stores as of September 25, 2004 and 65 open stores as of September 27, 2003. 

Net sales of the Retail segment grew to $2.4 billion during 2005 from $1.2 billion and $621 million in 2004 and 2003, respectively. The increases in net sales during both 2005 and 2004 reflect the impact of new store openings for each year, including the opening of 38 new stores in 2005 and 21 new stores in 2004. An increase in average revenue per store also contributed to the segment’s strong sales in 2005. With an average of 105 stores open during 2005, the Retail segment achieved annualized revenue per store of approximately $22.4 million, as compared to $15.6 million in 2004 with a 76 store average, and $11.5 million in 2003 with a 54 store average. 

As measured by the Company’s operating segment reporting, the Retail segment reported operating income of $151 million during 2005 as compared to operating income of $39 million during 2004 and an operating loss of $5 million during 2003. This improvement is primarily attributable to the segment’s year-over-year increase in average revenue per store, the impact of opening new stores, and the segment’s year- over-year increase in net sales, which resulted in higher leverage on occupancy, depreciation, and other fixed costs. 

Expansion of the Retail segment has required and will continue to require a substantial investment in fixed assets and related infrastructure, operating lease commitments, personnel, and other operating expenses. Capital expenditures associated with the Retail segment were $132 million in 2005, bringing the total capital expenditures since inception of the Retail segment to approximately $529 million. As of

September 24, 2005, the Retail segment had approximately 3,673 employees and had outstanding operating lease commitments associated with retail store space and related facilities of approximately $606 million. The Company would incur substantial costs should it choose to terminate its Retail segment or close individual stores. Such costs could adversely affect the Company’s results of operations and financial condition. 

Gross Margin 

Gross margin increased in 2005 to 29.0% of net sales from 27.3% of net sales in 2004.

to more favorable pricing on certain commodity components including LCD flat-panel

margin software sales; a favorable shift in direct sales related primarily to the Company’s Retail and online stores; and higher overall revenue that provided for more leverage on fixed production costs. These increases to gross margin were partially offset by an increase in lower margin iPod sales. 

The Company anticipates that its gross margin and the gross margin of the overall personal computer and consumer electronics industries will remain under pressure in light of price competition, especially for the iPod product line. The Company expects gross margin percentage to decline in the first quarter of 2006 primarily as a result of a shift in the mix of revenue toward lower margin products such as the iPod and content from the iTunes Music Store. 

The foregoing statements regarding the Company’s expected gross margin are forward-looking. There can be no assurance that current gross