<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-Q
(Mark One)
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended April 1, 2000
OR
[_] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from __________ to _________
Commission File No. 000-29715
----------------
eMachines, Inc.
(Exact Name of Registrant as Specified in its Charter)
Delaware 943311182
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
14350 Myford Road, Suite 100, Irvine, California 92606
(714) 481-2828
(Address, including zip code, and telephone number, including area code,
of Registrant's principal executive offices)
----------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]
As of May 1, 2000, there were 144,871,190 shares of the registrant's
Common Stock outstanding.
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eMachines, Inc.
INDEX
PART I--FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Page
----
<C> <S> <C>
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets at April 1, 2000 and
December 31, 1999.............................................. 3
Condensed Consolidated Statements of Operations for the
Quarters Ended April 1, 2000 and March 31, 1999................ 4
Condensed Consolidated Statements of Cash Flows for the
Quarters Ended April 1, 2000 and March 31, 1999................ 5
Notes to Condensed Consolidated Financial Statements........... 6
Management's Discussion and Analysis of Financial Condition and
Item 2. Results of Operations.......................................... 9
Item 3. Quantitative and Qualitative Disclosure About Market Risk...... 28
PART II--OTHER INFORMATION
Item 1. Legal Proceedings.............................................. 30
Item 2. Changes in Securities and Use of Proceeds...................... 31
Item 3. Defaults Upon Senior Securities................................ 31
Item 4. Submission of Matters to a Vote of Security Holders............ 31
Item 5. Other Information.............................................. 32
Item 6. Exhibits and Reports on Form 8-K............................... 32
A. Exhibits....................................................... 32
B. Reports on Form 8-K............................................ 32
Signature............................................................... 33
Exhibit Index........................................................... 34
</TABLE>
In this Report, "eMachines," the "Company," "we," "us" and "our"
collectively refers to eMachines, Inc. and its wholly-owned subsidiaries,
unless the context otherwise requires.
2
<PAGE>
PART I
Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
eMachines, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
April 1, 2000 and December 31, 1999
(in thousands, except share information)
<TABLE>
<CAPTION>
April 1, December 31,
2000 1999
-------- ------------
<S> <C> <C>
ASSETS
------
Current assets:
Cash and cash equivalents............................. $303,105 $114,823
Short-term investments................................ -- 19,897
Accounts receivable, less allowances ($3,168 at April
1, 2000 and $2,160 at December 31, 1999)............. 119,795 123,726
Inventories........................................... 68,934 65,260
Prepaid and other current assets...................... 4,389 3,992
-------- --------
Total current assets................................ 496,223 327,698
Property and equipment, net............................. 2,736 1,827
Intangible assets....................................... 136,630 --
Other assets............................................ 8,258 2,188
-------- --------
$643,847 $331,713
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)
-------------------------------------------------
Current liabilities:
Trade payables-related party.......................... $122,466 $131,935
Accounts payable...................................... 11,479 12,939
Accrued rebates....................................... 30,429 22,803
Accrued expenses and other current liabilities........ 28,392 19,855
-------- --------
Total current liabilities........................... 192,766 187,532
Deferred revenue--noncurrent portion.................... 2,050 1,343
-------- --------
Subordinated notes payable to stockholders.............. 560 560
-------- --------
Redeemable convertible preferred stock--Series A; $.01
par value; no shares authorized, issued and outstanding
at April 1, 2000; 25,000,000 shares authorized and
24,279,369 shares outstanding at December 31, 1999..... 150,014
-------- --------
Stockholders' equity (deficiency):
Preferred stock, $.01 par value; 35,000,000 shares
authorized; no shares issued and outstanding at April
1, 2000 and December 31, 1999........................
Common stock, $.0000125 par value; 350,000,000 shares
authorized; 144,864,342 and 78,019,538 shares
outstanding at April 1, 2000 and December 31, 1999,
respectively......................................... 2 1
Additional paid-in capital............................ 474,592 6,582
Unearned stock compensation........................... (1,458) (1,550)
Notes receivable from stockholders.................... (500) (500)
Accumulated deficit................................... (24,165) (12,269)
-------- --------
Total stockholders' equity (deficiency)............. 448,471 (7,736)
-------- --------
$643,847 $331,713
======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
3
<PAGE>
eMachines, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
Quarters ended April 1, 2000 and March 31, 1999
(in thousands, except share information)
<TABLE>
<CAPTION>
Quarter Ended
---------------------------
April 1,
2000 March 31, 1999
----------- --------------
<S> <C> <C>
Net revenues:
Hardware......................................... $ 246,443 $ 137,434
Internet......................................... 3,397 --
----------- ----------
Net revenues................................... 249,840 137,434
----------- ----------
Cost of revenues:
Hardware......................................... 234,979 131,101
Internet......................................... 353 --
----------- ----------
Cost of revenues............................... 235,332 131,101
----------- ----------
Gross Profit..................................... 14,508 6,333
Operating expenses:
Sales and marketing (includes $22 of non-cash
stock-based compensation in 2000)............... 6,060 2,719
Product development.............................. 512 --
Services and operations.......................... 313 --
Customer service and technical support........... 3,775 949
General and administrative (includes $69 and $41
of non-cash stock-based compensation in 2000 and
1999, respectively)............................. 5,101 1,147
Amortization of intangible assets................ 10,196 --
----------- ----------
Total operating expenses....................... 25,957 4,815
----------- ----------
Income (loss) from operations...................... (11,449) 1,518
Interest income (expense), net..................... 1,899 (2,390)
----------- ----------
Net loss........................................... (9,550) (872)
Accretion of mandatorily redeemable preferred stock
to redemption value............................... (2,346) --
----------- ----------
Net loss attributable to common stockholders....... $ (11,896) $ (872)
=========== ==========
Net loss per share attributable to common
stockholders:
Basic and diluted................................ $ (0.13) $ (0.02)
Shares used in computing net loss per share
attributable to common stockholders:
Basic and diluted................................ 88,216,680 57,600,000
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE>
eMachines, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
Quarters ended April 1, 2000 and March 31, 1999
(in thousands)
<TABLE>
<CAPTION>
Quarter Ended
----------------------------
April 1, 2000 March 31, 1999
------------- --------------
<S> <C> <C>
Cash flows from operating activities:
Net loss........................................ $ (9,550) $ (872)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Provision for bad debts and sales returns..... 1,008 561
Depreciation and amortization................. 10,406 33
Stock-based compensation expense.............. 91 41
Changes in operating assets and liabilities:
Accounts receivable........................... 3,730 (13,309)
Inventories................................... (2,009) (11,772)
Prepaid and other current assets.............. 727 67
Other assets.................................. (297) (7)
Trade payables-related party.................. (9,470) 18,260
Accounts payable.............................. (3,480) 2,621
Accrued rebates............................... 7,626 3,614
Accrued expenses and other current
liabilities.................................. 3,666 1,515
Deferred revenue--non current portion......... 707 562
-------- --------
Net cash provided by operating activities... 3,155 1,314
-------- --------
Cash flow from investing activities:
Cash acquired in business combination........... 5,651 --
Cash provided upon maturity of short-term
investments.................................... 19,897 --
Other assets.................................... (5,750) --
Acquisition of property and equipment........... (140) (661)
-------- --------
Net cash provided (used) in investing
activities................................. 19,658 (661)
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock in
connection with initial public offering, net of
offering costs................................. 165,149 --
Proceeds from issuance of common stock upon
exercise of common stock options............... 320 --
-------- --------
Net cash provided by financing activities... 165,469 --
-------- --------
Net increase in cash.............................. 188,282 653
Cash and cash equivalents, beginning of period.... 114,823 3,791
-------- --------
Cash and cash equivalents, end of period.......... $303,105 $ 4,444
======== ========
</TABLE>
Supplemental disclosure of noncash financing activities:
During the quarter ended April 1, 2000, the Company acquired FreePC, Inc. in
a non-cash transaction by issuing equity securities and assuming stock options
with an aggregate value of approximately $150,000. The total purchase price of
$150,182 was allocated to the net assets acquired and intangible assets as
described in Note 2--Business Combination.
During the quarter ended April 1, 2000, in connection with the Company's
initial public offering of common stock, all of the Company's preferred stock
converted into common stock. The preferred stock had a book value of $152,360
on the conversion date. See Note 3--Stockholder's Equity.
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
eMachines, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share information)
NOTE 1--BASIS OF PRESENTATION
The condensed consolidated financial statements include the accounts of
eMachines, Inc. and its subsidiary (the "Company"). All significant
intercompany balances and transactions have been eliminated in consolidation.
The interim condensed consolidated financial statements are unaudited. In the
opinion of management, the interim condensed consolidated financial statements
include all adjustments, consisting of only normal, recurring adjustments,
necessary for a fair presentation of the Company's financial position, results
of operation and cash flows. In the fourth quarter of 1999, the Company adopted
a fiscal-year convention for its year-end and quarter ends. Accordingly, the
fiscal year end for 2000 is the 52 or 53-week period ending on the Saturday
nearest December 31, and the fiscal quarters end on the thirteenth Saturday of
the quarterly period. This Quarterly Report on Form 10-Q should be read in
conjunction with the Company's audited financial statements contained in the
Company's final prospectus filed in connection with its registration statement
on Form S-1 (File No. 333-86219) on March 24, 2000. The interim results
presented herein are not necessarily indicative of the results of operations
that may be expected for the full fiscal year ending December 30, 2000, or any
other future period.
NOTE 2--BUSINESS COMBINATION
Effective January 14, 2000, the Company acquired FreePC, Inc. ("FreePC"). In
connection with the acquisition, the Board of Directors amended and restated
the Company's certificate of incorporation to designate 14,000,000 and
11,000,000 shares of its 50,000,000 shares of authorized preferred stock as
Series B preferred stock and Series C preferred stock, respectively. To
consummate the merger the Company issued 3,995,633 shares of common stock,
10,175,516 shares of Series B preferred stock, 7,458,370 shares of Series C
preferred stock, and warrants to purchase 9,269,834 shares of the Company's
common stock, in exchange for all of the outstanding shares of capital stock of
FreePC. In addition, the Company reserved 4,130,342 shares of its common stock
for issuance upon the exercise of 2,891,275 FreePC and Guide.com (a predecessor
of FreePC) common stock options assumed in connection with the acquisition,
plus 1,239,067 warrants issuable upon exercise of the options. The exchange
ratio was approximately 1.1 shares of the Company's capital stock and warrants
to purchase approximately 0.47 shares of the Company's common stock. The
transaction was accounted for using the purchase method of accounting. The
purchase price, based on an independent valuation, was approximately $150,182,
including approximately $182 for professional fees. The fair value of the
securities exchanged or assumed in connection with the acquisition was as
follows:
<TABLE>
<S> <C>
Common and preferred stock......................................... $135,600
Common stock warrants.............................................. 1,100
Options assumed, including warrants issuable upon exercise......... 13,300
--------
$150,000
========
</TABLE>
With respect to the options assumed as part of the acquisition, all vested
and unvested FreePC options exchanged for Company options are included as part
of the purchase price. The total estimated purchase price for the FreePC
acquisition has been allocated as follows to assets and liabilities based on
management's best estimates of their fair value with the excess costs over the
net assets acquired of $141,626 being allocated to goodwill.
<TABLE>
<S> <C>
Workforce.......................................................... $ 5,300
Goodwill........................................................... 141,626
Fair value of net assets........................................... 3,256
--------
$150,182
========
</TABLE>
6
<PAGE>
eMachines, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(in thousands, except share information
The intangible assets resulting from the purchase transaction are being
amortized over their estimated useful lives of three years using the straight-
line method.
The operating results of FreePC are included in the Company's condensed
consolidated financial statements from the date of acquisition. The unaudited
pro forma consolidated information set forth below presents the consolidated
results of operations as if the acquisition had occurred at the beginning of
the periods presented.These unaudited pro forma consolidated results have been
prepared for comparative purposes only and do not purport to be indicative of
what would have occurred if the acquisition had taken place at the beginning of
the period presented or the results that may occur in the future.Unaudited pro
forma consolidated results of operations for the quarters ended April 1, 2000
and March 31, 1999 are as follows:
<TABLE>
<CAPTION>
Quarter Ended
----------------------------
April 1, 2000 March 31, 1999
------------- --------------
<S> <C> <C>
Revenues......................................... $ 249,896 $ 137,480
Net loss attributable to common stockholders..... (14,729) (14,228)
Net loss per share attributable to common
stockholders:
Basic and diluted.............................. $ (0.17) $ (0.23)
Shares used in computing pro forma net loss per
share attributable to common stockholders:
Basic and diluted.............................. 88,737,849 61,595,633
</TABLE>
NOTE 3--STOCKHOLDERS' EQUITY
On March 24, 2000 the Company completed its initial public offering of
20,000,000 shares of the Company's common stock for proceeds of $180,000 before
$14,851 in offering costs. Upon completion of the offering all outstanding
shares of preferred stock, totaling 41,913,255 shares were converted one for
one into common shares. The outstanding preferred stock included 24,279,369
shares of Series A preferred stock issued for the Company's private placement
financing and 10,175,516 shares of Series B preferred stock and 7,458,370
shares of Series C preferred stock issued for the acquisition of FreePC. After
completion of the offering, the number of shares of common stock and preferred
stock that the Company's Board of Directors is authorized to issue was
increased pursuant to its Amended and Restated Certificate of Incorporation.
The number of shares of common stock was increased from 250,000,000 to
350,000,000 and the number of shares of preferred stock was increased from
25,000,000 to 35,000,000.
Concurrent with the completion of the initial public offering of the
Company's common stock, the exercise price and number of shares that may be
purchased was established for the warrants that were granted to America Online
("AOL") in connection with a marketing agreement between the Company and AOL
entered into in June 1999. The exercise price was calculated to be $11.25 per
share by multiplying 1.25 times the initial public offering price of $9.00. The
number of shares that may be purchased was calculated to be 1,111,111 shares by
dividing the aggregate exercise price of $12,500 by the exercise price of
$11.25 per share. The exercise price for the 1,239,067 warrants that were
issued to former stockholders of FreePC in connection with the acquisition of
FreePC is $17.13 per share.
NOTE 4--LITIGATION
In July 1999, Compaq Computer Corporation filed a complaint against the
Company, TriGem Computer, TriGem America and Korea Data Systems as defendants
in the U.S. District Court for the Southern District of
7
<PAGE>
eMachines, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(in thousands, except share information
Texas based on the defendants' alleged infringement of 13 patents held by
Compaq related to improved system processing speed, enhanced video graphics,
peripheral compatibility and overall system architecture. The complaint seeks
an accounting, treble damages, a preliminary and permanent injunction from
further alleged infringement, attorneys' fees and other unspecified damages.
The Company filed a response in September 1999, seeking declaratory judgment of
noninfringement and invalidity of Compaq's patents and asserting counterclaims
against Compaq that included false and misleading advertising under the Lanham
Act, business disparagement and unfair competition under Texas common law.
Packard Bell filed a complaint on October 6, 1999 in Federal District Court
for the Eastern District of California, alleging patent infringement on Packard
Bell patents which it asserts relates to (i) graphics controller, (ii) parallel
port controller, and (iii) bus interface of the Company's eTower machine. The
Company filed a response in January 2000 disputing infringement and asserting
that the patents at issue are invalid.
In October 1999, David Packard on behalf of a putative nationwide class,
filed a complaint against the Company as a defendant in the U.S. District Court
for the Eastern District of Texas based on the Company's alleged sale of
defective goods. Essentially identical complaints were filed contemporaneously
against Compaq, Hewlett-Packard and Packard Bell. The complaints claim that a
chip in the defendants' respective PC products contains a defect, which may
cause an error to occur when information is written to a floppy disk. The
complaint seeks unspecified monetary damages, injunctive relief and declaratory
relief. Although a response to the complaint has not been filed, the Company
believes that it has meritorious defenses and intends to vigorously defend
itself in this action.
All of these cases are currently in the early stages of discovery. As a
result, the Company is currently unable to estimate total expenses, possible
loss or range of loss that may be ultimately connected with these allegations.
The Company is indemnified against liability under the terms of its PC supply
agreement with respect to the Compaq and Packard Bell complaints. However,
there can be no assurance that the plaintiffs involved in these three cases
will not succeed in obtaining monetary damages or an injunction against the
production of the Company's PC products. The Company's defense of the claims
could result in significant expenses and diversion of management's attention
and other resources. The Company believes in the Compaq Computer Corporation
and Packard Bell cases that its direct financial exposure is limited under its
indemnification arrangements. However in each of the three cases discussed
above, the results of complex litigation of this sort are inherently uncertain
and difficult to predict and there can be no assurances that the results of
this litigation would not result in the Company's business being significantly
harmed, particularly if it affects production of the Company's PCs.
Various other lawsuits, claims and proceedings have been or may be asserted
against the Company, including those related to product liability, intellectual
property, Internet content, privacy, safety and health and employment matters.
Litigation is expensive and time consuming regardless of the merits of the
claim and could divert management's attention from the Company's business.
Moreover, the Company cannot predict the outcome of any litigation. Some
lawsuits, claims or proceedings may be disposed of unfavorably and the Company
may incur significant costs defending itself.
8
<PAGE>
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This report on Form 10-Q contains forward-looking statements based on our
current expectations, estimates and projections about our industry,
management's beliefs and certain assumptions made by us. Words such as
"anticipate," "expect," "intend," "plan," "believe," "may," "will" or similar
expressions are intended to identify forward-looking statements. In addition,
any statements that refer to expectations, projections or other
characterizations of future events or circumstances, including any underlying
assumptions, are forward-looking statements. Such statements are not guarantees
of future performance and are subject to certain risks, uncertainties and
assumptions that are difficult to predict. Therefore, our actual results could
differ materially and adversely from those expressed in any forward-looking
statements as a result of various factors. The section entitled "Risks That
Could Affect Our Financial Condition and Results of Operations" set forth in
this Form 10-Q and similar discussions in the final prospectus in connection
with our registration statement on Form S-1 (File No. 333-86219) discuss some
of the important risk factors that may affect our business, results of
operations and financial condition. You should carefully consider those risks,
in addition to the other information in this report and in our other filings
with the SEC, before deciding to invest in our company or to maintain or
increase your investment. We undertake no obligation to revise or update
publicly any forward-looking statements for any reason. The information
contained in this Form 10-Q is not a complete description of our business or
the risks associated with an investment in our common stock. We urge you to
carefully review and consider the various disclosures made by us in this report
and in our other reports filed with the SEC that discuss our business in
greater detail.
Overview
We sell high-quality, low-priced personal computers, or PCs, to develop
ongoing Internet-based consumer relationships designed to provide us with a
continuous stream of advertising and related revenues. We provide Internet
advertisers with an integrated approach to building their online brands that
includes our client-server software, promotional materials packaged with our
PCs and keyboards that provide one-touch access to selected Web sites. We were
incorporated in September 1998 and sold our first PC in November 1998. We
intend to aggressively pursue recurring revenue generating opportunities that
extend beyond the purchase of the PC or other Internet connected devices. To
this end, in January 2000, we acquired FreePC, Inc., a Bill Gross' idealab!
Company, that was one of the first companies to subsidize the purchase price of
the PC and Internet access with advertising sponsorships. Our acquisition of
FreePC's expertise and technical experience is a key element of our strategy to
enhance our Internet revenues.
We outsource the design and manufacturing of our PCs and monitors as well as
technical support, warehouse staffing, inspection, repair and repackaging of
returned PCs, and administration of our rebate program to third parties. As a
result, we have a relatively small internal organization that consisted of 140
employees as of April 1, 2000. Our hardware outsourcing strategy enables us to
minimize capital investment, maintain a low product cost structure and respond
quickly to market changes.
To date, we have derived substantially all of our revenues from the sales of
PCs and monitors to a limited number of large retailers. For the quarter ended
April 1, 2000, approximately 55.7% of our gross revenues were from sales of PCs
and monitors to our three largest retail customers. We expect to continue to
derive a significant percentage of our gross revenues from sales of PCs and
monitors to a limited number of leading retailers, as well as an increasing
portion from Internet-related activities.
We operate primarily in the United States. To date, all of our sales and
substantially all of our purchases from our suppliers have been made in U.S.
dollars. As a result, changes in currency exchange rates do not generally have
a direct effect on our operating results. However, we do face foreign business,
political and economic risks because our supply of PCs and monitors are
manufactured outside of the United States. In addition, changes in currency
exchange rates may affect the cost of the PCs and monitors we purchase from our
foreign suppliers, thereby indirectly affecting consumer demand for our
products and our net revenues. We intend to expand our sales outside of North
America.
9
<PAGE>
Our gross margins on hardware are affected by fluctuations in demand for our
products, the mix of products sold, the timing of new product implementations,
new product introductions by us and our competitors, changes in our pricing
policies and those of our competitors and component costs. In the future, our
gross margins may also be affected by fluctuations in demand for our Internet-
related services.
Our founding stockholders were Stephen A. Dukker, our Chief Executive
Officer, President and a member of our board of directors, and two wholly-owned
U.S. subsidiaries of Korean PC and monitor manufacturers--TriGem Corporation
and Korea Data Systems America. TriGem Computer, the parent corporation of
TriGem Corporation, manufactures all of our eTower PCs and eMonster PCs.
Historically, Korea Data Systems Co. Ltd., the parent corporation of Korea Data
Systems America, manufactured our eOne PCs and eSlate notebook PCs and,
together with the Taiwanese manufacturer Jean Company, all of our monitors. In
the future, we plan to establish supply relationships with other PC and monitor
manufacturers. Historically, we purchased substantially all of our PCs and
monitors from KDS USA, a company wholly-owned by Lap Shun Hui, which in turn
purchased them from these manufacturers. Mr. Hui is a member of our board of
directors and one of our stockholders. On January 24, 2000, we entered into a
supply agreement with TriGem Computer pursuant to which we will purchase all of
our TriGem-manufactured PCs directly from TriGem Computer.
In January we completed our acquisition of FreePC issuing 3,995,633 shares
of our common stock and 17,633,886 shares of our convertible preferred stock
for all of the outstanding shares of capital stock of FreePC. In addition, we
issued warrants to purchase 9,269,834 shares of common stock. We also assumed
options exercisable for 2,891,275 shares of common stock with warrants to
purchase an additional 1,239,067 shares of common stock upon exercise of the
options. As a result of the acquisition, each share of FreePC capital stock
issued or subject to an option to purchase FreePC common stock was exchanged
for approximately 1.10 shares of our common stock and a warrant to purchase
approximately 0.47 shares of our common stock. We accounted for the acquisition
using the purchase method. In connection with the FreePC acquisition, we
recorded approximately $147 million of intangible assets, the amortization of
which will adversely affect our earnings and profitability in 2000 through
2002.
In March 2000 we successfully completed our initial public offering of
common stock generating net proceeds to the company of $165.1 million. Upon the
completion of our public offering all 24,279,369 shares of our Series A
preferred stock were converted one for one into common stock and all 17,633,886
shares of preferred stock issued in our acquisition of FreePC were converted
one for one into common stock.
10
<PAGE>
Results of Operations
The following table sets forth a reconciliation of our net loss attributable
to common stockholders to income (loss) before non-cash charges for
amortization of intangible assets, stock-based compensation and accretion of
mandatorily redeemable preferred stock to redemption value.
<TABLE>
<CAPTION>
Quarter Ended
-----------------------------
April 1, 2000 March 31, 1999
------------- --------------
<S> <C> <C>
Net loss attributable to common
stockholders................................ $ (11,896) $ (872)
Amortization of intangible assets............ 10,196 --
Non-cash stock-based compensation............ 91 41
Accretion of mandatorily redeemable preferred
stock to redemption value................... 2,346 --
------------ ----------
Income (loss) before amortization of
intangible assets, non-cash stock-based
compensation and accretion of mandatorily
redeemable preferred stock to redemption
value....................................... $ 737 $(831)
============ ==========
Income (loss) per share before amortization
of intangible assets, non-cash stock-based
compensation and accretion of mandatorily
redeemable preferred stock to redemption
value:
Basic...................................... $ 0.01 $ (0.01)
Diluted.................................... $ 0.01 $ (0.01)
Shares used in computing income (loss) before
amortization of intangible assets, non-cash
stock-based compensation and accretion of
mandatorily redeemable preferred stock to
redemption value:
Basic...................................... 88,216,680 57,600,000
Diluted.................................... 126,050,426 57,600,000
</TABLE>
11
<PAGE>
In conjunction with the preceding reconciliation, the following table sets
forth for the periods indicated, the percentage of consolidated net revenues
represented by certain items in the Company's condensed consolidated statements
of operations. The percentages of consolidated net revenues exclude non-cash
charges for amortization of intangible assets, stock-based compensation and
accretion of mandatorily redeemable preferred stock to redemption value.
Percentage of Consolidated Net Revenue
<TABLE>
<CAPTION>
Quarter Ended
----------------------------------
April 1, 2000(1) March 31, 1999(2)
---------------- -----------------
<S> <C> <C>
Net revenues:
Hardware............................... 98.6% 100.0%
Internet............................... 1.4 --
----- -----
Net revenues......................... 100.0 100.0
----- -----
Cost of revenues:
Hardware............................... 94.1 95.4
Internet............................... 0.1 --
----- -----
Cost of revenues..................... 94.2 95.4
----- -----
Gross Profit........................... 5.8 4.6
Operating expenses:
Sales and marketing.................... 2.5 2.0
Product development.................... 0.2 --
Services and operations................ 0.1 --
Customer service and technical
support............................... 1.5 0.7
General and administrative............. 2.0 0.8
----- -----
Total operating expenses............. 6.3 3.5
----- -----
Income (loss) from operations............ (0.5) 1.1
Interest income (expense), net........... 0.8 (1.7)
----- -----
Income (loss) before accretion of
mandatorily redeemable preferred stock
to redemption value..................... 0.3% (0.6)%
===== =====
</TABLE>
- --------
(1) Excludes $10.2 million of amortization charges related to the acquisition
of FreePC, Inc. See "Note 2--Business Combination" in Notes to Condensed
Consolidated Financial Statements. Sales and marketing expenses exclude
$22,000 of non-cash stock-based compensation expense and general and
administrative expenses exclude $69,000 of non-cash stock-based
compensation expense.
(2) General and administrative expenses exclude $41,000 of non-cash stock-based
compensation expense.
Net Revenues
Net Hardware Revenues
To date substantially all of our hardware revenue has been derived from
sales of our PCs and monitors. We sell a variety of PC configurations and
monitor models to our retail customers. Our net hardware revenues increased
from $137.4 million for the quarter ended March 31, 1999 to $246.4 million for
the quarter ended April 1, 2000. This represents a 79% increase, which was due
to increased unit shipments at each price point and the expansion into higher
price points. In the quarter ended April 1, 2000, we shipped 521,000 PC units,
an increase of 82% over the number shipped in the quarter ended March 31, 1999.
Net revenue from extended service contracts and technical support during these
periods was minimal and reported with net hardware revenues.
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Internet Revenues
We recognized total Internet revenues of $3.4 million for the quarter ended
April 1, 2000. No Internet revenues were earned during the quarter ended March
31, 1999. The $3.4 million of Internet revenues for the quarter ended April 1,
2000 represents a 131% increase over the quarter ended December 31, 1999 and
was attributable to expanded Internet programs associated with our acquisition
of Free PC, Inc. and the continuation of our Internet-related services
including those through our marketing agreement with America Online. We expect
future Internet revenues to increase from advertising generated by our keyboard
buttons, our desktop client software, pre-loaded software offerings and other
Internet related services; and we expect Internet revenues to increase as a
percentage of our total revenues. However, quarter over quarter growth is not
expected to be of the same percentage magnitude as the growth experienced in
the quarter ended April 1, 2000 over the quarter ended December 31, 1999.
Cost of Revenues
Cost of revenues primarily consists of the cost of PCs and monitors,
Microsoft software licensing costs, inbound shipping costs, inventory valuation
reserves and costs of providing Internet access through e-machines.net. Cost of
revenues increased from $131.1 million for the quarter ended March 31, 1999 to
$235.3 million for the quarter ended April 1, 2000. This increase was due to
increases in unit shipments and expansion into higher cost products. We expect
cost of revenues to increase as revenues increase. Gross margin increased from
4.6% for the quarter ended March 31, 1999 to 5.8% for the quarter ended April
1, 2000. This increase was due to increased sales of higher margin products and
growth of our Internet business. Our historical gross margins may not be
indicative of our future results of operations.
Operating Expenses
Sales and Marketing
Excluding non-cash stock-based compensation charges, sales and marketing
expenses increased from $2.7 million for the quarter ended March 31, 1999 to
$6.0 million for the quarter ended April 1, 2000. As a percentage of net
revenues, sales and marketing costs, excluding non-cash stock-based
compensation charges, increased from 2.0% for the quarter ended March 31, 1999
to 2.5% for the quarter ended April 1, 2000. The absolute dollar increase was
primarily due to increased cooperative advertising costs and commission
expenses associated with increased sales volumes. The percentage increase is
due to expansion of our in-house sales force and our Internet related
activities. We expect sales and marketing expense to increase as sales volumes
increase.
Product Development
Following the acquisition of FreePC, we began investing in product
development to support and expand our Internet business. Product development
expense for the quarter ended April 1, 2000 was $512,000, or 0.2% of net
revenues. We expect to continue to increase our product development expenses in
absolute dollars as our Internet business grows.
Services and Operations
Services and operations expenses consists of internal information technology
support costs and was $313,000 or 0.1% of net revenues for the quarter ended
April 1, 2000. No services and operations expenses were incurred during the
quarter ended March 31, 1999. We expect these costs to increase in absolute
dollars as we continue to expand our capabilities in this area.
Customer Service and Technical Support
We outsource our customer service and technical support. Customer service
and technical support expenses increased from $0.9 million for the quarter
ended March 31, 1999 to $3.8 million for the quarter
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ended April 1, 2000. Customer service and technical support expenses increased
in absolute dollars as a result of increased sales volume. As a percentage of
net revenues, customer service and technical support expenses increased from
0.7% to 1.5%, as a result of increased call volumes and Internet related
services. We expect our customer service and technical support expenses to
increase as we expand our Internet-related activities and to increase to the
extent our sales volumes increase.
General and Administrative
General and administrative expenses consist primarily of payroll and related
expenses for management and administrative personnel, outsourced warehousing
activities, facilities expenses, professional service fees, travel and other
general corporate expenses. Excluding non-cash stock-based compensation
charges, general and administrative expenses increased from $1.1 million, or
0.8% of net revenues, for the quarter ended March 31, 1999, to $5.0 million, or
2.0 % of net revenues, for the quarter ended April 1, 2000. We anticipate that
general and administrative expenses will increase in absolute dollars due to
increased expenses associated with the addition of personnel and additional
professional fees, including costs associated with being a public company.
Interest Income and Expense
Net interest expense was $2.4 million for the quarter ended March 31, 1999
and consisted primarily of interest on trade payables. The Series A preferred
stock private placement in August 1999 raised net proceeds of $146.3 million
which were used to reduce trade payables and associated financing charges.
Interest expense was minimal during the quarter ended April 1, 2000 as our only
debt consists of $560,000 of long-term subordinated notes payable outstanding
to stockholders, which bear interest at 5.79% and mature on June 7, 2004. Net
interest income was $1.9 million for the quarter ended April 1, 2000 and was
earned through interest bearing cash equivalents and other interest bearing
short-term investments.
Liquidity and Capital Resources
On March 24, 2000, we completed our initial public offering of 20,000,000
shares of our common stock, providing us with net proceeds of $165.1 million.
The completion of our public offering coupled with our private placement
financing in August 1999 have provided us with working capital of $303.5
million as of April 1, 2000. Of this amount, $303.1 million consisted of cash
and cash equivalents. As of April 1, 2000, we had $560,000 of long-term
subordinated notes payable outstanding to stockholders, which bear interest at
5.79% and mature on June 7, 2004.
In August 1999, we completed our private placement of 24,279,369 shares of
our Series A preferred stock, providing us with net proceeds of $146.3 million.
Prior to the private placement, we financed our operations primarily through
extended payment terms on trade payables. The private placement proceeds were
used to reduce trade payables and associated financing expense.
Net cash provided by operating activities was $1.3 million for the quarter
ended March 31, 1999 and $3.2 million for quarter ended April 1, 2000. Cash
provided by operating activities for the quarter ended March 31, 1999 consisted
primarily of increases in trade payables that resulted from our financing
operations through extended payment terms on trade payables. Cash flows from
operating activities for the quarter ended April 1, 2000 were provided by
earnings of $737,000 before non-cash expenses and decreases in accounts
receivable.
Net cash used for investing activities was $661,000 for the quarter ended
March 31, 1999 and was used for the purchase of property and equipment. Net
cash provided by investing activities of $19.7 million for the quarter ended
April 1, 2000 came from the maturities of short-term investments and cash
acquired with the acquisition of FreePC. During the quarter ended April 1,
2000, the Company invested $5.75 million in foreign securities.
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Net cash for financing activities was nil for the quarter ended March 31,
1999. Net cash provided by financing activities for the quarter ended April 1,
2000, was $165.5 million, consisting of the net proceeds from our initial
public offering of common stock and proceeds from exercise of common stock
options.
We currently believe that our available funds as of April 1, 2000, will be
sufficient to meet our anticipated liquidity requirements for at least the next
12 months. If additional funds are required, financing may not be available on
acceptable terms, if at all, and may be dilutive to our stockholders.
RISKS THAT COULD AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In addition to the factors discussed in the "Management's Discussion and
Analysis of Financial Condition and Results of Operations" section and in our
Form S-1, our business, financial conditions and results of operations could be
impacted by a number of factors, including without limitation the following
factors.
Risks Related to Our Combined Business
Because we have operated for a limited period of time and our business is still
rapidly changing, there is limited information upon which to evaluate our
business.
We were incorporated in September 1998 and sold our first PC in November
1998. To date, most of our revenues have been derived from the sale of PCs and
monitors, and from the provision of customer support and other technical
services related to those PC products. The acquisition of FreePC in January
2000 has allowed us to accelerate our strategy of extending our historical
business as a high-quality, low-priced PC provider to offering computing and
Internet advertising offerings. As a result, we expect to derive a larger
portion of our revenues from Internet advertising sales and recurring Internet
revenues in the future, although our ability to generate significant revenue
from this business is unproven. Our limited operating history and the limited
operating history of FreePC and our evolving businesses make it difficult to
evaluate or predict our future business prospects. Our business and prospects
should be considered in light of the risks and difficulties typically
encountered by companies in the early stages of development, particularly those
in the rapidly changing PC and Internet commerce markets.
We have incurred significant losses and expect to incur additional losses in
the future.
We have incurred net losses, and at April 1, 2000, we had an accumulated
deficit of $24.2 million, which included $6.1 million for accretion of
mandatorily redeemable preferred stock to redemption value. Although we
experienced a period of rapid revenue growth from PC sales following our
inception, we may not be able to maintain this revenue growth, and we expect to
incur losses in the future. Further, FreePC has incurred significant losses
since its inception. In connection with the FreePC acquisition, we recorded
intangible assets of approximately $147 million, to be amortized over a period
of three years, which will adversely affect our earnings and profitability in
2000 and through 2002. In addition, our operating costs have increased
significantly as a result of the FreePC acquisition. We have not yet generated
significant revenue from our Internet business and we expect to experience
operating losses before amortization in that business in the future. As a
result, we expect to report losses on an operating basis after amortization of
intangible assets in our combined business for at least the next couple of
years.
Our quarterly operating results are subject to fluctuations and seasonality
that make it difficult to predict our future performance.
We expect our quarterly operating results to fluctuate significantly in the
future due to a number of factors. Because our PC business currently generates
low operating margins, a trend that we expect to continue for the foreseeable
future, slight variations in the prices of our PCs, component or manufacturing
costs or operating costs could significantly affect our operating results in
future periods. In addition, the Internet advertising and
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e-commerce market is highly competitive and subject to rapid change and our
ability to generate any significant revenue from that business is unproven.
Some of the other factors that could affect our quarterly operating results
include:
. the timing and amount of Internet advertising and e-commerce activity
generated through our hot-key enabled keyboards that provide one-touch
access to selected Web sites, our desktop client software and other
initiatives;
. acceptance by consumers of computing devices that include our Internet
offerings;
. continued acceptance and growth of the Internet as a medium for buying
and selling goods and services;
. acceptance by advertisers of the Internet as an efficient means for
reaching consumers;
. our ability or our suppliers' ability to effectively develop and support
new PC models;
. reductions in the prices of PC products, and new product or Internet
service announcements and introductions, by us or our competitors;
. fluctuations in the amount of, and the number of our PC buyers claiming
product rebates;
. popularity of the PCs and monitors we sell, and changes in our mix of
products;
. achieving and maintaining a low-cost business model in our PC business
and managing the third-party relationships necessary to do so;
. the cost of our PC products, including our key suppliers' component
costs and ability to obtain sufficient supply; and
. our key suppliers' ability to manufacture and deliver sufficient
quantities of our PC products, and to maintain the quality of our PC
products.
In addition, our limited operating history makes it difficult for us to
accurately identify all of the possible factors and plan our operations
accordingly. Furthermore, because our operating expenses are based on our
expectations of future revenues and we have recently significantly increased
our operating expenses as a result of our acquisition of FreePC, unexpected
quarterly fluctuations in revenue or a failure to generate significant revenue
from our Internet business could significantly harm our operating results. If
our operating results in any future quarter do not meet the expectations of
securities analysts or investors, the price of our common stock could
significantly decline.
Seasonal fluctuations may also affect our quarterly operating results.
Historically, demand for PCs and PC-related services and consumer retail sales
have been significantly stronger in the fourth quarter of each year and weaker
in the first and second quarter of each year. We believe that the seasonal
impact on our business of these cycles will increase to the extent that PCs
continue to become more consumer-oriented or entertainment-driven products and
e-commerce continues to gain broader acceptance. As a result, we expect our net
revenues from both our PC business and our Internet businesses generally to be
greater in the fourth quarter and lower in the first and second quarters of
each year.
We have experienced a period of rapid growth, and if we are unable to manage
this growth successfully, our business could be significantly harmed.
Our net revenues increased from $137.4 million for the quarter ended March
31, 1999 to $249.8 million for the quarter ended April 1, 2000. Our total
number of employees has grown from 10 at December 31, 1998 to 140 at April 1,
2000. Our growth has placed, and will continue to place, a significant strain
on our management systems, infrastructure, resources and planning and
management processes.
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As we grow, we will also need to continue to assimilate new employees, as
well as expand, train and manage our workforce. Several key members of our
management team have joined us recently in connection with our acquisition of
FreePC. In addition to performing their regular duties, these individuals must
spend a significant amount of time learning our management systems and our
historical business model in order to help us extend that model to offering
integrated computing and Internet solutions. Further, our senior management
team has limited experience in the management and administration of a public
company. If our senior management team is unable to effectively integrate
themselves into our business or work together as a management team, we may be
unable to manage our business causing substantial harm to our business.
If we lose key personnel or are unable to attract and retain additional
personnel when needed, we may not be able to successfully operate our business.
Our future success depends on the skills, experience and performance of our
senior management and key personnel, especially that of our President and Chief
Executive Officer, Stephen A. Dukker. Additionally, the FreePC management team
is key to the success of our Internet business. We must retain these
individuals and be able to attract and retain additional key personnel when
needed in the future. Competition in the PC and Internet and e-commerce markets
for these types of individuals with business and technical expertise is high.
All of our senior management and key personnel are at-will employees and may
terminate their employment with us at any time without warning. Further, we do
not maintain "key man" life insurance with respect to any of our employees. If
we lose key personnel, especially Mr. Dukker, or if we are not able to attract
and retain additional personnel when needed, we may be unable to successfully
introduce new products and services or otherwise implement our business
strategy.
We are subject to risks associated with acquisitions, in general, and with our
acquisition of FreePC, in particular.
In January 2000, we acquired FreePC. We may not successfully integrate the
additional personnel, operations, technology and products of FreePC into our
business, or retain FreePC employees, including key personnel. In particular,
with the acquisition of FreePC, we have extended our historical business as a
high-quality, low-priced PC provider to include integrated computing and
Internet advertising offerings. We may not realize the expected benefits from
these offerings. The acquisition may also strain our existing financial and
managerial controls and reporting systems and procedures.
We intend to continue to make investments in complementary companies,
products or technologies. If we buy a company, we could have difficulty in
integrating that company's personnel and operations. In addition, the
employees, including key personnel, may decide not to work for us. If we make
other types of acquisitions, we could have difficulty integrating the acquired
technology or products into our operations. These difficulties could disrupt
our ongoing business, distract our management and employees and increase our
expenses. In addition, as a result of future acquisitions, we may increase our
debt or dilute our existing stockholders if we issue equity securities to pay
for the acquisition.
If we do not maintain our reputation and expand our name recognition, we may
lose consumer and advertising customers.
Developing and maintaining awareness of our "eMachines" brand name is
critical to achieving widespread acceptance of our computing and Internet
advertising offerings. Promotion and enhancement of our brand will depend
largely on whether we cost-effectively provide reliable and desired products
and services to consumers and advertisers and the effectiveness of our
marketing efforts. Currently, retailers are our first point of contact with
consumers. If these retailers reduce or cease advertising our products, we may
need to increase our own sales and marketing expenses to create and maintain
brand awareness among potential consumers. If consumers do not perceive our
products to be of high quality, our brand name and reputation could be
significantly harmed. Also, if advertisers do not perceive our reputation among
consumers to be good, they may
17
<PAGE>
not be willing to offer as much for our services. Furthermore, the importance
of brand recognition will increase as competition in the PC and Internet
advertising markets increases. If we fail to successfully promote our brand
name or if we incur significant expenses promoting and maintaining our brand
name, we may lose PC and Internet advertising sales.
If we do not continually introduce new products and services to keep pace with
rapid technological change, we may not be competitive and could experience a
decline in sales and loss of market share.
The PC and Internet advertising markets are both characterized by rapid
ongoing technological change, changes in user requirements and preferences,
frequent new service introductions embodying new processes and technologies and
evolving industry standards and practices that could render our existing
products and services obsolete. We must regularly introduce new products,
including new PC configurations, and enhanced Internet services to maintain
retailer, consumer and advertiser interest in our products and services. Any
new PC or other Internet access devices or Internet services that we introduce
may not be successful. In addition, the successful introduction of new products
or services by us or our competitors may significantly harm the sale of, or
gross margins on, our existing products or services. We may not be able to
quickly adapt to future changes in the PC and Internet access device industry,
in particular, because we do not maintain a PC or Internet access device
research and development group. Currently, we work closely with TriGem
Computer, one of our principal stockholders and the manufacturer of all of our
eTower PCs, to evaluate the latest developments in PC-related technology. If we
do not have access to new technology in the future, we may not be able to
successfully incorporate new technology into our products or deliver new
products or features in a timely and cost-effective manner.
We are involved in litigation that may be costly and time-consuming.
In July 1999, Compaq Computer Corporation filed a complaint against us,
TriGem Computer, TriGem America and Korea Data Systems as defendants in the
U.S. District Court for the Southern District of Texas based on the defendants'
alleged infringement of 13 patents held by Compaq related to improved system
processing speed, enhanced video graphics, peripheral compatibility and overall
system architecture. The complaint seeks an accounting, treble damages, a
preliminary and permanent injunction from further alleged infringement,
attorneys' fees and other unspecified damages. We filed a response in September
1999, seeking declaratory judgment of noninfringement and invalidity of
Compaq's patents and asserting counterclaims against Compaq that included false
and misleading advertising under the Lanham Act, business disparagement and
unfair competition under Texas common law. The case is currently in the early
stages of discovery. As a result, we are currently unable to estimate total
expenses, possible loss or range of loss that may be ultimately connected with
these allegations. We are indemnified against liability under the terms of our
PC supply agreement. We cannot assure you that Compaq will not succeed in
obtaining monetary damages or an injunction against the production of our PC
products. Our defense of the claims could result in significant expenses and
diversion of management's attention and other resources. Although we believe
our direct financial exposure is limited under our indemnification
arrangements, the results of complex litigation of this sort are inherently
uncertain and difficult to predict and there can be no assurances that the
results of this litigation would not result in our business being significantly
harmed, particularly if it affects production of our PCs.
Packard Bell filed a complaint on October 6, 1999 in Federal District Court
for the Eastern District of California, alleging patent infringement on Packard
Bell patents which it asserts relates to (i) graphics controller, (ii) parallel
port controller, and (iii) bus interface of our eTower machine. We filed a
response in January 2000 disputing infringement and asserting that the patents
at issue are invalid. We are in the early stages of discovery. As a result, we
are currently unable to estimate total expenses, possible loss or range of loss
that may be ultimately connected with these allegations. We are indemnified
against liability under the terms of our PC supply agreement. There can be no
assurances that Packard Bell will not succeed in obtaining monetary damages or
an injunction against the production of our PC products. Our defense of the
claims could result in significant expenses and diversion of management's
attention and other resources. Although we
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believe our direct financial exposure is limited under our indemnification
arrangements, the results of complex litigation of this sort are inherently
uncertain and difficult to predict, and there can be no assurances that the
results of this litigation would not result in our business being significantly
harmed, particularly if it affects production of our PCs.
In October 1999, David Packard, on behalf of a putative nationwide class,
filed a complaint against us as a defendant in the U.S. District Court for the
Eastern District of Texas based on our alleged sale of defective goods.
Essentially identical complaints were filed contemporaneously against Compaq,
Hewlett-Packard and Packard Bell. The complaints claim that a chip in the
defendants' respective PC products contains a defect which may cause an error
to occur when information is written to a floppy disk. The complaint seeks
unspecified monetary damages, injunctive relief and declaratory relief. The
lawsuit against us is in the early stages of discovery and we have not yet
filed a response. Although we believe that we have meritorious defenses and
intend to vigorously defend ourselves in this action, these types of litigation
are inherently complex and unpredictable. There can be no assurances that the
suit will not succeed in obtaining unspecified monetary damages, injunctive and
declaratory relief against the production of our PC products. Our defense of
the claims could result in significant expenses and diversion of management's
attention and other resources. In addition, there can be no assurances that the
results of this litigation would not result in our business being significantly
harmed.
Various other lawsuits, claims and proceedings have been or may be asserted
against us, including those related to product liability, intellectual
property, Internet content, privacy, safety and health and employment matters.
Litigation is expensive and time consuming regardless of the merits of the
claim and could divert management's attention from our business. Moreover, we
cannot predict the outcome of any litigation. Some lawsuits, claims or
proceedings may be disposed of unfavorably to us and we may incur significant
costs defending ourselves.
We may not be able to compete effectively if we are not able to protect our
intellectual property.
We rely on a combination of trademark, trade secret, patent and copyright
law and contractual restrictions to protect our intellectual property. e-
machines is our registered trademark in the United States. We have also applied
to register several trademarks including eMachines and the "e" logo in the
United States. We have also applied to register marks in the European
Community, the United Kingdom, Brazil, Japan, Taiwan, China, Canada and Mexico.
We also have a United States patent application currently pending. If we are
not successful in obtaining the patent protection we seek, our competitors may
be able to replicate our ad optimization technology and compete more
effectively against us. The legal protections described above, even if
successful, would afford only limited protection. Unauthorized parties may
attempt to copy aspects of our products, services, or otherwise attempt to
obtain and use our intellectual property. Enforcement of trademark rights
against unauthorized use, particularly over the Internet and in other
countries, may be impractical or impossible and could generate confusion and
diminish the value of the mark. Litigation may be necessary to enforce our
intellectual property rights, to protect our trade secrets and to determine the
validity and scope of the proprietary rights of others. Any litigation could
result in substantial costs and diversion of our resources and could seriously
harm our business and operating results. In addition, our inability to protect
our intellectual property may harm our business and financial prospects.
Products that contain, or are rumored to contain, defects could result in
significant costs to us, decreased sales of our products, damage to our brand
and lawsuits.
The design and production of PC components is highly complex. Because we do
not design or produce our own PC products, we must rely on suppliers and
component manufacturers to provide us with high-quality products. If any of our
PC products contain defective components, we could experience delays in
shipment of these products and increased costs. Further, the design of software
is highly complex, and software often contains defects that may be undiscovered
for long periods of time. If we are not successful in designing this
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software, or if defects in our software or in our PC products are discovered
after we have shipped our affected software or PC products in volume, we could
be harmed in the following ways:
. upgrades, replacements or recalls could impose substantial costs on us;
. rumors, false or otherwise, could be circulated by the press and other
media, which could cause a decrease in sales of our products and
significant damage to our brand; and
. our PC buyers could file suits against us alleging damages caused by
defective products.
For example, in October 1999, David Packard, on behalf of a putative
nationwide class, filed complaints against us, Hewlett-Packard and Compaq in
the U.S. District Court for the Eastern District of Texas based on alleged sale
of defective goods. The complaint alleges that a chip in the respective
defendants' PC products contains a defect that causes an error to occur when
information is written to a floppy disk. For a discussion of these complaints
and the risks associated with the lawsuit against us, see the risk factor "We
are involved in litigation that may be costly and time-consuming" above.
If demand for Internet access devices, in general, and PCs, in particular, does
not continue to grow, we could have excessive inventories that could result in
write-offs.
The future success of our business model depends on the continued strong
demand for Internet access devices, generally, and for PCs, in particular.
Although we currently focus our efforts on high-quality, low-priced PC
products, we expect consumer demand for more powerful PCs and other Internet
access devices to increase with advances in technology and declines in prices.
To meet these demands, we must successfully gauge the level and timing of
consumer demand for PCs and other Internet access devices and match the supply
of each. The PC and Internet access device markets are characterized by rapid
new product and technology introductions and generally declining prices for
existing products. Demand for PCs and other Internet access devices might be
significantly reduced if consumers perceive little technological advantage in
new products or believe that the price of a new product is not worth the
perceived technical advantage. Further, if consumers view anticipated changes
as significant, such as the introduction of a new operating system or
microprocessor architecture, overall market demand for PCs and other Internet
access devices may decline because potential consumers may postpone their
purchases until release of the new product or in anticipation of lower prices
on existing products following the introduction of new models. Reduced demand
could result in excessive inventories that could lead to write-offs of some or
all of the excess inventories and could take several quarters to correct.
Risks Principally Related to Our Internet Business
The Internet advertising market is new and unproven and may not continue to
develop.
The Internet has not been used as an advertising medium for a sufficient
period of time to demonstrate its effectiveness. Our business would be
adversely affected if the Internet advertising market fails to develop. Most of
our current or potential advertising customers have not devoted a significant
portion of their advertising expenditures to Internet advertising and may not
find Internet advertising to be effective for promoting their products and
services relative to advertising using traditional media.
Currently, there are no widely accepted standards for measuring the
effectiveness of Internet advertising. We cannot be certain that such standards
will develop to sufficiently support Internet advertising as a significant
advertising medium. Advertisers may not accept our or third-party measurements
of impressions or click-throughs on Web sites utilizing our services. In
addition, the effectiveness of Internet advertising depends on the accuracy of
information contained in the databases used to target advertisements. We cannot
be certain that the information in our databases will be accurate or that
advertisers will be willing to have advertisements targeted by any database
containing such potential inaccuracies. Actual or perceived ineffectiveness of
online advertising in general, or the actual or perceived inaccuracy of
measurements or database information in particular, could limit the long-term
growth of online advertising.
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The advertising links that we provide using our hot-key-enabled keyboards
and client software and the banner advertisements that we serve may not be
effective advertising methods. Other forms of Internet advertising may be more
effective or gain wider acceptance; nonetheless, we may not be able to take
advantage of these other forms of advertising. Moreover, "filter" software
programs that limit advertising from being delivered to a user's computer are
currently available. The Internet advertising market and our business could be
adversely affected if use of filter software becomes widespread.
Adoption of online direct marketing, particularly by those entities that
have historically relied upon traditional means of direct marketing, such as
telemarketing and direct mail, requires the broad acceptance of a new and
substantially different approach to direct marketing. Intensive marketing and
sales efforts may be necessary to educate prospective advertisers regarding the
uses and benefits of our direct marketing services to generate demand for such
services. Enterprises may be reluctant or slow to adopt a new approach that may
replace, limit, or compete with their existing systems. In addition, since
online direct marketing is emerging as a new and distinct market apart from
online advertising, potential adopters of online direct marketing services will
increasingly demand functionality tailored to their specific requirements.
Our ability to generate Internet-based revenues is unproven and we may never
achieve profitability in our Internet business.
We first began bundling the eWare desktop client software with our PCs
during December 1999 and did not begin production of our first keyboard with
Internet hot-keys until January 2000. Given our limited history offering these
Internet-based services, evaluating our performance is difficult. In addition,
although FreePC had relationships with a large number of advertisers, our
business model is significantly different than FreePC's, and as expected many
of these advertisers have not continued to do business with us as we have
discontinued the distribution of free computers and expect to cease providing
free Internet access service. You should consider the uncertainties that we may
encounter as we develop our Internet business in this rapidly evolving market,
such as:
. consumer demand for, and acceptance of, our eWare Internet client and
hot-key-enabled keyboards;
. our ability to create user-friendly applications that appeal to
consumers;
. our ability to contract with content providers who will furnish
information that our users find attractive;
. our ability to support a large number of users;
. our ability to anticipate and adapt to a developing market and to
rapidly changing technologies;
. our unproven and evolving business model; and
. our need to expand significantly our internal resources to support
growth of our product and service offerings.
If we are unable to address successfully these issues, we will be unable to
expand our Internet business, compete effectively or achieve profitability in
the Internet segment of our business.
Our Internet-based revenues will suffer if consumers do not use the hot-keys,
desktop client software and other Internet-related services that we provide
them.
We expect to generate future revenues from sources such as Internet
advertising, sponsorships, e-commerce and Internet application services. The
success of our Internet operations depends upon the use by our consumers of the
hot-keys on our keyboards and our desktop client software to reach selected
advertisers' Web sites. Many of our potential consumers have never purchased
Internet access service, used the Internet, e-mail or other Internet-based
applications or engaged in e-commerce transactions. Potential users must use
our desktop client software and hot-keys as part of their Internet and e-
commerce experience in order for us to
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receive recurring Internet revenues. Because these keys and the menu bar have
only been operational for a limited period of time and because they are new
methods of accessing Web sites and Internet-based services, whether enough
users of our PCs will use these features to create a sufficiently large
audience to attract advertisers is uncertain. In addition, use of the hot-keys
and our desktop client software depends on the appeal to our consumers of the
linked Web sites. We rely on market research to determine the categories of
products and services in which consumers are likely to be interested. Should
our reliance on this research prove to be misguided, we may fail to select
relevant categories of interest to consumers or fail to adequately provide
links to superior content within these categories. In addition, we have no
control over the experience that our consumers have while visiting these Web
sites. Consumers who are not satisfied with their experience may decide not to
use our hot-keys or desktop client software. Should this occur, our ability to
generate advertising revenue will be significantly harmed.
We face risks related to expanding into new services and business areas, in
particular, e-commerce.
To increase our revenues, we will need to expand our operations by promoting
new or complementary products and by expanding the breadth and depth of our
services. Specifically, our future success will depend, in part, on obtaining
revenues from the facilitation of e-commerce transactions with online and
traditional retailers. The market for e-commerce services is extremely
competitive. Because we have limited experience in this market, we may have
limited success. If we expand our operations in this manner, we will require
significant resources for additional development and such expansion may strain
our management, financial and operational resources. Our expansion into new
product and service offerings may not be timely or may not generate sufficient
revenues to offset their cost. If this occurs, our business will be seriously
harmed.
If we are unable to compete successfully for users, we could experience a loss
of revenues and market share.
The markets for PCs, Internet appliances and Internet advertising are
intensely competitive, evolving and subject to rapid technological change.
These markets are characterized by an increasing number of entrants. We compete
for users, and consequently for potential electronic commerce and advertising
revenue, directly or indirectly, with the following categories of competitors:
. vendors of personal computers, such as Apple, Compaq, Dell, Gateway,
Hewlett-Packard and IBM;
. vendors of stand-alone Internet appliances, such as InfoGear, Netpliance
and WebTV;
. Internet service providers, such as America Online, EarthLink,
Mindspring, Microsoft and NetZero;
. Internet portals, such as Excite@Home, Lycos and Yahoo!; and
. providers of Internet advertising services, such as 24/7 Media,
DoubleClick and Engage Technologies.
Virtually all of our current and potential competitors have longer operating
histories, significantly greater financial, technical, marketing and other
resources, significantly greater name recognition and a substantially larger
installed base of customers than we do. In addition, many of our competitors
have nationally known brands or well-established relationships and have
extensive knowledge of our industry. Moreover, our current and potential
competitors have established or may establish cooperative relationships among
themselves or with third parties to increase the ability of their products to
address consumer needs or to combine hardware product and Internet service
offerings.
If we are unable to sell America Online's Internet access services to our PC
buyers, our revenues and profits would be reduced.
Our future success depends in part on our ability to sell Internet access
services to our PC buyers. The PC industry and the Internet industry are
currently evolving and converging. We believe that this convergence will
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result in the PC becoming the Internet appliance that attracts consumers to
enter into multi-year Internet access service contracts. In addition, since we
receive bounty payments and other revenues from America Online depending on the
service our PC buyers choose, our business would be harmed if the reputation of
America Online or the popularity of America Online's AOL Classic or CompuServe
2000 suffer and a significant number of buyers do not also purchase Internet
access service from America Online. If Internet access services fees decline
significantly or become free, an ISP rebate program would be unattractive to
consumers and our revenues and profits would be reduced.
Our future growth depends on the continued use of the Internet.
We believe a significant number of our PC buyers are purchasing our products
and services as a means of connecting to the Internet. As a result, our future
success is substantially dependent upon continued growth in Internet use. The
adoption of the Internet medium for commerce and communications generally
requires the understanding and acceptance of a new way of purchasing goods and
exchanging information. The use and acceptance of the Internet may not increase
for a number of other reasons, including the following:
. actual or perceived lack of security of information, such as credit card
numbers, which are transmitted over the Internet;
. high cost or lack of availability of access;
. congestion or traffic or other usage delays on the Internet;
. inconsistent quality of service;
. possible outages due to damage to the Internet;
. uncertainty regarding intellectual property ownership; and
. government regulation of the Internet.
Capacity constraints caused by growth in the use of the Internet may impede
further development of the Internet to the extent that users experience delays,
transmission errors and other difficulties. If the necessary infrastructure,
products, services or facilities are not developed to mitigate the effects of
these factors, or if the Internet does not become a viable and widely used
commercial and communication medium, our products and services would be less
attractive and our future growth would be impaired.
If software we develop or software developed by, or licensed from, third
parties, has any unanticipated defects or becomes unavailable, we could
experience service interruptions that could increase our repair costs or reduce
our revenues.
We have developed and are further developing two-way client software as well
as other applications that will be bundled with our PCs. Some of our Internet-
based services rely on software provided by third parties that is bundled with
our PCs. We have no control over the quality of this software. Our software and
this third-party supplied software may contain undetected errors, defects or
bugs. These defects could cause service interruptions that could damage our
reputation or increase our product repair costs, prevent us from delivering
advertisements, cause us to lose revenue, delay market acceptance of our
Internet-based services or divert our development resources, any of which could
cause our business to suffer. If these problems cannot be fixed in a timely
manner, we may be unable to fulfill our obligations to our advertising
customers, which could significantly harm our business.
Our servers are located at a single site and, in the event of a natural
disaster, our client software would not operate.
We depend on the efficient and uninterrupted operations of our Web servers
and other hardware systems. Our Web servers and other hardware systems are
located in Sunnyvale, California. Our Web servers and other
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hardware systems are vulnerable to damage from earthquakes, fire, floods, power
loss, telecommunications failures, and similar events. If any of these events
result in damage to our Web servers or other hardware systems, we may be unable
to deliver Internet advertising and other related Internet services for our
customers until the damage is repaired. If this occurs, we may lose customers,
users of our client software and revenue, and may incur substantial costs in
repairing any damage.
Online security breaches could result in a loss of consumer confidence in e-
commerce, which could lessen our ability to implement our business strategy.
Because many of our advertisers encourage people to use the Internet to
purchase goods and services, our business could be seriously harmed if Internet
users reduce their use of the Internet because of security concerns. We
currently ask consumers to provide us with registration and other information
and we rely on encryption and authentication technology to securely transmit
this confidential information. In addition, a party that is able to circumvent
the security of our server systems could steal proprietary information or cause
interruptions in our operations. Our efforts to protect our server systems may
not be successful. Any well-publicized compromise of confidential information,
whether during the transmission of data or while it is stored on our servers,
could damage our reputation, expose us to a risk of loss, litigation or
liability, and deter people from using the Internet. Our insurance policies may
not be adequate to reimburse us for losses caused by security breaches.
We could be exposed to liability or increased costs if new case law is decided,
or new government regulation is enacted, regarding the Internet.
The law relating to our Internet business and operations is evolving, and no
clear legal precedents have been established. For example, tax authorities in a
number of states are currently reviewing the appropriate tax treatment of
companies engaged in e-commerce, and new state tax regulations may subject us
to additional state sales or other taxes. The adoption of any new Internet laws
and regulations or the application of existing laws and regulations to the
Internet and e-commerce could decrease the demand for our products and services
or increase the cost of doing business. In addition, the applicability to the
Internet of existing laws in various jurisdictions governing issues such as
property ownership, sales and other taxes, libel and personal privacy is
uncertain and may take years to resolve. If we were alleged to have violated
federal, state or foreign civil or criminal law, even if we could successfully
defend such claims, it could occupy significant amounts of management's time,
harm our business reputation and negatively affect our operating results and
financial condition.
Risks Principally Related to Our PC Business
Because our business depends on outsourcing a substantial portion of our PC
operations, if we were unable to do so in the future, we could incur
significantly higher costs which would reduce our revenues and our profits.
Historically, we have had relatively low manufacturing and operating costs
because we outsource most of our operating and manufacturing functions,
including system assembly, warehouse labor, distribution, research, product
design, warranty services and customer support. In addition, we have had
relatively low distribution costs because we distribute our products primarily
through a limited number of large retailers. We may not be successful in
managing our relationships with any of these third parties, and if existing
third-party suppliers cannot provide these services at commercially reasonable
prices, or at all, and we are not able to find suitable alternative suppliers,
our business would be significantly harmed. Moreover, we may not be able to
monitor or control effectively the quality of the PCs and monitors manufactured
by our suppliers. Low-quality products, poor customer service, or similar
inadequacies may harm our brand name, which would reduce our revenues and
profits.
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Because we currently depend solely on three manufacturers for our PCs and
monitors, if supply is reduced or discontinued, our growth rate would decline
which would harm our business and financial results.
TriGem Computer currently manufactures all of our eTower and eMonster PCs.
Historically, Korea Data Systems Co. manufactured our eOne PCs and eSlate
notebook PCs and, together with Jean Company, a Taiwanese manufacturer, all of
our monitors. We have no obligation to order, take minimum delivery or purchase
products at pre-negotiated prices from TriGem Computer, Korea Data Systems Co.
or Jean Company. Additionally, other than in the case of TriGem Computer as
described below, absent a purchase order submitted by us, Korea Data Systems
and Jean Company have no contractual obligation to supply us with PCs and
monitors. Further, TriGem Computer's PC production facility in Korea is
currently operating at full capacity. In order to meet anticipated demand for
our products and the products of other customers, TriGem Computer recently
entered into an outsourcing manufacturing agreement for a facility in Xiamen,
China and opened a new facility in Shenyang, China. The Xiamen facility
currently has production capacity of approximately 90,000 PC units per month.
The Shenyang facility is a final-assembly plant with production capacity of
approximately 150,000 PC units per month. Under the terms of our supply
agreement, TriGem Computer has agreed to reserve a portion of its manufacturing
capacity at its facilities to meet our supply requirements. TriGem Computer,
Korea Data Systems Co. and Jean Company provide other vendors with PCs and
monitors. As a result, we may not benefit from any increased production
capacity. If we are unable to obtain a sufficient supply of PCs or monitors to
meet the demand for our products, our growth rate would decline which could
reduce our sales, revenue and market share. In the future, we plan to establish
supply relationships with other PC and monitor manufacturers. There can be no
assurances that we will be able to enter into supply or other agreements on
terms acceptable to us with other manufacturers to provide us with PCs and
monitors.
Our suppliers depend on a limited number of key suppliers for microprocessors
and other components used in our products.
Our suppliers generally use standard parts and components available from a
number of vendors. However, our suppliers are dependent on Intel Corporation
and Advanced Micro Devices, Inc. for their supply of microprocessors. If, in
the future, our suppliers are unable to obtain sufficient quantities of
microprocessors from Intel or Advanced Micro Devices, or if these companies
stop producing microprocessors that meet our needs, our suppliers could
experience increases in component costs or delays in product shipments that
would significantly harm our business. Even where multiple vendors are
available, our suppliers' strategy has been to concentrate purchases from a
single source to obtain favorable pricing. Our profit margins may decline and
our business would be significantly harmed if supply shortages led to price
increases or production delays for our products.
Because average selling prices of PCs decline rapidly, if we fail to properly
manage our inventory, we may be unable to meet consumer demand or we could have
excess inventories.
The average selling prices of PCs are subject to rapid declines. To address
the problems created by excess inventory in the face of rapid price decreases,
PC vendors must carefully manage their inventory. Additionally, due to our
narrow margins, we must manage our inventory more efficiently than traditional
PC vendors. From time to time in the past, our inventory has been limited by
the capacity of our manufacturers and may be limited in the future. We may be
unsuccessful in managing the supply of our PCs and monitors to meet demand in
the future. Our business is dependent on our ability to quickly sell our PC
products through the retail channel. We must carefully monitor market demand
for, and supply of, our products in an effort to match supply to consumer
demand. If we overestimate the supply needed to meet consumer demand, we could
have excess inventory. If we underestimate needed supply or otherwise maintain
too little inventory, we may not be able to react quickly to sudden increases
in market demand for a given product.
Retailers generally have the right to return a portion of excess inventory
purchased in the prior quarter within a limited period of time. Increased
inventory levels in our distribution channels, whether due to a
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decrease in consumer demand for our products, lower-than-anticipated demand for
PCs in general, problems in managing product transitions or component pricing
movements could significantly harm our profitability. Production delays at the
beginning of a new PC product cycle could affect our sales of newer products
and how we manage the sale of older PC product inventory held by retailers. If
we are unable to sell our aging products at anticipated prices, our margins
would be reduced. In managing our supply chain, we must accurately forecast
consumer demand for our products.
The international operations of our suppliers of PCs and monitors expose us
to currency, trade, regulatory, political and other risks.
All of our PCs and monitors are currently being manufactured in Korea,
China, Taiwan and Malaysia. Our current and potential future international
suppliers' operations, and in turn our operating results, are subject to a
number of risks associated with international operations including:
. fluctuations in currency values;
. export duties, import controls and trade barriers;
. restrictions on the transfer of funds;
. political and economic instability; and
. compliance with foreign laws.
Our success depends on our ability to compete successfully in the PC industry.
The PC industry is highly competitive and we expect this competition to
increase significantly, particularly in the low-priced PC market. We have been
able to gain market share by selling high-quality PCs at prices significantly
lower than those offered by established PC vendors. We expect pricing pressures
in the PC market to continue, particularly as more vendors combine Internet
access with the purchase of a PC. PC vendors may continue to reduce their
prices to compete with us at our low price points. Large PC vendors such as
Compaq, Gateway, Hewlett-Packard and IBM have significantly greater financial,
marketing and technical resources than we do and may decide to accept lower
margins or losses on a sustained basis on their low-priced PC sales to regain
market share. The introduction of low-priced PCs combined with the brand
strength, extensive distribution channels and financial resources of the larger
PC vendors may cause us to lose market share.
Most major PC vendors have begun to offer Internet access services. Some PC
vendors are trying to increase their sales of higher-priced PCs by offering
additional services, such as free Internet access for a limited period of time.
In addition, other PC vendors are adopting programs similar to ours that rebate
a portion of the purchase price of PCs in exchange for entering into multi-year
Internet access service contracts. There are relatively few barriers preventing
competitors from entering this market. As a result, new market entrants pose a
threat to our business. We do not own any patented technology that precludes or
inhibits competitors from entering the low-priced PC market. Existing or future
competitors may develop or offer products or services that are comparable or
superior to ours at a lower price, which could erode our competitive position.
For example, in the last quarter of 1999 one retailer began offering its own
branded, low-priced PCs in conjunction with Internet access service from
America Online. Our PC and monitor suppliers either are not contractually bound
or have only limited obligations to meet our demand for products and can divert
some or all of their output to others, including our competitors, or sell
directly to the retail channel. If any of these events were to occur, our
market share could be reduced unless we were able to successfully compete with
these parties and source high-quality PCs and monitors from other low-cost
manufacturers.
The future of our PC business depends on PCs remaining the predominant Internet
access device.
The future of our PC business depends on PCs remaining the predominant
Internet access device. Internet services are currently accessed primarily by
PCs. However, television set-top boxes, hand-held products and
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other non-PC devices may increasingly be used to access the Internet.
Television set-top boxes equipped with modems and cable modems allow users to
transmit data at substantially faster speeds than the analog modems currently
incorporated in our PCs. If consumers prefer this or any other alternative
devices to PCs to access the Internet, sales of our PCs may slow. We may try to
enter these markets by introducing our own non-PC devices to access the
Internet or by forming relationships with companies that manufacture and/or
sell such devices. There can be no assurances that we will be successful in
entering such markets.
Because we depend on licenses of intellectual property from third parties to
produce our PC products, the loss of any of these licenses would significantly
harm our financial results.
We are required to obtain licenses from software providers in order to
market and sell our products and services. In particular, we currently pre-
install Windows 98 and Microsoft Works on our PCs pursuant to a license. We
plan to install Windows 2000 on our PCs in the future pursuant to a license
that we expect to enter into with Microsoft. However, if we are unable to
maintain these licenses, or obtain the necessary licenses in the future, we may
be forced to market products without these technological features or software.
We may also be forced to discontinue sales of our products that incorporate
allegedly protected technology for which we have no license or defend legal
actions taken against us relating to our use of the allegedly protected
technology. Our inability to obtain licenses on competitive terms necessary to
sell our PCs at a profit would significantly harm our financial results.
Because we depend on a limited number of large retailers for a significant
portion of our revenues, the loss of any of these retailers could significantly
harm our financial results.
We depend substantially on retailers to sell our PCs and monitors. Since
inception, we have derived a significant portion of our gross revenues from
sales of our PCs and monitors to a limited number of large retailers. For the
quarter ended April 1, 2000, approximately 55.7% of our gross revenues were
from sales of PCs and monitors to Best Buy, Office Depot and Circuit City, our
three largest retail customers. We expect to continue to derive a large
percentage of our gross revenues from sales of PCs and monitors to a limited
number of leading retailers. However, our retail customers are not
contractually committed to future purchases of our products and could
discontinue carrying our products at any time. In addition, we compete with an
increasing number of companies for access to limited shelf space with these
retailers. Generally, these retailers limit the number of PC brands they carry
and may stop carrying our PCs at any time. Any significant disruption of our
relationship with any of our major retailers, any significant reduction in
purchases by them or any significant delays in payments by them, could affect
our ability to generate revenues or results of operations.
If we are unable to monitor and manage our product rebate programs, our
revenues could decrease.
We currently offer product rebates to buyers of our PCs. We have limited
historical data to assist us in determining what percentage of consumers will
claim these product rebates. At the same time, we must approximate future
product rebate redemptions in order to price our products effectively. If an
unexpectedly large number of our PC buyers redeemed the product rebates to
which they were entitled, the effective average selling price of our products
would be reduced below the level we anticipated and our revenues would
decrease.
We rely on the availability of rebates offered by Internet service providers to
sell our PCs, and if such rebates are discontinued, our sales could decrease.
To help sell PCs, we rely on the availability of rebates offered by Internet
service providers to purchasers of new computers who subscribe for their
Internet access services. These rebates reduce the effective price of our PC
models, making them more affordable for consumers. If these rebates were
discontinued, the effective prices of our PCs would increase, which likely
would reduce sales of our PCs. A significant decrease in sales of PCs would
harm our business.
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Risks Related to Our Common Stock
Our principal stockholders can exercise a controlling influence over our
business and affairs.
Our four principal stockholders, TriGem Corporation, Korea Data Systems
America, Stephen A. Dukker and Bill Gross and his affiliated entities, owned
approximately 55% of our common stock as of May 1, 2000. If these stockholders
acted or voted together, they would have the power to elect our directors and
to exercise a controlling influence over our business and affairs. In addition,
this concentration of ownership could prevent a change in control that might
otherwise be beneficial to our stockholders.
We may have potential conflicts of interest with our principal stockholders
that could be resolved in a manner that is inconsistent with other
stockholders' interests.
Conflicts of interest may arise between us and our principal stockholders in
a number of areas relating to our present and ongoing relationships, which
could be resolved in a manner that is inconsistent with our other stockholders'
interests.
Substantial future sales of our common stock in the public market may depress
our stock price.
Our current stockholders hold a substantial number of shares of our common
stock that they will be able to sell in the public market in the future. Sales
of a substantial number of shares of our common stock in the future could cause
our stock price to fall. In addition, the sale of these shares could impair our
ability to raise capital through the sale of additional stock.
Our management has broad discretion over the use of our capital.
Our management can spend our capital in ways with which our stockholders may
not agree.
Our charter documents and Delaware law could make it more difficult for a third
party to acquire us and discourage a takeover.
Our certificate of incorporation and bylaws are designed to make it
difficult for a third party to acquire control of us, even if a change in
control would be beneficial to stockholders. As a Delaware corporation, we are
also subject to the Delaware anti-takeover statute contained in Section 203 of
the Delaware General Corporation Law. These provisions could make it more
difficult for a third party to acquire us, even if doing so would be beneficial
to our stockholders.
Our stock price may be volatile.
The market price for our common stock is likely to be highly volatile and
subject to wide fluctuations in response to factors including those set forth
in the items under "Risks That Could Affect Our Financial Condition and Results
of Operations". An active public market for our common stock may not develop or
be sustained. In addition, the stock markets in general, and The Nasdaq
National Stock Market and technology companies in particular, have experienced
extreme price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of such companies. The trading
prices of many comparable technology companies' stocks are at or near
historical highs. These trading prices are substantially above historic levels
and may not be sustained. These broad market and industry factors may seriously
impact the market price of our common stock, regardless of our actual operating
performance.
Item 3. QUANTITATIVE AND QUALITATIVE DISCUSSION OF MARKET RISK
We are exposed to fluctuations in interest rates and market values of our
investments. Our exposure to fluctuations in interest rates and market values
of our investments relates primarily to our short-term investment
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portfolio, which is included in cash and cash equivalents and short-term
investments. We have not used derivative financial instruments in our
investment portfolio. We invest our excess cash in highly liquid commercial
paper and U.S. Government debt securities with maturities of less than one
year, and, by policy, we limit the amount of credit exposure to any one issuer.
Due to the short-term nature of our investments, the impact of interest rate
changes would not be expected to have a significant impact on the value of
these investments. The effect of interest rate and investment risk on us has
not been significant.
Investments in both fixed rate and floating rate interest earning
instruments carry a degree of interest rate risk. Fixed rate securities may
have their fair market value adversely impacted due to a rise in interest
rates, while floating rate securities may produce less income than expected if
interest rates fall. Our fixed rate debt consists of $560,000 in notes payable,
bearing interest at 5.79 percent, to various stockholders.
We generally limit our investments to short-term, highly rated, fixed income
facilities such as repurchase agreements collateralized by government
securities and A-1/P-1 commercial paper. We intend to maintain our current
investment policy, which is designed to preserve principal while at the same
time maximizing the after-tax income we receive from our investments without
significantly increasing risk. Some of the securities that we may invest in may
be subject to market risk. This means that a change in prevailing interest
rates may cause the principal amount of the investment to fluctuate. For
example, if we hold a security that was issued with a fixed interest rate at
the then-prevailing rate and the prevailing interest rate later rises, the
principal amount of our investment will probably decline. To minimize this risk
in the future, we generally intend to maintain our portfolio of cash
equivalents and short-term investments in a variety of securities, including
commercial paper, money market funds, government and non-government debt
securities. However, we may, when and if the opportunity arises, acquire or
invest in complementary businesses, products and technologies. . Such
investments may be illiquid for an indefinite period of time, or otherwise
subject to greater risk than that allowed for our remaining cash assets. In
addition, as of April 1, 2000 we had investments totaling $5.75 million in
foreign securities, which are included in other assets in our financial
statements. To the extent any of our investments are in foreign securities, we
may be subject to foreign currency exchange rate risks.
We currently have no floating rate indebtedness, hold no derivative
instruments and do not earn significant foreign sourced income. Accordingly,
changes in interest rates or currency exchange rates do not generally have a
direct effect on our financial position. In addition, we have primarily
operated in the United States and Canada and all purchases and sales to date
have been made in U.S. dollars. Foreign currency exchange rates, however, may
affect the cost of our PCs and monitors purchased from our foreign suppliers,
thereby indirectly affecting consumer demand for our products and our net
revenues. In addition, to the extent that changes in interest rates and
currency exchange rates affect general economic conditions, we would also be
affected by such changes.
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PART II.
OTHER INFORMATION
Item 1: Legal Proceedings
In July 1999, Compaq Computer Corporation filed a complaint against us,
TriGem Computer, TriGem America and Korea Data Systems as defendants in the
U.S. District Court for the Southern District of Texas based on the defendants'
alleged infringement of 13 patents held by Compaq related to improved system
processing speed, enhanced video graphics, peripheral compatibility and overall
system architecture. The complaint seeks an accounting, treble damages, a
preliminary and permanent injunction from further alleged infringement,
attorneys' fees and other unspecified damages. We filed a response in September
1999, seeking declaratory judgment of noninfringement and invalidity of
Compaq's patents and asserting counterclaims against Compaq that included false
and misleading advertising under the Lanham Act, business disparagement and
unfair competition under Texas common law. The case is currently in the early
stages of discovery. As a result, we are currently unable to estimate total
expenses, possible loss or range of loss that may be ultimately connected with
these allegations. We are indemnified against liability under the terms of our
PC supply agreement. We cannot assure you that Compaq will not succeed in
obtaining monetary damages or an injunction against the production of our PC
products. Our defense of the claims could result in significant expenses and
diversion of management's attention and other resources. Although we believe
our direct financial exposure is limited under our indemnification
arrangements, the results of complex litigation of this sort are inherently
uncertain and difficult to predict and we cannot assure you that the results of
this litigation would not result in our business being significantly harmed,
particularly if it affects production of our PCs.
Packard Bell filed a complaint on October 6, 1999 in Federal District Court
for the Eastern District of California, alleging patent infringement on Packard
Bell patents which it asserts relates to the (i) graphics controller, (ii)
parallel port controller, and (iii) bus interface of our eTower machine. We
filed a response in January 2000 disputing infringement and asserting that the
patents at issue are invalid. We are in the early stages of discovery. As a
result, we are currently unable to estimate total expenses, possible loss or
range of loss that may be ultimately connected with these allegations. We are
indemnified against liability under the terms of our PC supply agreement. We
cannot assure you that Packard Bell will not succeed in obtaining monetary
damages or an injunction against the production of our PC products. Our defense
of the claims could result in significant expenses and diversion of
management's attention and other resources. Although we believe our direct
financial exposure is limited under our indemnification arrangement, the
results of complex litigation of this sort are inherently uncertain and
difficult to predict and we cannot assure you that the results of this
litigation would not result in our business being significantly harmed,
particularly if it affects production of our PCs.
In October 1999, David Packard on behalf of a putative nationwide class,
filed a complaint against us as a defendant in the U.S. District Court for the
Eastern District of Texas based on our alleged sale of defective goods.
Essentially identical complaints were filed contemporaneously against Compaq,
Hewlett-Packard and Packard Bell. The complaints claim that a chip in the
defendants' respective PC products contains a defect which may cause an error
to occur when information is written to a floppy disk. The complaint seeks
unspecified monetary damages, injunctive relief and declaratory relief. The
lawsuit against us is in the early stages of discovery and we have not yet
filed a response. Although we believe that we have meritorious defenses and
intend to vigorously defend ourselves in this action, these types of litigation
are inherently complex and unpredictable. We cannot assure you that the class
action suit will not succeed in obtaining unspecified monetary damages,
injunctive and declaratory relief against the production of our PC products.
Our defense of the claims could result in significant expenses and diversion of
management's attention and other resources. In addition, we cannot assure you
that the results of this litigation would not result in our business being
significantly harmed.
It is common in the PC manufacturing industry for patent, trademark and
other intellectual property claims to be asserted against companies. We receive
notices from time to time that our technology allegedly infringes on
intellectual property rights held by others. As a result, we may be required to
defend legal actions relating to allegedly protected technology. Various other
lawsuits, claims and proceedings have been or may be asserted
30
<PAGE>
against us, including those related to product liability, intellectual
property, environmental, safety and health and employment matters. Litigation
is expensive and time consuming regardless of the merit of the claim and could
divert management's attention from our business. Moreover, the outcome of
litigation cannot be predicted with certainty. Some lawsuits, claims or
proceedings may be disposed of unfavorably to us.
Item 2: Changes in Securities and Use of Proceeds
On January 14, 2000, pursuant to an Agreement and Plan of Reorganization
between us and FreePC, we issued to the stockholders of FreePC: 3,995,633
shares of common stock; warrants to purchase an additional 9,269,834 shares of
common stock; 10,175,516 shares of our Series B preferred stock and 7,458,370
shares of our Series C preferred stock. In addition, we assumed options
exercisable for (i) an aggregate of 2,891,275 shares of common stock; and (ii)
warrants to purchase an aggregate of 1,239,067 shares of Common Stock. These
securities were issued in transactions exempt from registration under the
Securities Act of 1933 in reliance upon Section 4(2) of the Securities Act of
1933.
We filed a Registration Statement on Form S-1 (File No. 333-86219) with the
Securities and Exchange Commission registering a total of 20,000,000 shares of
our common stock with a maximum aggregate offering price of $180.0 million,
which Registration Statement was declared effective by the SEC on March 23,
2000. On March 24, 2000 our shares commenced trading and on March 29, 2000, we
completed the sale of all 20,000,000 registered shares of common stock at a
price of $9.00 per share in our initial public offering pursuant to the
Registration Statement. The principal underwriters for the offering were Credit
Suisse First Boston Corporation, Chase Securities Inc., FleetBoston Robertson
Stephens Inc. and Salomon Smith Barney Inc.
In connection with the offering, we paid an aggregate of $12.6 million in
underwriting discounts and commissions and paid other expenses of approximately
$2.3 million, none of which were paid directly or indirectly to any of our
directors or officers, any person owning 10% or more of any class of our equity
securities, or any of our affiliates. After deducting the underwriting
discounts and commissions and other expenses, we received aggregate proceeds
from the offering of approximately $165.1 million. We intend to use the
proceeds from this offering primarily for general corporate purposes, including
working capital, expansion of our sales and marketing organization, and capital
expenditures. Pending such use, we have invested such proceeds in short-term,
interest-bearing, investment-grade securities. None of the net proceeds of the
offering were paid directly or indirectly to any of our directors or officers,
any person owning 10% or more of any class of our equity securities, or any of
our affiliates.
On March 29, 2000, upon the closing of the initial public offering of our
common stock, all outstanding shares of our Series A preferred stock
(consisting of 24,279,369 shares), Series B preferred stock (consisting of
10,175,516 shares) and Series C Preferred Stock (consisting of 7,458,370
shares) were converted on a share-for-share basis into shares of our common
stock.
During the quarter ended April 1, 2000, following the exercise of options to
purchase shares of common stock that had been granted under our 1998 Stock
Plan, the FreePC 1999 Stock Plan and the Guide.com 1998 Stock Option Plan by 27
employees and consultants, we issued an aggregate of 937,148 shares of common
stock for an aggregate purchase price of approximately $320,000. All of such
sales of common stock were made in transactions exempt from registration under
the Securities Act of 1933 in reliance upon Section 4(2) of the Securities Act
of 1933.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matter to a Vote of Security Holders.
In connection with our acquisition of FreePC, pursuant to a written consent
of our stockholders, last dated January 10, 2000, our stockholders approved our
Amended and Restated Certificate of Incorporation to, among
31
<PAGE>
other things create two series of preferred stock to be issued to holders of
FreePC capital stock and to increase the number of authorized shares of capital
stock that we may issue to 300,000,000, 250,000,000 of which shall be common
stock and 50,000,000 of which shall be preferred stock. Holders of
approximately 75.4% of our outstanding capital stock consented to the foregoing
actions, and the remainder abstained from voting.
In connection with our initial public offering, pursuant to a written
consent of our stockholders, last dated March 17, 2000, our stockholders
approved: (a) our Amended and Restated Certificate of Incorporation to be filed
with the Secretary of State of the State of Delaware following the closing of
our initial public offering of common stock, (b) the adoption of our Amended
and Restated 1998 Stock Plan and the reservation of up to 5,000,000 shares of
common stock for issuance under such plan, plus an annual increase to be added
on the first day of our fiscal year beginning in 2001 equal to the lesser of
(i) 2,000,000 shares of our common stock, (ii) 4% of our outstanding shares of
common stock on such date, or (iii) a lesser amount determined by the Board,
and (c) the adoption of our 2000 Employee Stock Purchase Plan and the
reservation of up to 300,000 shares of common stock for issuance under such
plan, plus an annual increase to be added on the first day of our fiscal year
beginning in 2001 equal to the lesser of (i) 300,000 shares of our common
stock, (ii) 1% of our outstanding share of common stock on such date, or (iii)
a lesser amount determined by the Board. Holders of approximately 84.2% of our
outstanding stock consented to the foregoing actions, and the remainder
abstained from voting.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
A. Exhibits
<TABLE>
<CAPTION>
Exhibit
Number Description of Document
------- -----------------------
<C> <S>
3.1 Amended and Restated Certificate of Incorporation (incorporated by
reference to Exhibit 3.2 to eMachines' Registration Statement on
Form S-1 (File No. 333-86219) effective March 23, 2000 (the "S-1
Registration Statement"))
3.2 Amended and Restated Bylaws (incorporated by reference to Exhibit
3.4 to the S-1 Registration Statement)
27.1 Financial Data Schedule
</TABLE>
B. Reports on Form 8-K
None.
32
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
eMachines, Inc.
/s/ Steven H. Miller
Dated: May 15, 2000 By: _________________________________
Steven H. Miller
Chief Financial Officer
(Principal Financial and
Accounting Officer)
33
<PAGE>
Index to Exhibits
<TABLE>
<CAPTION>
Exhibit
Number Description of Document
------- -----------------------
<C> <S>
3.1 Amended and Restated Certificate of Incorporation (incorporated by
reference to Exhibit 3.2 to eMachines' Registration Statement on Form
S-1 (File No. 333-86219) effective March 23, 2000 (the "S-1
Registration Statement"))
3.2 Amended and Restated Bylaws (incorporated by reference to Exhibit 3.4
to the S-1 Registration Statement)
27.1 Financial Data Schedule
</TABLE>
34
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-30-2000
<PERIOD-START> JAN-01-2000
<PERIOD-END> APR-01-2000
<CASH> 303,105
<SECURITIES> 0
<RECEIVABLES> 122,963
<ALLOWANCES> 3,168
<INVENTORY> 68,934
<CURRENT-ASSETS> 496,223
<PP&E> 3,443
<DEPRECIATION> 707
<TOTAL-ASSETS> 643,847
<CURRENT-LIABILITIES> 192,766
<BONDS> 0
0
0
<COMMON> 2
<OTHER-SE> 448,469
<TOTAL-LIABILITY-AND-EQUITY> 643,847
<SALES> 249,840
<TOTAL-REVENUES> 249,840
<CGS> 235,332
<TOTAL-COSTS> 235,322
<OTHER-EXPENSES> 25,957<F1>
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (1,899)
<INCOME-PRETAX> (11,896)
<INCOME-TAX> 0
<INCOME-CONTINUING> (11,896)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (11,896)
<EPS-BASIC> (.13)
<EPS-DILUTED> (.13)
<FN>
<F1>ALL OPERATING EXPENSES 15,761
GOODWILL AMORTIZATION 10,196
------
$25,957
=======
</FN>
</TABLE>
