppenheimer
That is true, but really underneath this, what you're seeing is that the June quarter is not as strong from a consumer perspective. We had a really strong March quarter.
I think you may see a bit more pronounced effect this year going from March to June in part upon what we saw from the consumer sales in March and heading into the education buying season.
Tony Sakanagi - Sanford Bernstein
I also have a question about margins. I know historically you've qualitatively discussed about margins between relative categories in your business, so specifically on a qualitative basis, could you help us understand if iPod hardware margins, so just the hardware portion of iPod was higher than your Mac hardware margins this quarter?
Peter Oppenheimer
We have a long standing practice of not releasing specific gross margins; however, the corporate gross margin was over 35%, which exceeded our guidance. iPod was key in achieving that result.
Tony Sakanagi - Sanford Bernstein
I understand your policy of not specific gross margins, but historically you've given a range it was obviously much lower than it is now, at above or below 20% and you have made relative comments; so can you at least provide any further details on a relative basis, Peter?
Peter Oppenheimer
What I can tell you is that both our Mac and iPod hardware margins were quite strong in the quarter. They've both benefited from a very favorable commodity environment; but also we had better service costs and leverage from the revenue and a good mix.
Tony Sakanagi - Sanford Bernstein
On the R&D side, your revenues have been growing at about 20% a quarter. Your R&D expense has been remarkably flat for the last six quarters.
Is there an inflection point or a bend, particularly with some of the ostensible increased functionality that you're going to hope to bring in the form of software to both your Apple TV platform and your phone offerings? Should we be expecting an inflection point in R&D and why hasn't it gone up somewhat commensurately with sales, especially given all the new product initiatives that you have?
Peter Oppenheimer
First of all, we are very confident in not only in what we plan to do with iPhone and Apple TV, but also OS 10 and our applications. We have just fantastic folks in our software and hardware engineering areas.
In the last quarter or so, we have capitalized our software development. I talked about that in my prepared remarks.
So that played into this quarter. The R&D as a percent of our revenue was 3% this quarter.
It had been running at 4%, and without the capitalization you would have seen a trend that was similar to the past. The dollars are going up, just along with our revenue.
We're going to continue to invest in our business, particularly in engineering and you'll continue to see our spending go up and I think continue to see just a great flow of products from the team.
Operator
Your next question comes from Richard Gardner – Citigroup.
Richard Gardner - Citigroup
I wanted to go back to the earlier question, Peter, on passing favorable component prices through to customers. I realize it's been your longstanding practice to do this when you introduce these new products, but I was wondering why you wouldn't make an exception in an environment like the one that we're in, in the first quarter, where you had dramatic declines in prices?
Is it because you don't believe that there would be enough elasticity there to justify it? Or is it because of the intricacies of managing price protection and channel inventories and so forth?
What is your strategy there?
Timothy Cook
We believe our products are very competitively priced. If you look at the Mac, we grew at 36% year over year, this is over three times the industry growth.
If you look at it by geo it's even more incredible. The IDC was projecting a 4% growth rate for the U.S.
We grew in the Americas at 36%, so nine to ten times. IDC was projecting 5% for Europe, we grew at 38%.
This is now the ninth quarter out of the past ten that the Mac has grown over the market. The Mac seems to have enormous momentum.
If you look at iPod and look at the share that we have, we're over 70% in the U.S., we're over 60% in Australia and Canada, we're over 50% in Japan and Hong Kong, and really growing on a year-over-year basis in most of Western Europe. We feel we're very competitively priced.
Operator
Your next question comes from Richard Farmer – Merrill Lynch.
Richard Farmer – Merrill Lynch
This is a little bit of a follow-up in variation on that question and the gross margin question, but more specifically with respect to the iPod hardware business. When you talk about the factors affecting gross margin, you mentioned the education mix, the component pricing, and the display price cuts.
Are there any other factors within the iPod hardware business specifically outside of the component price environment that you mentioned that would influence your gross margin guidance? I'm thinking of things like price changes or feature capacity increases, or significant mix changes maybe within the iPod line that would cause your gross margin outlook to change outside of components?
Thanks.
Peter Oppenheimer
I'm sorry, I can't help you there. We have a longstanding practice of not talking about future products and I've given you my view of why I think gross margin will decline sequentially.
Operator
Your next question comes from Bill Shope – JP Morgan.
Bill Shope – JP Morgan
Were there any significant changes in the mix between HDD and flash-based iPods this quarter versus last? Obviously, I'm only looking for a qualitative answer there.
Peter Oppenheimer
We don't get into reporting that level of product detail, but if you look at the ASPs from the December to the March quarter, you'll see they were relatively flat.
Bill Shope – JP Morgan
On the new EMI deal you guys announced this quarter, assuming some of the other labels follow suit and you reach the target that Steve had mentioned for the end of the year for DRM-free music, will the economics of iTunes change in any way from a margin perspective, given the increased price for higher quality tracks?
Peter Oppenheimer
Our philosophy has been to run the music store just a little bit over breakeven because we think that selling music and now videos, helps us to sell iPods and accessories. So that's been our strategy and Tim just walked you through some of the results and the growth that we've seen around the world in iPod.
I think the strategy is working extremely well.
Operator
Your next question comes from Bill Fearnley - FTN Midwest.
Bill Fearnley - FTN Midwest
On the channel side, could you give an update on the direct sales versus the indirect mix? Did the mix of direct versus indirect help margin in the quarter?
Peter Oppenheimer
Bill, the direct sales, which we define as sales through the retail stores, online, direct to education and enterprise customers and through the music store, were 50% in the quarter and that was reasonably close to our expectations.
Bill Fearnley - FTN Midwest
Also on the iPod, if I could ask another question, you've been thinking about revenue by geography and the opportunity for iPod outside the United States. Could you give some additional color on how the iPod did outside the U.S.
and how it did versus your expectations? And sort of the same thing for the Mac, as well?
I see the revenue and things like that by geography, but if you could add additional color on the product side, even directionally, that would be helpful.
Timothy Cook
I'll repeat some of the things I said before and then add a few other things. On the Mac point of view, we're growing at a significant multiple of the market in the U.S., in Europe and in Asia Pacific.
Asia Pacific is our fastest-growing region. It grew at 89% year over year.
The IDC projection for Asia Pacific was only 14%. That's over six times the market.
I mentioned before the U.S. and Europe numbers, and so essentially in every major geography outside of Japan, the Mac is growing at a multiple of the market and not just for one quarter, but in fact, a substantial number of quarters as I'd mentioned before.
As we've gotten out of the Intel transition, in fact, we've been over three times the market growth for the last three quarters. September was 30%, December was 28%, March was 36%.
We're doing really, really well. On the iPod, like the Mac, we're doing very well outside the U.S.
I covered briefly some of the share numbers, but we're now over 60% in Australia and Canada in share, we continue to be over 50% in Japan, we've now gone over 50% in Hong Kong, we are in the 40% to 50% range in the U.K., in Switzerland, in Singapore, in Denmark. We hit a high in Germany of 28% in the most recent numbers.
So pretty much everywhere you look on a year-over-year basis, you would see really good progress. We are very pleased with it.
Bill Fearnley - FTN Midwest
One more question on the Mac, if I could. Do you expect the Mac Pro to have a positive effect on Mac ASPs here in the upcoming quarter at all?
Peter Oppenheimer
Bill, we don't forecast ASPs or product level results, but as Tim commented, we're very excited about our new Mac Pro introduction and all the Apple and developer software that goes with it. So we certainly are expecting good things going forward.
Operator
Your next question comes from Kevin Hunt - Thomas Weisel Partners.
Kevin Hunt - Thomas Weisel
A follow-up on the earlier question about seasonality. I think over the last couple quarters, you've given some seasonality on both the iPod and the Macs.
Maybe you could help us understand that a little bit better for the June quarter in terms of what the normal declines or increases would be? Also, is the Leopard push out any part of the reason why you might be being more cautious on the Mac side of things?
Peter Oppenheimer
Let me start with your Mac and iPod question. For Macs, sales have typically increased from the March to June quarters, but at lower ASPs as a result of the education buying season beginning.
The June quarter typically sees higher K-12 sales, while the September quarter tends to see stronger higher education sales. But the June and September quarters are really our bigger education selling seasons.
For the iPod, as I commented before, the June quarter is usually seasonally the weakest from a consumer perspective. Last year we saw iPod sales decline sequentially from the March to June quarters despite there being some constraints in the beginning of the March quarter.
This year we were in good supply and demand balance throughout the March quarter and so we'd expect to see a bigger sequential decline. But we view this as a seasonality issue and not an iPod specific issue.
As Tim has commented now twice, we couldn't be happier with our market share results.
Kevin Hunt - Thomas Weisel
On the iTunes store, can you give us any kind of milestone update of where you stand on number of music and video downloads to date?
Peter Oppenheimer
I don't have anything new to share with you beyond what we've recently put out and you can find that on the website. I'm sorry.
Operator
Your next question comes from Ingrid Ebeling - JMP Securities.
Ingrid Ebeling - JMP Securities
A couple things on the iPhone. Can you give an update on the timing of the iPhone outside the United States?
Timothy Cook
Yes. We still plan to be in Europe in the fourth calendar quarter of this year and we continue to plan to be in Asia in 2008.
Ingrid Ebeling - JMP Securities
In terms of distribution in the U.S. with the iPhone, it will be exclusive with AT&T Cingular and Apple, or will other Cingular partners be distributing the product such as Best Buy or Radio Shack or what not?
Timothy Cook
It will be sold through Cingular stores, the Cingular.com, Apple.com and Apple retail stores.
Ingrid Ebeling - JMP Securities
Can you please repeat the statistics you gave on market share for the iPods?
Timothy Cook
Sure. What I said was that the U.S.
is over 70%, Australia and Canada are over 60%, Japan and Hong Kong are over 50%, the U.K., Switzerland, Singapore, and Denmark are over 40%. All of those data points are GFK data points, I think, with the exception of the U.S., which is MPD.
Operator
Your next question comes from Ben Boland - Cleveland Research.
Ben Boland - Cleveland Research
I was hoping to get a better understanding of the internal design strategy. Given the more favorable component pricing environment, substantial price declines you've seen in the NAND flash over the last several quarters, has that had an influence on how you look at product design and kind of what you look at in terms of introducing in the future?
Timothy Cook
Ben, as you know, we don't really comment on our future product plans.
Ben Boland - Cleveland Research
Could you give us a read on what percent of industry music sales were digital in the quarter? I think last quarter it was around 11% or 12%.
Could you say where that's trending now? As that grows as a percentage of total music sales, could you explain if there's any influence to the royalty rates you pay to the music companies?
Peter Oppenheimer
We do not talk about our agreements with the music companies so I'm sorry, we can't help you there. I've not seen the most recent quarter’s digital percent of total sales, but the trend is going up.
Here in the United States our market share of legally purchased and downloaded music is over 85%. We're seeing very strong growth on the iTunes music store I think based upon its great merchandising and its seamless integration with the iPod.
Ben Boland - Cleveland Research
What was depreciation in the quarter?
Peter Oppenheimer
I don't have that handy. Maybe Nancy can grab it.
Why don't we go to the next question and I'll give it to you in the next answer.
Operator
Your next question comes from Shaw Wu - American Technology.
Shaw Wu - American Technology Research
First on Japan. Japan continues to somewhat lag, it's been flat three quarters in a row.
What's going on there, and what are you going to do to address it? On your expenses, Peter, you are guiding expenses up quite a bit sequentially.
You talked about iPhone related expenses. A little more color in terms of what types of programs and promotions you plan to do there?
Timothy Cook
In terms of Japan it is a very challenging market for us. The Japan PC market according to IDC contracted by 2% last quarter.
That's identical to what we did in terms of iPod and the MP3 market, we've maintained an over 50% share for some time; however, the MP3 market itself isn't growing, so our units as a consequence are growing very small single-digit. That coupled with an ASP decline in iPod produces a negative revenue compare year over year.
We have a number of things going with the channels on merchandising, we're running Macintosh, the Mac/PC ad on television, so we have a series of things that we're doing to try to turn things around. It is literally the only major market in the world that we're not doing well in.
It is very frustrating.
Peter Oppenheimer
Shaw, let me first answer Ben's question, the depreciation and amortization in the March quarter was about $69 million. In terms of OpEx, we remain very confident in our business and products.
We're continuing to invest for long-term growth, including this quarter in the launching of the iPhone in late June and Apple TV this past quarter. We are increasing spending in our engineering areas, our retail stores, and also increasing other marketing and advertising programs, and of course, seeing some increased expenses related to the higher revenue and stock-based compensation.
Operator
The final question today will come from Chris Whitmore - Deutsche Bank.
Chris Whitmore - Deutsche Bank
It looks like Mac channel inventory levels were down a bit versus last quarter. Can you quantify the impact of that inventory reduction on Mac unit sales during the quarter?
Secondly, is there any reason why you're taking those inventory levels down?
Timothy Cook
Chris, we started the quarter in the three to four week range. We ended in the three to four week range and the absolute number of units were very similar from beginning to end.
Chris Whitmore - Deutsche Bank
I apologize, I must have had a bad piece of data there from last call. Second question relates to cash margins on iPhone versus the company average or versus the iPod.
Is it fair to say that you expect the iPhone to have higher cash margins than the core business?
Peter Oppenheimer
We're not making financial projections at an individual product line and Chris, we have not yet shipped the product. So we're very excited about iPhone and bringing our great hardware and software design capabilities to this market.
We believe that we can really delight customers and we can't wait to launch the products and have customers get their hands on it.
Nancy Paxton
A replay of today's call will be available as a podcast on the iTunes store, as a webcast on apple.com/investor, and via telephone. The number for the telephone replay is 719-457-0820.
Confirmation code is 8958004. These replays will be available beginning at approximately 5:00 p.m.
Pacific time today. Members of the press with additional questions can contact Steve Dowling at 408-974-1896 and financial analysts can contact Joan Hoover or me with additional questions.
Joan's at 408-974-4570 and I'm at 408-974-5420. Thanks again for joining us.
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