<PAGE>
===============================================================================
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 July 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 August 1, 2000, there were 144,932,765 shares of the registrant's
Common Stock outstanding.
===============================================================================
<PAGE>
eMachines, Inc.
INDEX
PART I--FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Page
----
<C> <S> <C>
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets at July 1, 2000 and
December 31, 1999............................................... 3
Condensed Consolidated Statements of Operations for the Quarters
Ended and Six Months Ended July 1, 2000 and June 30, 1999....... 4
Condensed Consolidated Statements of Cash Flows for the Six
Months Ended July 1, 2000 and June 30, 1999..................... 5
Notes to Condensed Consolidated Financial Statements............ 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................... 11
Item 3. Quantitative and Qualitative Disclosure About Market Risk....... 31
PART II--OTHER INFORMATION
Item 1. Legal Proceedings............................................... 32
Item 2. Changes in Securities and Use of Proceeds....................... 32
Item 3. Defaults Upon Senior Securities................................. 32
Item 4. Submission of Matters to a Vote of Security Holders............. 32
Item 5. Other Information............................................... 32
Item 6. Exhibits and Reports on Form 8-K................................ 33
A. Exhibits........................................................ 33
B. Reports on Form 8-K............................................. 33
Signature................................................................ 34
Exhibit Index............................................................ 35
</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
July 1, 2000 and December 31, 1999
(in thousands, except share information)
<TABLE>
<CAPTION>
July 1, December 31,
2000 1999
-------- ------------
<S> <C> <C>
ASSETS
------
Current assets:
Cash and cash equivalents............................. $191,093 $114,823
Short-term investments................................ 15,341 19,897
Accounts receivable, less allowances ($4,515 and
$2,160 at July 1, 2000 and December 31, 1999,
respectively)........................................ 83,175 123,726
Inventories........................................... 115,877 65,260
Prepaid and other current assets...................... 6,657 3,992
-------- --------
Total current assets................................ 412,143 327,698
Property and equipment, net............................. 2,818 1,827
Intangible assets....................................... 121,637 --
Other assets............................................ 7,960 2,188
-------- --------
$544,558 $331,713
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)
-------------------------------------------------
Current liabilities:
Trade payables-related party.......................... $ 69,659 $131,935
Accounts payable...................................... 10,245 12,939
Accrued rebates....................................... 33,341 22,803
Accrued expenses and other current liabilities........ 43,043 19,855
-------- --------
Total current liabilities........................... 156,288 187,532
Deferred revenue--noncurrent portion.................... 1,998 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 July 1, 2000; 25,000,000 shares authorized;
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.........
Common stock, $.0000125 par value; 350,000,000 shares
authorized; 144,886,415 and 78,019,538 shares
outstanding at July 1, 2000 and December 31, 1999,
respectively......................................... 2 1
Additional paid-in capital............................ 474,252 6,582
Unearned stock compensation........................... (1,367) (1,550)
Notes receivable from stockholders.................... (500) (500)
Accumulated deficit................................... (86,675) (12,269)
-------- --------
Total stockholders' equity (deficiency)............. 385,712 (7,736)
-------- --------
$544,558 $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 and Six Months Ended July 1, 2000 and June 30, 1999
(in thousands, except share information)
<TABLE>
<CAPTION>
Quarter Ended Six Months Ended
------------------------- -------------------------
June 30, June 30,
July 1, 2000 1999 July 1, 2000 1999
------------ ----------- ------------ -----------
<S> <C> <C> <C> <C>
Net revenues:
Hardware............... $ 121,237 $ 213,879 $ 367,680 $ 351,313
Internet............... 3,239 -- 6,636 --
------------ ----------- ------------ -----------
Net revenues......... 124,476 213,879 374,316 351,313
------------ ----------- ------------ -----------
Cost of revenues:
Hardware............... 156,533 207,689 391,512 338,790
Internet............... 486 -- 839 --
------------ ----------- ------------ -----------
Cost of revenues..... 157,019 207,689 392,351 338,790
------------ ----------- ------------ -----------
Gross profit (loss).... (32,543) 6,190 (18,035) 12,523
Operating expenses:
Sales and marketing
(includes $22, $16,
$44 and $16 of non-
cash stock-based
compensation,
respectively)......... 4,685 2,814 10,745 5,533
Product development.... 732 -- 1,244 --
Customer service and
technical support..... 6,454 1,573 10,229 2,522
General and
administrative
(includes $69, $83,
$138 and $124 of non-
cash stock-based
compensation,
respectively)......... 7,008 2,270 12,422 3,417
Amortization of
intangible assets..... 14,994 -- 25,190 --
------------ ----------- ------------ -----------
Total operating
expenses............ 33,873 6,657 59,830 11,472
------------ ----------- ------------ -----------
Income (loss) from
operations.............. (66,416) (467) (77,865) 1,051
Interest income
(expense), net.......... 3,906 (2,570) 5,805 (4,960)
------------ ----------- ------------ -----------
Net loss................. (62,510) (3,037) (72,060) (3,909)
Accretion of mandatorily
redeemable preferred
stock to redemption
value................... -- -- (2,346) --
------------ ----------- ------------ -----------
Net loss attributable to
common stockholders..... $ (62,510) $ (3,037) $ (74,406) $ (3,909)
============ =========== ============ ===========
Net loss per share
attributable to common
stockholders:
Basic and diluted...... $ (0.43) $ (0.05) $ (0.64) $ (0.07)
Shares used in computing
loss:
Basic and diluted...... 144,873,927 62,215,385 116,374,619 59,920,442
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE>
eMachines, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
Six Months Ended July 1, 2000 and June 30, 1999
(in thousands)
<TABLE>
<CAPTION>
Six Months Ended
--------------------------
July 1, 2000 June 30, 1999
------------ -------------
<S> <C> <C>
Cash flows from operating activities:
Net loss.......................................... $(72,060) $(3,909)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Provision for bad debts, sales returns and sales
incentives..................................... 2,355 8,733
Depreciation and amortization................... 25,623 103
Stock-based compensation expense................ 182 140
Changes in operating assets and liabilities:
Accounts receivable............................. 39,004 (88,039)
Inventories..................................... (48,952) (9,955)
Prepaid and other current assets................ (1,542) (2,499)
Trade payables-related party.................... (62,276) 76,653
Accounts payable................................ (4,714) 3,908
Accrued rebates................................. 10,538 16,534
Accrued expenses and other current liabilities.. 18,316 6,976
Deferred revenue--non current portion........... 655 --
-------- -------
Net cash provided (used) by operating
activities..................................... (92,871) 8,645
-------- -------
Cash flow from investing activities:
Cash acquired in business combination............. 5,651 --
Cash provided upon maturity of short-term
investments...................................... 4,556 --
Other assets...................................... (5,750) (241)
Acquisition of property and equipment............. (445) (1,284)
-------- -------
Net cash provided (used) in investing
activities..................................... 4,012 (1,525)
-------- -------
Cash flows from financing activities:
Proceeds from issuance of common stock in
connection with initial public offering, net of
offering costs................................... 164,802 --
Proceeds from issuance of common stock upon
exercise of common stock options................. 327 --
-------- -------
Net cash provided by financing activities....... 165,129 --
-------- -------
Net increase in cash................................ 76,270 7,120
Cash and cash equivalents, beginning of period...... 114,823 3,791
-------- -------
Cash and cash equivalents, end of period............ $191,093 $10,911
-------- -------
</TABLE>
Supplemental disclosure of noncash financing activities:
In January 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 $150,083 was allocated
to the net assets acquired and intangible assets as described in Note 3--
Business Combination.
In March 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 4--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 subsidiaries (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 each fiscal quarter ends 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--EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, June 1999 and June 2000, the Financial Accounting Standards
Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities," SFAS No. 137, "Accounting for Derivative Instruments and
Hedging Activities--Deferral of the Effective Date of FSAB Statement No. 133"
and SFAS No. 138, "Accounting for Derivative Instruments and Hedging
Activities--An Amendment of SFAS No. 133." SFAS No. 133, as amended requires
the recognition of all derivatives as either assets or liabilities in the
balance sheet and the measurement of those instruments at fair value. The
accounting for changes in the fair value of a derivative depends on the planned
use of the derivative and the resulting designation. The Company is required to
implement SFAS No. 133, as amended, in the first quarter of 2001. The Company
has not determined the effects, if any, adoption of SFAS No. 133, as amended,
will have on its consolidated financial statements.
In March 2000, the Financial Accounting Standards Board issued FASB
Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions
Involving Stock Compensation--an interpretation of APB Opinion No. 25." FIN 44
clarifies the application of APB Opinion No. 25 and, among other issues
clarifies the following: the definition of an employee for purposes of applying
APB Opinion No. 25; the criteria for determining whether a plan qualifies as a
noncompensatory plan; the accounting consequence of various modifications to
the terms of the previously fixed stock options or awards; and the accounting
for an exchange of stock compensation awards in a business combination. FIN 44
is effective July 1, 2000, but certain conclusions in FIN 44 cover specific
events that occurred after either December 15, 1998 or January 12, 2000. The
Company does not expect the application of FIN 44 to have a material impact on
the Company's consolidated financial position or results of operations.
In December 1999, the SEC issued Staff Accounting Bulletin ("SAB") No. 101,
"Revenue Recognition in Financial Statements" which summarizes the views of the
staff of the SEC in applying generally accepted accounting principles to
revenue recognition in financial statements. In March 2000 and June 2000 the
SEC issued SAB No. 101A and SAB No. 101B, which delayed the implementation
dates of SAB No. 101. The Company will be required to adopt the accounting
provisions of SAB No. 101, as amended, no later than the fourth quarter of
2000. The Company does not believe that the implementation of SAB No. 101 will
have a material impact on the Company's consolidated financial position or
results of operations.
6
<PAGE>
eMachines, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(in thousands, except share information)
NOTE 3--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 $150,083,
including approximately $83 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 was 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 $141,527 being allocated to goodwill.
<TABLE>
<S> <C>
Workforce.......................................................... $ 5,300
Goodwill........................................................... 141,527
Fair value of net assets........................................... 3,256
--------
$150,083
========
</TABLE>
As a result of the reduction in the workforce acquired with the acquisition
of FreePC, during the quarter ended July 1, 2000, the Company wrote-off $2,754
of the workforce intangible assets as a charge to amortization expense. The
intangible assets resulting from the purchase transaction are being amortized
over their estimated useful lives of three years using the straight-line
method.
7
<PAGE>
eMachines, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(in thousands, except share information)
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 and the six
months ended July 1, 2000 and June 30, 1999 are as follows:
<TABLE>
<CAPTION>
Quarters Ended Six Months Ended
--------------------------- ---------------------------
July 1, 2000 June 30, 1999 July 1, 2000 June 30, 1999
------------ ------------- ------------ -------------
<S> <C> <C> <C> <C>
Revenues................ $ 124,476 $ 213,959 $ 374,372 $ 351,439
Net loss attributable to
common stockholders.... (62,510) (23,055) (77,239) (37,282)
Net loss per share
attributable to common
stockholders:
Basic and diluted..... $ (0.43) $ (0.35) $ (0.66) $ (0.58)
Shares used in computing
pro forma net loss per
share attributable to
common stockholders:
Basic and diluted..... 144,873,927 66,211,018 116,636,628 63,916,075
</TABLE>
NOTE 4--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
$15,198 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 9,269,834 warrants that were
issued to former stockholders of FreePC and 1,239,067 warrants issuable upon
exercise of options assumed in connection with the acquisition of FreePC is
$17.13 per share.
NOTE 5--EARNINGS PER SHARE
The Company computes net income (loss) per share in accordance with SFAS No.
128, "Earnings Per Share" which requires dual presentation of basic earnings
per share ("EPS") and diluted EPS. Basic EPS is computed using the weighted
average number of common shares outstanding during the period. Diluted EPS is
8
<PAGE>
eMachines, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(in thousands, except share information)
computed using the weighted average number of common shares and potentially
dilutive shares outstanding during the period. Potential common shares consist
of shares issuable upon the exercise of stock options and warrants using the
treasury stock method and convertible preferred stock. Potentially dilutive
shares are excluded from the computation in loss periods as their effect would
be antidilutive. The following table sets forth potentially dilutive securities
that were excluded in the computation of diluted net loss per share in the
periods presented, as their effect would have been antidilutive.
<TABLE>
<CAPTION>
Quarters Ended Six Months Ended
-------------------------- --------------------------
July 1, 2000 June 30, 1999 July 1, 2000 June 30, 1999
------------ ------------- ------------ -------------
<S> <C> <C> <C> <C>
Basic Weighted Average
Shares................. 144,873,927 62,215,385 116,374,619 59,920,442
Dilutive effect of Stock
Options and Warrants... 1,470,202 353,830 1,904,175 314,300
Dilutive effect of
Preferred Shares....... -- -- 17,853,520 --
----------- ---------- ----------- ----------
Diluted Weighted Average
Shares................. 146,344,129 62,569,215 136,132,314 60,234,742
</TABLE>
NOTE 6--INVENTORY
Inventories consist principally of personal computers and monitors and are
stated at the lower of cost, determined by the moving average method, or
market. Due to adverse market conditions in the second quarter of 2000, the
Company determined that the cost of certain of its inventory was in excess of
market value and wrote down this inventory by $21.6 million.
NOTE 7--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 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.
9
<PAGE>
eMachines, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(in thousands, except share information)
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.
10
<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 within the
meaning of Section 27A of the Securities Act of 1933, as amended and Section
21E of the Securities Exchange Act of 1934, as amended, including but not
limited to 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
The Company. We were incorporated in September 1998 by our founding
stockholders: (i) Stephen A. Dukker, our Chief Executive Officer, President and
a member of our board of directors; (ii) TriGem Corporation, the wholly-owned
U.S. subsidiary of TriGem Computer, the Korea-based manufacturer of our eTower
and eMonster PCs; and (iii) Korea Data Systems America, the wholly-owned U.S.
subsidiary of Korea Data Systems Co., Ltd., the Korea-based company that
historically manufactured our eOne PCs, eSlate notebook PCs and our monitors.
We continue to purchase monitors from Korea Data Systems America, among others.
We sold our first PC in November 1998. In March 2000 we successfully completed
the initial public offering of our common stock generating net proceeds to us
of $164.8 million.
Products. 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.
Manufacturing. 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 139 employees as of July 1, 2000. Our hardware outsourcing
strategy enables us to minimize capital investment and maintain a low product
cost structure. During the quarter ended July 1, 2000, we partnered with
Alorica, Inc., as our new customer service and technical support provider and
we plan to continue to establish supply relationships with other PC and monitor
manufacturers in order to reduce our dependence on our current suppliers.
Revenues. To date, we have derived most of our revenues from the sales of
PCs and monitors to a limited number of large retailers. For the six months
ended July 1, 2000, approximately 54.8% 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.
11
<PAGE>
Results of Operations
The following table reconciles net loss attributable to common stockholders
to 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>
Quarters Ended Six Months Ended
--------------------------- ---------------------------
July 1, 2000 June 30, 1999 July 1, 2000 June 30, 1999
------------ ------------- ------------ -------------
(in thousands except share and per share amounts)
<S> <C> <C> <C> <C>
Net loss attributable to
common stockholders.... $ (62,510) $ (3,037) $ (74,406) $ (3,909)
Amortization of
intangible assets...... 14,994 -- 25,190 --
Non-cash stock-based
compensation........... 91 99 182 140
Accretion of mandatorily
redeemable preferred
stock to
redemption value....... -- -- 2,346 --
------------ ----------- ------------ -----------
Loss before amortization
of intangible assets,
non-cash stock-based
compensation and
accretion of
mandatorily redeemable
preferred stock to
redemption value....... $ (47,425) $ (2,938) $ (46,688) $ (3,769)
============ =========== ============ ===========
Loss per share before
amortization of
intangible assets, non-
cash stock-based
compensation and
accretion of
mandatorily redeemable
preferred stock to
redemption value:
Basic and diluted...... $ (0.33) $ (0.05) $ (0.40) $ (0.06)
Shares used in computing
loss:
Basic and diluted...... 144,873,927 62,215,385 116,374,619 59,920,442
</TABLE>
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 our 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 Revenues
<TABLE>
<CAPTION>
Quarters Ended Six Months Ended
-------------------------------- --------------------------------
July 1, 2000(1) June 30, 1999(2) July 1, 2000(3) June 30, 1999(4)
--------------- ---------------- --------------- ----------------
<S> <C> <C> <C> <C>
Net revenues:
Hardware............... 97.4% 100.0% 98.2% 100.0%
Internet............... 2.6 0.0 1.8 0.0
----- ----- ----- -----
Net revenues......... 100.0 100.0 100.0 100.0
Cost of revenues:
Hardware............... 125.7 97.1 104.6 96.4
Internet............... 0.4 0.0 0.2 0.0
----- ----- ----- -----
Cost of revenues..... 126.1 97.1 104.8 96.4
----- ----- ----- -----
Gross profit (loss).... (26.1) 2.9 (4.8) 3.6
Operating expenses:
Sales and marketing.... 3.7 1.3 2.9 1.6
Product development.... 0.6 0.0 0.3 0.0
Customer service and
technical support..... 5.2 0.7 2.7 0.7
General and
administrative........ 5.6 1.1 3.3 1.0
----- ----- ----- -----
Total operating
expenses............ 15.1 3.1 9.2 3.3
----- ----- ----- -----
Income (loss) from
operations............. (41.2) (0.2) (14.0) 0.3
Interest income
(expense), net......... 3.1 (1.2) 1.5 (1.4)
Loss before accretion of
mandatorily redeemable
preferred stock to
redemption value....... (38.1)% (1.4)% (12.5)% (1.1)%
===== ===== ===== =====
</TABLE>
12
<PAGE>
--------
(1) Excludes $15.0 million of amortization charges related to the acquisition
of FreePC, Inc. See "Note 3--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) Sales and marketing expenses exclude $16,000 of non-cash stock-based
compensation expense and general and administrative expenses exclude
$83,000 of non-cash stock-based compensation expense.
(3) Excludes $25.2 million of amortization charges related to the acquisition
of FreePC, Inc. See "Note 3--Business Combination" in Notes to Condensed
Consolidated Financial Statements. Sales and marketing expense exclude
$44,000 of non-cash stock-based compensation expense and general and
administrative expenses exclude $138,000 of non-cash stock-based
compensation expense.
(4) Sales and marketing expenses exclude $16,000 of non-cash stock-based
compensation expense and general and administrative expenses exclude
$124,000 of non-cash stock-based compensation expense.
Net Revenues
Net Hardware Revenues. To date substantially all of our hardware revenues
have 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 decreased to $121.2 million for the quarter ended July 1, 2000 from
$213.9 million for the quarter ended June 30, 1999. This represents a 43.3%
decrease and was due to decreased unit shipments, promotional discounts given
and increased rebate programs. Due to adverse market conditions, $9.7 million
of promotional discounts were provided to customers and $7.9 million of rebate
incentives, in addition to normal mail-in rebates, were given on selected
models during the quarter ended July 1, 2000. For the quarter ended July 1,
2000, we shipped 326,000 PC units, a decrease of 29% from the quarter ended
June 30, 1999. For the six months ended July 1, 2000, net hardware revenues
increased to $367.7 million from $351.3 million for the six months ended June
30, 1999. This represents a 4.7% increase and is due to increased PC unit
shipments. For the six months ended July 1, 2000 PC unit shipments increased
8.8% over the prior year period. Net revenue from extended service contracts
and technical support during these periods was minimal and reported with net
hardware revenues.
Internet Revenues. We recognized total Internet revenues of $3.2 million and
$6.6 million for the quarter ended and six months ended July 1, 2000,
respectively. No Internet revenues were earned during the six months ended June
30, 1999. Internet revenues as a percentage of consolidated net revenues
increased to 2.6% for the quarter ended July 1, 2000 from 1.4% of consolidated
net revenues for the quarter ended April 1, 2000. Internet revenues increased
as a percentage of consolidated net revenues as the result of the development
of recurring revenues associated with the maturing of our installed base not
related to current-period PC unit shipments. 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. However, we do not expect the same magnitude of increase in Internet
revenues as a percentage of consolidated net revenues in subsequent periods,
and, in fact, Internet revenues as a percentage of consolidated net revenues
may decrease in periods of increased PC revenues.
Cost of Revenues
Cost of revenues consists primarily 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 decreased to $157.0 million for the quarter ended July 1, 2000 from
$207.7 million for the quarter ended June 30, 1999. This decrease was due to
decreased unit shipments offset by a $21.6 million write down of inventory as
described in "Note 6--Inventory" to our Condensed Consolidated Financial
Statements included with this report on Form 10-Q. For the six months ended
July 1, 2000, cost of revenues increased to $392.4 million from $338.8 million
for the six months ended June 30, 1999. This increase was due to increased unit
shipments and the $21.6 million write down of inventory in the quarter ended
July 1, 2000.
13
<PAGE>
Gross Margin
As a result of the $21.6 million write down of inventory, $9.7 million of
promotional discounts provided to customers and $7.9 million of rebate
incentives, in addition to normal mail-in rebates, given on selected models
during the quarter ended July 1, 2000, cost of revenues exceeded net revenues
from sales resulting in negative gross margins of 26.1% and 4.8% for the
quarter and six months ended July 1, 2000, respectively. This compares with
positive gross margins of 2.9% and 3.6% for the quarter and six months, ended
June 30, 1999, respectively.
Operating Expenses
Sales and Marketing. Excluding non-cash stock-based compensation charges,
sales and marketing expenses increased to $4.7 million, or 3.7% of net revenues
for the quarter ended July 1, 2000, from $2.8 million or 1.3% of net revenues
for the quarter ended June 30, 1999. For the six months ended July 1, 2000,
excluding non-cash stock-based compensation charges, sales and marketing
expenses increased to $10.7 million or 2.9% of net revenues from $5.5 million
or 1.6% of net revenues for the six months ended June 30, 1999. The increase in
absolute dollars and percentage of net revenues was due primarily to the
expansion of our in-house sales and marketing force through the acquisition of
FreePC, our Internet-related sales and marketing activities and marketing funds
provided to retail customers. 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 July 1, 2000 was $700,000 or 0.6% of
net revenues and for the six months ended July 1, 2000 product development
expense was $1.2 million or 0.3% of net revenues. We expect to continue to
increase our product development expenses in absolute dollars as our Internet
business grows.
Customer Service and Technical Support. We outsource our customer service
and technical support. Customer service and technical support expenses
increased to $6.5 million, or 5.2% of net revenues for the quarter ended July
1, 2000 from $1.6 million, or 0.7% of net revenues for the quarter ended June
30, 1999. For the six months ended July 1, 2000 customer service and technical
support expenses increased to $10.2 million, or 2.7% of net revenues from $2.5
million, or 0.7% of net revenues for the six months ended June 30, 1999.
Customer service and technical support expenses increased in absolute dollars
and percentage of net revenues as a result of increased call volume due to our
larger installed base, expenses associated with the transition of outsourcing
customer service and technical support to Alorica from our previous provider
and increased Internet-related services. Excluding transition charges, 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
to $6.9 million, or 5.6% of net revenues, for the quarter ended July 1, 2000,
from $2.2 million, or 1.1% of net revenues, for the quarter ended June 30,
1999. For the six months ended July 1, 2000, excluding non-cash stock-based
compensation charges, general and administrative expenses increased to $12.3
million, or 3.3% of net revenues from $3.3 million, or 1.0% of net revenues for
the six months ending June 30, 1999. The increase in general and administrative
expenses is due to increased expenses associated with the addition of
personnel, additional professional fees, including costs associated with being
a public company. Included in general and administrative expenses for the
quarter ended July 1, 2000 was a charge of $1.1 million to increase our
accounts receivable reserve to reflect a higher risk of loss associated with
the possibility of financial difficulties for some of our dot com partners and
increased legal fees of $800,000 for the quarter and $1.3 million for the six
months ended July 1, 2000, respectively. This compares to legal fees of $99,000
for the six months ended June 30, 1999. We expect to sustain current levels of
spending for legal fees in the near future due to continuing litigation
expenses.
14
<PAGE>
Interest Income and Expense. Net interest income was $3.9 million for the
quarter ended July 1, 2000 and $5.8 million for the six months ended July 1,
2000. Net interest income was earned from interest-bearing cash equivalents and
other interest bearing short-term investments. Interest expense was minimal for
the six months ended July 1, 2000 because our only debt consists of $560,000 of
long-term subordinated notes payable to certain stockholders. Net interest
expense was $2.6 million for the quarter ended June 30, 1999 and $5.0 million
for the six months ended June 30, 1999. Interest expense consisted primarily of
interest on trade payables. The private placement of our Series A preferred
stock in August 1999 raised net proceeds of $146.3 million, which were used to
reduce trade payables, and associated financing charges.
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 $164.8 million.
The completion of our public offering coupled with our private placement
financing in August 1999 have provided us with working capital of $255.9
million as of July 1, 2000. Of this amount, $206.4 million consisted of cash,
cash equivalents and short-term investments.
In August 1999, we completed the 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 used by operating activities was $92.9 million for the six months
ended July 1, 2000. The primary uses of cash were purchases of inventory
exceeding sales demand and decreases in trade payables. Net cash provided by
operating activities was $8.6 million for six months ended June 30, 1999,
consisting primarily of increases in trade payables that resulted from our
financing operations through extended payment terms on trade payables.
Net cash provided by investing activities of $4.0 million for the six months
ended July 1, 2000 resulted from the maturities of short-term investments and
cash acquired with the acquisition of FreePC. In February 2000, we invested
$5.75 million in foreign securities. Net cash used for investing activities was
$1.5 million for the six months ended June 30, 1999 and was used primarily for
the purchase of property and equipment.
Net cash provided by financing activities for the six months ended July 1,
2000, was $165.1 million, consisting of the net proceeds from our initial
public offering of common stock and proceeds from exercise of common stock
options. For the six months ended June 30, 1999, there was no net cash provided
by financing activities.
We currently believe that our available funds as of July 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.
Recent Accounting Pronouncements
A discussion of recent accounting pronouncements appears in Note 2 to our
Condensed Consolidated Financial Statements included with this report on Form
10-Q.
15
<PAGE>
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 increased
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 July 1, 2000, we had an accumulated
deficit of $86.7 million. 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. In the
quarter ended July 1, 2000, we experienced a decline in our PC sales due to the
retail channel oversupply of PCs resulting from decreased consumer demand for
these and other higher priced non-PC products. 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 the years 2000 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. Net loss from operations for
the quarter ended July 1, 2000, before amortization of intangible assets and
non-cash stock-based compensation was $47.4 million or a loss of $0.33 per
share, compared to a loss of $2.9 million or $0.05 per share in the year-
earlier period.
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 the quarter ended July 1, 2000, PC prices decreased as a
result of significant discounts and rebates given to the retail channel to
stimulate sales. This decrease in prices, among other things, adversely
affected our financial results in this quarter. In addition, the Internet
advertising and e-commerce market is highly competitive and subject to
16
<PAGE>
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;
. our key suppliers' ability to manufacture and deliver sufficient
quantities of our PC products, and to maintain the quality of our PC
products;
. our Internet partners' ability to pay us on time and provide our users
with their services;
. our ability to manage inventory supply and accurately predict consumer
demand for our PC products and Internet services; and
. our ability to effectively enter new markets, including international
markets.
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.
If we are unable to manage our growth successfully, our business could be
significantly harmed.
Our total number of employees has grown from 10 at December 31, 1998 to 139
at July 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.
17
<PAGE>
As we continue to grow, we will need to assimilate new employees, as well as
expand, train and manage our workforce. We recently hired John Dickinson,
Senior Vice President and General Manager of our Internet Division, and Jack
Ferry, Vice President of Operations, to join our management team. In addition
to performing their regular duties, these individuals as well as all new
employees, 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 manage
our growth, integrate new employees into our business and 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. We must retain our senior management and
key personnel 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. In the second
quarter of 2000, several key personnel resigned from the company, including
Steven H. Miller, our Chief Financial Officer, and Donald S. LaVigne, our
Executive Vice President of Strategy and Business Development and the former
CEO of FreePC. 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 have experienced difficulties in
successfully integrating the additional personnel, operations, technology and
products of FreePC into our business. In particular the acquisition has placed
additional burdens on our existing financial and managerial controls and
reporting systems and procedures, and we have experienced difficulty in
retaining FreePC employees, including key personnel. Several of our officers
who joined us in connection with our acquisition of FreePC are no longer
working for us, including Donald S. LaVigne, who was our executive vice
president of strategy and business development and the former CEO of FreePC.
The acquisition of FreePC allowed us to extend our historical business as a
high-quality, low-priced PC provider to include integrated computing and
Internet advertising offerings. We may not, however, realize the expected
benefits from these offerings if we cannot successfully complete the
integration of FreePC.
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. Further, we may increase our debt or dilute our existing stockholders
if we issue equity securities to pay for future acquisitions.
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 points of contact
18
<PAGE>
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 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 the second quarter ended July 1, 2000, we announced
an alliance with Microsoft pursuant to which we will sell an Internet access
device. The success of this product is uncertain. In addition, the successful
introduction of new products or services by our competitors or us 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 certain of our suppliers, including TriGem Computer, one of our
principal stockholders and the manufacturer of all of our eTower and eMonster
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
19
<PAGE>
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 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 that 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 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, this type of litigation is inherently complex
and unpredictable. There can be no assurances that the suit will not succeed in
obtaining unspecified monetary damages, injunctive or 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
20
<PAGE>
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 or our partners who
have bundled their software on our computers are not successful in designing
this software, or if defects in our or our partner's software or in our PC
products are discovered after we have shipped the 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.
The success of our Internet access device is uncertain.
During the second quarter of 2000, we announced an alliance with Microsoft
for us to sell an Internet access device and we have entered into supply and
other agreements in connection with this device. The success of this device and
other similar devices that we may sell in the future is uncertain and depends
on many factors, including, among others:
. The success and duration of our alliance with Microsoft and other
alliances into which we may enter in the future with respect to our
Internet access device;
. the success and continuation of efforts to promote our Internet access
device;
. Microsoft's and other potential partners' willingness to provide rebates
to the purchasers of our Internet access device;
. our purchasers' willingness to enter into contracts with and pay ISPs in
order to receive rebates; and
21
<PAGE>
. the competitiveness of the price and features of our Internet access
device versus similar products from competing manufacturers.
There can be no assurance that we will be able to enter the Internet access
device market successfully or that if we enter the market successfully, our
efforts will be met with consumer acceptance.
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.
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 new approaches 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 a result many
of these advertisers have not continued to do business with us as we have
discontinued distributing free computers and 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;
22
<PAGE>
. 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, which, among other things, may
not prove to be attractive to Internet partners; 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 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. Some of our
current and future advertisers may not want to partner with us if our Internet-
based services do not prove to be effective for them. 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
23
<PAGE>
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, as well as other PC manufacturers who have or may be entering
into the Internet appliance market;
. 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 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.
24
<PAGE>
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 or, in the case
of eWare, whether this software will be available to our users on a continuous
basis. If eWare is not available to our users, we may experience, among other
things, increased technical support costs and decreased Internet advertising
revenues, which could have a negative impact on our results of operations. 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 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
25
<PAGE>
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. For example, we recently
transitioned our customer support functions to a new vendor. If we cannot
successfully transition these operations, or if the new vendor cannot provide
the level of service we require, our business may be 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.
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.
We currently purchase all of our monitors from Korea Data Systems Co. and Jean
Company. 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 monitors. Our
suppliers are currently operating below full capacity, but may operate at full
capacity in the future. In order to meet anticipated demand for our products
and the products of other customers, TriGem Computer currently utilizes an
outsourcing manufacturing contractor in Xiamen China to manufacture some of our
low priced PC models and its wholly-owned facility, in Shenyang, China, to
manufacture our other PCs. Both facilities are final-assembly plants with
production capacity of approximately 250,000 PC units per month. TriGem
anticipates opening an additional factory in Korea later this year, with
expected additional capacity of approximately 200,000 PC units per month. Under
the terms of our supply agreement with TriGem Computer, TriGem Computer has
agreed to reserve a portion of its manufacturing capacity at its facilities to
meet our supply requirements. Some of the terms of our supply agreement with
TriGem Computer are subject to periodic adjustment and there can be no
assurance that renegotiation of those terms will be favorable to us or that
such renegotiation will not have a negative impact on our results of
operations. 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. We recently entered into a supply agreement for the
manufacture of our Internet access device. There can be no
26
<PAGE>
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 and may need to liquidate such inventory, either of which
could have a material impact on our financial results. For example, due to
adverse market conditions in the second quarter of 2000, we determined that the
cost of certain of our inventory was in excess of market value and wrote down
this inventory by $21.6 million. Conversely. 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 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.
27
<PAGE>
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 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 plan 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 assurance that such efforts will be successful or that our efforts
will be met with consumer acceptance.
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. We will install Windows
Millenium on our PCs for sale in upcoming quarters pursuant to a license 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.
28
<PAGE>
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
six months ended July 1, 2000, approximately 54.8% 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.
We have announced that we will be selling our PCs in Europe through an alliance
with Dixons. Our expansion into international markets or our alliance with
Dixons may not prove to be successful.
An important element of our strategy is to expand our operations into
international markets. To this effect, we entered into an alliance with Dixons
during the second quarter of 2000. We expect that international sales through
our relationship with Dixons will begin in the third quarter of 2000 and will
account for an increasing percentage of our revenues over the foreseeable
future. We have no experience in marketing, selling and distributing our
services internationally. International sales are subject to certain inherent
risks, including unexpected changes in regulatory requirements and tariffs,
difficulties in managing foreign operations, longer payment cycles, problems in
collecting accounts receivable and potentially adverse tax consequences.
In addition, since our international sales will be made through an alliance
with Dixons, such sales will depend on Dixons' ability to distribute and market
our products and our ability to manage our relationship with Dixons. This
strategic alliance will not be considered a success if it does not generate a
significant amount of PC sales in Europe and does not expand our business
internationally. Moreover, this relationship may adversely affect our ability
to enter into agreements with other potential distribution partners in Europe.
Finally, if we become dependent on Dixons for distribution of our products in
Europe and, if our relationship with Dixons terminates, we may not be able to
find distributors to replace Dixons in those markets. To the extent that we are
unable to expand international sales in a timely and cost-effective manner, our
business could be harmed and we cannot assure you that we will be able to
expand internationally. Further, our international expansion will depend in
part on the acceptance of the Internet abroad.
29
<PAGE>
Additionally, because our international sales are expected to be denominated
in U.S. dollars, the strengthening of the U.S. dollar vis a vis the currencies
of those countries into which we sell our products and services could make our
products and services relatively more expensive thereby decreasing the price-
competitiveness of our products and services.
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 August 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 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. These broad
market and industry factors may seriously impact the market price of our common
stock, regardless of our actual operating performance.
30
<PAGE>
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 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, bearing
interest at 5.79 percent, payable 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 July 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-source income. Accordingly,
changes in interest rates or currency exchange rates do not generally have a
direct effect on our financial position. To date, 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. As
well, the strengthening of the U.S. dollar vis a vis the currencies of those
countries into which we sell our products and services in the future could make
our products and services relatively more expensive, thereby decreasing the
price-competitiveness of our products and services. 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.
31
<PAGE>
PART II.
OTHER INFORMATION
Item 1: Legal Proceedings
A discussion of legal proceedings in which we are involved appears in Note 7
to our Condensed Consolidated Financial Statements and in the Section entitled
"Risks That Could Affect Our Financial Condition and Results of Operations--We
are involved in litigation that may be costly and time-consuming," each of
which is included with this report on Form 10-Q.
Item 2: Changes in Securities and Use of Proceeds
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. The
SEC declared the Registration Statement effective 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.
In connection with the offering, we paid an aggregate of $12.6 million in
underwriting discounts and commissions and paid other expenses of approximately
$2.6 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 $164.8 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 these uses, we have invested the 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.
During the quarter ended July 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 9
employees and consultants, we issued an aggregate of 19,740 shares of common
stock for an aggregate purchase price of approximately $7,064. All of such
sales of common stock were made in transactions exempt from registration under
the Securities Act of 1933, as amended, in reliance upon Section 4(2) of the
Securities Act of 1933, as amended.
During the quarter ended July 1, 2000, we issued options to purchase 797,095
shares of our common stock at a grant price of $2.375 per share, and options to
purchase 200,000 shares of our common stock at a grant price of $4.875 per
share; each of these issuances were to employees at the director level and
below, who had previously been granted options to purchase our common stock.
These additional options were granted for the purpose of retaining current
employees and are in addition to other options that we granted during the
quarter ended July 1, 2000 and that we may grant from time to time under the
terms of our 1998 Stock Plan, as amended and restated.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information
None.
32
<PAGE>
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)
10.1 Employment Agreement for John Dickinson, dated July 4, 2000
27.1 Financial Data Schedule
</TABLE>
B. Reports on Form 8-K
None.
33
<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/ Corinne T. Bertrand
Dated: August 15, 2000 By: _________________________________
Corinne T. Bertrand
Vice President, Finance and
Acting Treasurer
(Principal Financial and
Accounting Officer)
34
<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)
10.1 Employment Agreement for John Dickinson, dated July 4, 2000
27.1 Financial Data Schedule
</TABLE>
35
