<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
AMENDMENT NO. 1 TO
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period from September 27, 1998 to December 26, 1998
---------------------------------------
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 Number 0-16930
EGGHEAD.COM, INC.
-----------------
(Exact name of registrant as specified in its charter)
Washington 91-1296187
---------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization Identification Number)
521 S.E. Chkalov Drive 98683
---------------------- -----
Vancouver, Washington (Zip Code)
---------------------
(Address of principal executive offices)
(360) 883-3447
--------------
(Registrant's telephone number, including area code)
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 such 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 _____
-----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock:
Class Outstanding at
----- January 23, 1999
Common Stock ----------------
$.01 par value 24,701,353 shares
<PAGE>
PART 1. FINANCIAL INFORMATION
ITEM 1. Financial Statements and Supplementary Data
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Egghead.com, Inc.:
We have audited the accompanying consolidated balance sheets of Egghead.com,
Inc. (a Washington corporation) and subsidiaries as of December 26, 1998, and
the related statements of operations, shareholders' equity and cash flows for
the nine months then ended. These financial statements are the responsibility of
Egghead.com, Inc.'s management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Egghead.com, Inc. and
subsidiaries as of December 26, 1998, and the results of their operations and
their cash flows for the nine months then ended in conformity with generally
accepted accounting principles.
/s/ Arthur Andersen LLP
Seattle, Washington
January 22, 1999
2
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Dollars in thousands, except per share amounts)
<TABLE>
<CAPTION>
March 28, December 26,
ASSETS 1998 1998
---------------- --------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 67,381 $ 59,017
Accounts receivable, net of allowance for doubtful
accounts of $2,611 and $1,079, respectively 5,670 1,660
Merchandise inventories, net 12,923 14,591
Prepaid expenses and other current assets 999 651
Property held for sale 8,224 1,224
--------- ---------
Total current assets 95,197 77,143
--------- ---------
Property and equipment, net 2,394 6,921
Goodwill, net 33,225 32,061
Other assets 336 270
--------- ---------
$ 131,152 $ 116,395
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 15,834 $ 16,916
Accrued liabilities 12,002 12,584
Reserves and liabilities related to restructuring 17,226 8,138
--------- ---------
Total current liabilities 45,062 37,638
---------
Long-term liabilities 3 --
--------- ---------
Total liabilities 45,065 37,638
--------- ---------
Commitments and contingencies
Shareholders' equity:
Preferred stock, $.01 par value: 10,000,000 authorized
No shares issued and outstanding -- --
Common stock, $.01 par value:
50,000,000 shares authorized;
23,492,502 and 24,765,384 shares issued
and outstanding, respectively 235 248
Additional paid-in capital 160,669 174,939
Retained deficit (74,817) (96,430)
--------- ---------
Total shareholders' equity 86,087 78,757
--------- ---------
$ 131,152 $ 116,395
========= =========
</TABLE>
See Notes to Consolidated Financial Statements.
3
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
(Amounts in thousands, except per share data)
<TABLE>
<CAPTION>
Three months ended Nine months ended
-- ------------------------------- ---------------------------------
December 27, December 26, December 27, December 26,
1997 1998 1997 1998
-------------- -------------- -------------- ---------------
(unaudited) (unaudited)
<S> <C> <C> <C> <C>
Net sales:
Online 23,663 41,875 $ 33,150 $ 106,449
Retail 75,456 -- 185,420 --
--------- --------- --------- ---------
Total net sales 99,119 41,875 218,570 106,449
Cost of sales:
Online 20,446 38,520 28,090 96,325
Retail 63,026 -- 154,320 --
--------- --------- --------- ---------
Total net sales 83,472 38,520 182,410 96,325
--------- --------- --------- ---------
Gross profit:
Online 3,217 3,355 5,060 10,124
Retail 12,430 -- 31,100 --
--------- --------- --------- ---------
Total gross profit 15,647 3,355 36,160 10,124
Selling and marketing expenses 16,353 10,976 36,275 23,664
General and administrative expenses 4,878 4,137 13,287 10,892
Amortization of goodwill 393 430 577 1,278
Depreciation 1,293 722 3,708 1,594
--------- --------- --------- ---------
Operating loss (7,270) (12,910) (17,687) (27,304)
--------- --------- --------- ---------
Other income, net 642 4,045 2,496 5,691
--------- --------- --------- ---------
Loss before income taxes (6,628) (8,865) (15,191) (21,613)
Income tax benefit (provision) -- -- -- --
--------- --------- --------- ---------
Net loss (6,628) (8,865) $ (15,191) $ (21,613)
========= ========= ========= =========
Basic loss per share (0.29) (0.36) $ (0.75) $ (0.90)
--------- --------- --------- ---------
Weighted average common shares outstanding 23,005 24,519 20,241 24,123
========= ========= ========= =========
See Notes to Consolidated Financial Statements
</TABLE>
4
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Dollars in thousands)
<TABLE>
<CAPTION>
Nine months ended
----------------------------
December 27, December 26,
1997 1998
------------ ------------
(unaudited)
Cash flows from operating activities:
<S> <C> <C>
Net loss from operations $(15,191) $(21,613)
-------- --------
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization 3,963 2,872
Deferred rent (332) (3)
(Gain) loss on disposition of assets (6) (270)
(Gain) on sale of equity investment -- (3,349)
Changes in assets and liabilities:
Accounts receivable, net 7,938 4,010
Merchandise inventories (18,821) (1,668)
Prepaid expenses & other current assets (2) 348
Other assets (727) (48)
Discontinued operations, net (2,666) --
Accounts payable 8,959 1,082
Restructuring reserves (4,967) (9,323)
Accrued liabilities 3,433 582
-------- --------
Total adjustments (3,228) (5,767)
-------- --------
Net cash provided by (used in)
operating activities (18,419) (27,380)
-------- --------
Cash flows from investing activities:
Additions to property and equipment (2,247) (5,725)
Proceeds from sale of property and equipment 7 7,110
Proceeds from sale of equity investment -- 3,348
-------- --------
Net cash provided by (used in)
investing activities (2,240) 4,733
-------- --------
Cash flows from financing activities:
Payments on notes payable of acquired subsidiary (6,000) --
Proceeds from stock issuances 311 14,283
Payments made on capital lease obligations (125) --
-------- --------
Net cash provided by (used in)
financing activities (5,814) 14,283
-------- --------
Net increase (decrease) in cash and cash equivalents (26,473) (8,364)
-------- --------
Cash and cash equivalents at beginning
of period 83,473 67,381
-------- --------
Cash and cash equivalents at end of period $ 57,000 $ 59,017
======== ========
See Notes to Consolidated Financial Statements
</TABLE>
5
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (continued)
(Dollars in thousands)
Nine months ended
--------------------------------
December 27, December 26
1997 1998
--------- ----------
(unaudited)
Supplemental disclosures of cash
paid (received) during the year :
Interest $ 32 $ 16
Income taxes $ (699) $ (234)
Supplemental disclosure of non-cash investing and financing activities:
During fiscal 1998, the Company acquired Surplus Software, Inc. for the
issuance of 5.3 million shares of common stock. See Note 7.
See Notes to Consolidated Financial Statements.
6
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
(Amounts in thousands)
<TABLE>
<CAPTION>
Additional Retained
Common Stock Paid-in Earnings
Shares Amount Capital (Deficit) Total
---------- ---------- ------------- ------------- --------
<S> <C> <C> <C> <C> <C>
Balance, March 28, 1998 23,493 $ 235 $160,669 $(74,817) $ 86,087
Stock issued for cash, pursuant to employee stock
purchase plan 14 -- 47 -- 47
Stock issued for cash, pursuant to stock option plan 1,258 13 14,223 -- 14,236
Net loss -- -- -- (21,613) (21,613)
-------------------------------------------------------------
Balance, December 26, 1998 24,765 $ 248 $174,939 $(96,430) $ 78,757
=============================================================
</TABLE>
See Notes to Consolidated Financial Statements.
7
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
All references herein to fiscal 1998 relate to the fiscal year ended March 28,
1998 and all references to fiscal 1999 refer to the fiscal year ended April 3,
1999.
Note 1 Summary of Significant Accounting Policies
Business
Egghead.com, Inc. is an online retailer of personal computer hardware, software,
peripherals, accessories, other related products, and other consumer and
business products. Its direct and indirect wholly owned subsidiaries are Surplus
Software, Inc. (Surplus Direct, d/b/a Surplus Direct and d/b/a Egghead.com),
DJ&J Software Corporation (DJ&J, d/b/a Egghead Computer), EH Direct, Inc. (EH
Direct) and MPI Corporation (d/b/a Mac's Place). References to "Egghead.com" or
the "Company" include Egghead.com, Inc., its predecessors, and its subsidiaries,
unless the context otherwise requires. Surplus Direct was acquired as a wholly
owned subsidiary on August 14, 1997. The Company recapitalized a previously
wholly owned subsidiary, ELEKOM Corporation (Elekom), on November 11, 1997,
retaining a 25 percent interest until November 9, 1998 when the remaining
ownership was sold (Note 9).
Consolidation
The consolidated financial statements include the accounts of Egghead.com, Inc.
and its wholly owned subsidiaries, Surplus Direct, DJ&J, EH Direct and MPI
Corporation, and include all such adjustments and reclassifications necessary to
eliminate the effect of significant intercompany accounts and transactions.
Fiscal Years
Egghead.com uses a 52/53-week fiscal year, ending on the Saturday nearest March
31. Fiscal quarters are such that the first three quarters consist of 13 weeks
and the fourth quarter consists of the remaining 13/14 weeks. Fiscal 1998 had 52
weeks. Fiscal 1999 will consist of 53 weeks. The 13-week periods ended December
27, 1997 and December 26, 1998 are referred to herein as the third quarter of
fiscal 1997 and fiscal 1998, respectively or the three months ended December 27,
1997 or December 26, 1998, respectively. The 39-week periods ended December 27,
1997 and December 26, 1998 are referred to herein as the first nine months of
fiscal 1998 and fiscal 1999 or the nine months ended December 27, 1997 or
December 26, 1998, respectively.
Basis of Presentation
The accompanying financial statements have been prepared in accordance with
generally accepted accounting principles and pursuant to the rules and
regulations of the Securities and Exchange Commission. The statements of
operations for the three months ended December 27, 1997 and December 26, 1998
and the statement of cash flows for the nine months ended December 27, 1997 are
unaudited. These statements reflect the adjustments which are, in the opinion of
management, necessary to fairly state the results of the interim periods;
however, they do not include all the information and footnotes required by
generally accepted accounting principles for complete financial statements.
These adjustments are of a normal and recurring nature. The results of
operations for the nine month period ended December 26, 1998 are not necessarily
indicative of the results to be expected for the year ending April 3, 1999.
Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. The most significant estimates
with regard to these financial statements are the restructuring and
reorganization reserves and liabilities.
Cash and Cash Equivalents
Egghead.com considers all highly liquid investments with a maturity of three
months or less at the time of purchase to be cash equivalents. The carrying
amount of cash equivalents approximates fair value because of the short-term
maturity of those instruments. Cash and cash equivalents as of March 28, 1998
and December 26, 1998 include restricted cash of $1.6 million and $2.5 million,
respectively.
8
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 1 Summary of Significant Accounting Policies (continued)
Accounts Receivable
The Company offers payment terms of 30 days to small businesses, educational
institutions and governmental entities. Egghead.com records a provision for
uncollectible customer accounts receivable based upon historical experience. In
addition, certain advertising and promotional expenditures are reimbursable from
suppliers under cooperative advertising and other promotional and marketing
development fund arrangements. Amounts qualifying for reimbursement are recorded
as receivables from the suppliers and as a corresponding reduction of net
advertising expense in the period the promotion occurs. Also included in
accounts receivable are credit card receivables and amounts due from vendors for
returned inventory and other programs. Egghead.com records a provision for
uncollectible vendor receivables based upon historical experience.
Merchandise Inventories
Merchandise inventories are accounted for using the first-in, first-out cost
method and are stated at the lower of cost or market. Egghead.com maintains
reserves for the obsolescence of merchandise inventory. These reserves totaled
approximately $3.1 million and $1.8 million at March 28, 1998 and December 26,
1998, respectively. Management has developed a plan to dispose of this obsolete
inventory and believes the reserve is adequate to cover any losses on
disposition. Inventories on the balance sheet are shown net of reserves.
Property and Equipment
Property and equipment are stated at cost, net of accumulated depreciation.
Depreciation of equipment, furniture and fixtures is provided using the
straight-line method over their estimated useful lives ranging from two to seven
years. Depreciation of buildings is provided using the straight-line method over
their estimated useful lives of up to 30 years. Amortization of leasehold
improvements is provided using the straight-line method over the lesser of the
lease term or the assets' estimated useful lives. The Company periodically
reviews its long-lived assets for impairment.
Property Held for Sale
Property held for sale is stated at the lower of carrying value or estimated net
realizable value.
Goodwill
Net assets of businesses acquired in purchase transactions are recorded at fair
value at the date of acquisition. Goodwill is amortized over 20 years. Goodwill
at March 28, 1998 and December 26, 1998 was $33.2 million and $32.1 million,
which is net of accumulated amortization of $1.0 million and $2.3 million,
respectively. The Company periodically reviews goodwill for possible impairment.
Accounts Payable
Outstanding checks included in accounts payable were $2.7 million and $2.5
million at March 28, 1998 and December 26, 1998, respectively.
Revenue Recognition
Revenue from sales of product is recognized upon merchandise shipment.
Egghead.com records a provision for sales returns and allowances based upon
historical experience.
Income Statement Captions
Online net sales, online costs of sales, and online gross profit consist of the
results of the Company's online shopping Web sites and inbound telephone orders.
Retail net sales, retail cost of sales, retail gross profit and retail selling
and marketing expenses consist of the retail stores and the direct response and
catalog/mail-order divisions.
9
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 1 Summary of Significant Accounting Policies (continued)
Income Taxes
Egghead.com determines its income tax accounts in accordance with Statement of
Financial Accounting Standards (SFAS) No. 109. Deferred income taxes result
primarily from temporary differences in the recognition of certain items for
income tax and financial reporting purposes
Earnings (Loss) Per Share
Basic earnings (loss) per share amounts are computed by dividing the net income
(loss) by the weighted average number of shares of common stock outstanding
during the year in accordance with SFAS No. 128, "Earnings per Share." Diluted
earnings per common share are not disclosed as potentially dilutive securities
would have been anti-dilutive to the loss per share calculation in both the
three months and nine months ended December 27, 1997 and December 26, 1998.
Stock-based Compensation
The Company accounts for its stock-based awards using the intrinsic value method
in accordance with Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees," and its related interpretations and
complies with the disclosure provisions of SFAS No. 123, "Accounting for
Stock-based Compensation."
Advertising Costs
The cost of advertising is expensed the first time the advertising takes place,
except for direct-mail advertising, which is capitalized and amortized over its
expected period of future benefits in accordance with the American Institute of
Certified Public Accountants' Statement of Position (SOP) 93-7. Direct-mail
advertising consists primarily of catalogs. The capitalized costs of the catalog
advertising are amortized over the eight-week period following the publication
of the catalog. At December 26, 1998, approximately $72,000 of advertising costs
were reported as assets. These amounts do not include reimbursements received
from vendors for advertisement of their products.
Reclassifications
Certain prior year balances have been reclassified to conform with the
nine-month period ended on and as of December 26, 1998 presentation. These
reclassifications had no effect on retained earnings or net income as previously
reported.
Recent Accounting Pronouncements
During June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities. The new standard
requires companies to record derivatives on the balance sheet as assets or
liabilities, measured at fair value. Gains or losses resulting from changes in
the values of those derivatives would be accounted for depending on the use of
the derivative and whether it qualifies for hedge accounting. Due to the
Company's minimal use of derivatives, the new standard is expected to have no
material impact on its financial position or results of operations. SFAS No. 133
will be effective for the Company's fiscal year 2001.
In April 1998, SOP 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use" was issued. SOP 98-1 provides guidance
for determining whether computer software is internal-use software and on
accounting for proceeds of computer software originally developed or obtained
for internal use and then subsequently sold to the public. It also provides
guidance on capitalization of the costs incurred for computer software developed
or obtained for internal use. The Company has not capitalized any costs that
will have to be written off to comply with SOP 98-1. The Company's current
policies for capitalizing costs incurred for computer software developed or
obtained for internal use comply with SOP 98-1.
10
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 2 Property and Equipment
The components of property and equipment at March 28, 1998, and December 26,
1998 were as follows (in thousands):
<TABLE>
<CAPTION>
March 28, December 26,
1998 1998
---------- ------------
<S> <C> <C>
Equipment $ 4,857 $ 10,162
Leasehold improvements 597 1,172
Furniture and fixtures 165 387
-------- --------
5,619 11,721
--------
--------
Less accumulated depreciation and
Amortization (3,225) (4,800)
-------- --------
Property and equipment, net $ 2,394 $ 6,921
======== ========
</TABLE>
Property held for sale at March 28, 1998 included Egghead.com's headquarters
building in Liberty Lake, Washington and property in Kalispell, Montana.
Property held for sale at December 26, 1998 included property in Kalispell,
Montana. See Note 10.
Note 3 Income Taxes
Given its recent losses, Egghead.com determined that its deferred tax assets do
not meet the realization criteria of SFAS No. 109. Under SFAS No. 109, the
realization of the deferred tax assets depends on generating future taxable
income. Egghead.com management has determined that it is more likely than not
that the deferred tax assets could not be currently realized. Therefore, the
Company did not record a tax benefit for the three months and nine months ended
December 27, 1997 or December 26, 1998.
Deferred income taxes result primarily from temporary differences in certain
items for income tax and financial reporting purposes. The tax effects of
temporary differences giving rise to the deferred tax assets are as follows:
<TABLE>
<CAPTION>
March 28, December 26,
1998 1998
---------------- ---------------
<S> <C> <C>
Accounts receivable $ 898 $ 427
Merchandise inventories 2,060 1,746
Property and equipment 2,007 1,658
Net operating loss carryforwards 22,993 30,479
Reserves and liabilities related to restructuring 5,937 2,395
Accrued liabilities and other 2,232 2,651
---------------- ---------------
Total deferred tax assets 36,127 39,356
Less valuation allowance (36,127) (39,356)
================ ===============
Net deferred tax assets $ - $ -
================ ===============
</TABLE>
Egghead.com's net operating loss carryforwards can be recovered over a 15-year
period and begin to expire at the end of the following fiscal years:
2011 $ 1,680
2012 13,381
2013 52,421
2014 21,613
-----------
$ 89,095
11
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 4 Stock Option and Stock Purchase Plans
Employee Stock Purchase Plan
The Egghead.com, Inc. 1989 Employee Stock Purchase Plan (the 1989 Plan) provides
options to acquire the Common Stock of Egghead.com to substantially all
full-time and certain other employees at the lesser of 85% of the fair market
value of the Common Stock on July 1, or 85% of the fair market value on the
following June 30 of each plan year. Under the 1989 Plan, a maximum of 650,000
shares were reserved for issuance. As of December 26, 1998, there were 286,610
shares available for future issuance.
The 1997 Nonofficer Employee Stock Option Plan
In October 1997, the Board of Directors approved the 1997 Nonofficer Employee
Stock Option Plan (the NOE Plan), under which 500,000 shares of Egghead.com's
Common Stock were reserved for issuance. In April 1998, the NOE plan was amended
to increase the number of shares reserved thereunder to 1,000,000. Options
granted under the NOE Plan generally vest over four years and terminate after 10
years. As of December 26, 1998, 482,658 shares were available for grant and
500,964 shares were subject to outstanding options, which have been granted at
prices ranging from $5.38 to $22.00 per share. As of December 26, 1998, 18,385
options were vested.
The Surplus Software, Inc. 1996 Stock Option Plan
In August 1997 as part of the acquisition of Surplus, Egghead.com assumed all of
the outstanding options to purchase common stock of Surplus Direct under the
Surplus Software, Inc. 1996 Stock Option Plan. Appropriate adjustments were made
to the number of shares and exercise price of each Surplus option to reflect the
same ratio at which the Surplus Direct common stock was converted into
Egghead.com common stock under the acquisition. The options have retained their
original option dates, option term and vesting schedules. The options vest over
four years and terminate after 10 years, unless otherwise noted. No additional
stock options will be granted under the assumed Surplus Software, Inc. 1996
Stock Option Plan. As of December 26, 1998, 65,727 shares were subject to
outstanding options, which have exercise prices ranging from $0.97 to $2.26 per
share. As of December 26, 1998, 11,732 options were vested.
The Amended and Restated 1993 Stock Incentive Compensation Plan
In September 1993, Egghead.com's shareholders approved the 1993 Stock Option
Plan (the 1993 Plan and together with the 1986 Plan, the Plans), under which
2,000,000 shares of Egghead.com's Common Stock were reserved for issuance. The
1993 Plan replaced the 1986 Combined Incentive and Non-Qualified Stock Option
Plan (the 1986 Combined Plan) under which 2,000,000 shares were originally
reserved for issuance. The number of shares reserved for issuance under the 1993
Plan was increased by the shares reserved for issuance under the 1986 Combined
Plan that were not subject to outstanding stock options. Shares presently
subject to outstanding stock options under the 1986 Combined Plan, which
subsequently are canceled or expire, will increase the number of shares reserved
for issuance under the 1993 Plan. No additional stock options will be granted
under the 1986 Combined Plan. In October 1997, the 1993 Plan was amended by the
Board of Directors to provide that options granted on or after October 29, 1997
vest over four years and terminate after 10 years, unless otherwise noted. Any
option granted prior to October 29, 1997 under the 1993 Plan vests annually over
three years and terminates after 10 years, unless otherwise noted. On December
1, 1998, the 1993 Plan was amended and restated by the Board of Directors to
allow the granting of stock awards and to change the name of the plan to the
Amended and Restated 1993 Stock Incentive Compensation Plan.
12
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 4 Stock Option and Stock Purchase Plans (continued)
Options granted, exercised, and canceled under the Plans are summarized as
follows:
December 27, December 26,
1997 1998
Average Average
Exercise Exercise
Shares Price Shares Price
---------- ---------- --------- ----------
(unaudited)
Outstanding at beginning 2,183,528 $ 7.75 1,748,319 $ 5.27
of period
Options granted(1) 949,443 4.84 340,000 9.63
Options exercised (52,093) 5.82 (316,611) 4.57
Options canceled (851,726) 10.04 (157,701) 5.63
--------- ----- --------- ----
Outstanding, end of period 2,229,152 5.61 1,614,007 6.29
========= ==== ========= ====
Exercisable, end of period 1,123,868 $ 5.96 1,056,127 $ 5.39
========= ====== ========= ======
Available for grant in
future years 924,624 952,003
======= =======
(1) One million options granted to an officer during fiscal 1997 vest over a
period of 18 months, with 691,300 and 1,000,000 vested as of December 27, 1997
and December 26, 1998, respectively.
The following table summarizes information regarding all stock options
outstanding at December 26, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
Remaining Average Average
Contractual Exercise Exercise
Range of Exercise Prices Number Life Price Number Price
<S> <C> <C> <C> <C> <C>
$0.967 - $4.8125 279,734 8.04 years $ 3.87 51,609 $ 3.88
$5.375 - $7.8125 1,398,500 8.24 years 5.64 1,070,500 5.42
$8.06 - $10.75 857,640 8.06 years 9.35 173,311 9.75
$10.9375 - $16.00 98,824 0.16 years 12.50 98,824 12.50
$17.00 - $22.00 18,500 4.48 years 20.54 10,000 20.00
----------- ------------
$0.967 - $22.00 2,653,198 7.83 years $7.01 1,404,244 $6.50
</TABLE>
13
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 4 Stock Option and Stock Purchase Plans (continued)
Egghead.com accounts for these plans under the intrinsic value-based method of
accounting, under which no compensation cost has been recognized. Had
compensation cost for these plans been determined consistent with SFAS No. 123,
Egghead.com's net income and earnings per share would have been reduced to the
following pro forma amounts:
<TABLE>
<CAPTION>
Nine months ended
December 27, December 26,
1997 1998
----------------- ---------------
(unaudited)
<S> <C> <C>
Net Loss As Reported $ (15,191) $ (21,613)
Pro Forma (17,886) (23,452)
Loss per share As Reported $ (0.75) $ (0.90)
Pro Forma (0.88) (0.97)
</TABLE>
The effects of applying SFAS No. 123 in this pro forma disclosure are not
indicative of future amounts. SFAS No. 123 does not apply to options granted
prior to April 1, 1995, and additional grants in future years are anticipated.
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model, with the following assumptions used for
grants in the nine-months ended December 27, 1997 and December 26, 1998:
Nine months ended
December 27, December 26,
1997 1998
------------- --------------
(unaudited)
Dividend yield 0% 0%
Volatility 70% 95%
Risk-free interest rate 6.27% 5.39%
Expected stock option life 3.5 yrs. 4.3 yrs
Using these assumptions, the weighted average fair value of options granted was
$2.97 and $6.32 in the nine months ended December 27, 1997 and December 26,
1998, respectively.
Option Repricing
On April 23, 1997, the Compensation Committee of the Egghead.com Board of
Directors approved a plan pursuant to which certain executive officers were
offered an opportunity to exchange options having exercise prices in excess of
the then current fair market value for new options having an exercise price of
$4.375 per Egghead.com Common Share. Recipients of the repriced replacement
options received credit for vesting under the original options, but could not
exercise the new options for a one-year period following the date of grant of
the new options. The Compensation Committee approved an option repricing on the
same terms for employees other than executive officers on April 4, 1997.
14
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 4 Stock Option and Stock Purchase Plans (continued)
Restated Nonemployee Director Stock Option Plan
In September 1993, Egghead.com's shareholders approved the Nonemployee Director
Stock Option Plan, and in August 1995, Egghead.com's shareholders approved
amendments thereto (as amended, the Director Plan) under which 450,000 shares of
Egghead.com's Common Stock were reserved for issuance. The Director Plan was
restated by the Board of Directors on September 2, 1998. Options granted under
the Director Plan generally vest over three years and terminate after 10 years.
As of December 26, 1998, 110,000 shares were available for grant and 272,500
shares were subject to outstanding options, which have been granted at prices
ranging from $5.88 to $10.75 per share.
As of December 26, 1998, options for 118,000 shares were vested.
The Executive Plan
In February 1989, the Board of Directors approved four-year employment
agreements and stock option agreements for three executive officers who are no
longer with Egghead.com, whereby the officers' compensation was based on equity
incentives. Each drew an annual salary of $1 per year during his term of
employment. Options to acquire up to 1,700,000 shares of Common Stock were
authorized under the Executive Plan. As of December 26, 1998, 325,000 options
approved under the Executive Plan were never granted and 200,000 were subject to
outstanding options, which have been granted to such former executive officers
of Egghead.com at prices ranging from $10.38 to $20.00 per share. All
outstanding options are vested and expire in February 1999. As of December 26,
1998, 1,175,000 of the options had been exercised at prices ranging from $10.38
to $20.00 per share. The Executive Plan is no longer active and no further
options will be granted under the Executive Plan, which will terminate on
February 22, 1999.
Note 5 401(k) Plan
Egghead.com had two 401(k) retirement plans for the benefit of its employees, a
DJ&J plan and a Surplus Direct plan (assumed in the acquisition). After six
months of full-time employment (more than 1,000 hours), an employee was eligible
to participate in the DJ&J plan. Prior to March 29, 1997, employee contributions
were matched by Egghead.com at 50% of the employee's contribution up to 4% of
their compensation. Egghead.com contributions were fully vested upon the
completion of two years of service. Subsequent to March 29, 1997, Egghead.com
discontinued the guaranteed matching of employee contributions. Egghead.com may,
however, make voluntary contributions in the future.
In the Surplus Direct plan, an employee was eligible to participate in the plan
after six months of full-time employment (more than 1,000 hours). Employee
contributions were matched by Egghead.com at 25% of the employee's contribution
up to 5% of their compensation. Egghead.com contributions are fully vested upon
the completion of five years of service. Egghead.com contributions were
approximately $9,000 and $29,000 in the nine months ended December 27, 1997 and
December 26, 1998 respectively.
Effective January 1, 1999, the DJ&J plan was amended and restated to merge the
Surplus Software Plan into the DJ&J Plan and become the Egghead.com Plan ("The
Plan"). In the Plan, employee contributions are matched by Egghead.com at 25% of
the employee's contribution up to 5% of their compensation upon the employee's
completion of six months of full-time employment or one year of eligibility
service (more than 1,000 hours).
15
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 6 Commitments and Contingencies
Significant Suppliers
In the nine months ended December 27, 1997 and December 28, 1998, one primary
distributor accounted for approximately 12% and 10%, respectively, of
Egghead.com's purchases. The loss of this distributor could have a material
adverse effect on the Egghead.com's operating results and financial condition.
Credit Line for Inventory Financing
In December 1998, the Company was approved for a credit line of $5 million for
the financing of inventory. The terms of such financing will vary depending on
the vendor terms. The credit line is fully secured by the inventory purchased
through the agreement with the lender, Finova Capital Corporation. The lender
has reserved the right to discontinue the inventory financing at any time at
their discretion. At December 26, 1998, there were no borrowings outstanding
under this line of credit.
Leases
Egghead.com leases corporate offices and distribution facilities under operating
leases with remaining lives on most leases ranging from one to six years. The
leases generally require Egghead.com to pay taxes, insurance and certain common
area maintenance costs.
Aggregate rental expense, including common area maintenance charges, for all
operating leases for the nine months ended December 27, 1997 and December 26,
1998 was approximately $5.9 million and $1.1 million, respectively. As of
December 26, 1998, future minimum rental payments under noncancelable operating
leases for headquarters and distribution facilities, and equipment consisted of
the following (in thousands):
<TABLE>
<CAPTION>
Operating
Fiscal Year Leases
---------
<S> <C>
Remainder of 1999 $ 287
2000 816
2001 626
2002 463
Thereafter 1,050
-----
Total minimum payments $ 3,242
======
</TABLE>
The Company has recorded a liability for retail stores and distribution facility
lease terminations in connection with its retail restructure. See Note 8.
16
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 7 Acquisition
On August 14, 1997, the Company acquired Surplus Direct by issuing 5,310,888
shares of common stock and 289,112 options to purchase common stock of
Egghead.com, Inc. The transaction included payment of $6.0 million of Surplus
Direct debt. At the time, Surplus Direct was engaged in direct marketing of
off-price computer hardware and software through catalogs and two Internet
commerce sites. This acquisition was recorded using the purchase method of
accounting. Operating results of Surplus Direct are included in the statement of
operations from the date of acquisition. An excess purchase price of
approximately $34.2 million, over identifiable assets, was determined based on
the fair values of assets acquired and liabilities assumed. Amortization of
goodwill will be over a period of 20 years.
Note 8 Restructuring and Reorganization
In the fourth quarter of fiscal 1997, Egghead.com recorded a $24.0 million
restructuring and impairment charge to reorganize its operations. This plan
involved among other things, closing 70 of the 156 Egghead stores, a significant
reduction in its headquarters staff and the closure of its Lancaster,
Pennsylvania distribution center. This charge included $6.2 million for the
liquidation of inventory, $5.8 million in settlement of store and warehouse
leases, $4.4 million for fixed asset dispositions and miscellaneous expenses,
$3.3 million of store closing costs and related fixed asset dispositions, $3.3
million for severance and related benefits and $1.0 million in disposition and
impairment of real estate. The $24.0 million restructuring charge was recorded
as a $6.2 million charge to gross profit, a $1.8 million charge to selling and
marketing expenses, a $0.3 million charge to general and administrative expense
and a $15.6 million charge to restructuring and impairment charges. The Company
anticipates that the remaining payables as of December 26, 1998, related to the
restructuring, consisting primarily of $0.6 million in lease obligations and
$0.3 million in severance will be substantially settled by the end of fiscal
1999.
In the fourth quarter of fiscal 1998, Egghead.com recorded a $37.6 million
restructuring charge to reorganize its operations for a plan involving, among
other things, closing the remaining Egghead stores, a significant reduction in
its headquarters staff and the closure of its Sacramento, California
distribution center. This charge includes approximately $17.1 million for retail
lease terminations and related fixed asset disposals, $10.0 million for store
closing costs, $6.2 million for the liquidation of inventory, $2.1 million for
the closure of the Sacramento distribution center and $2.2 million in severance,
fixed asset disposal and other miscellaneous expenses related to the reduction
of the Company's headquarters operation. The $37.6 million restructuring charge
was recorded as a $6.2 million charge to gross profit, a $6.4 million charge to
selling and marketing expenses, a $0.5 million charge to general and
administrative expense and a $24.5 million charge to restructuring and
impairment charges. The $24.5 million fiscal 1998 restructuring and impairment
charge was partially offset by a reduction of $5.0 million in fiscal 1997
restructuring and impairment reserves. There were no other adjustments to the
restructuring reserves. Egghead.com anticipates that the settlement of all
leases and claims related to the restructuring will be substantially completed
by the end of fiscal 1999. At December 26, 1998, the remaining payables related
to the restructuring consisted primarily of $5.9 million in retail lease
obligations, $0.7 million in severance and employee benefits and $0.4 million
miscellaneous costs.
17
<PAGE>
EGGHEAD.COM, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements (continued)
Note 9 Recapitalization and Sale of Subsidiary
On November 11, 1997 Egghead.com recapitalized its then wholly owned subsidiary
ELEKOM. As part of the recapitalization, certain venture capitalists invested
capital in ELEKOM, reducing the Company's ownership percentage to approximately
26% as of March 28, 1998. Prior to recapitalization, income and expenses of
ELEKOM were recorded in the Company's operating results. After recapitalization,
the Company's share of the results of operations of ELEKOM were included using
the equity method of accounting and are reflected in the other income (expense)
in the Company's consolidated statements of operations. On November 9, 1998, the
remaining ownership in ELEKOM was sold at a gain of approximately $3.3 million.
An additional $0.6 million gain is being deferred due to a contingency clause in
the sales agreement and will be held in escrow until April 30, 2000, subject to
favorable resolution of the contingencies.
Note 10 Sale of Property
On May 1, 1998, the Company sold its previous headquarters building located in
Liberty Lake, Washington, for approximately $7.5 million. The building was
recorded in the Property Held for Sale on the Company's Balance Sheet as of
March 28, 1998. The Company leases approximately 7,000 square feet of the
building over a lease term of one year, including extensions.
Note 11 Subsequent Event
In January 1999, the Company's Board of Directors approved a plan to issue
additional shares of Common Stock in a public offering.
18
<PAGE>
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the
Consolidated Financial Statements of Egghead.com and the notes thereto included
elsewhere in this filing. References in this filing to "Egghead.com," "Egghead,"
"we," "our," and "us" refer to Egghead.com, Inc. and our wholly owned
subsidiaries, unless the context otherwise requires.
The following "Management's Discussion and Analysis of Financial Condition and
Results of Operations" contains forward-looking statements based on current
expectations, estimates and projections about our industry, management's beliefs
and certain assumptions made by management. All statements, trends, analyses and
other information contained in this Report on Form 10-Q relative to trends in
net sales, gross margin, expense levels, liquidity and capital resources, as
well as other statements in this Report on Form 10-Q, including, but not limited
to, words such as "expect(s)," "anticipate(s)," "intend(s)," "plan(s),"
"believe(s)," "seek(s)," "estimate(s)," and other similar expressions,
constitute forward-looking statements. These forward-looking statements are not
guarantees of future performance. Because these forward-looking statements
involve risks and uncertainties, there are important factors that could cause
actual results to differ materially from those expressed or implied by these
forward-looking statements, including those set forth under `Liquidity and
Capital Resources," and "Additional Factors That May Affect Future Results"
included in this "Management's Discussion and Analysis of Financial Condition
and Results of Operations." Particular attention should be paid to the
cautionary statements involving our limited online operating history, our
history of losses and expectation of future losses, the unpredictability of our
future revenues and fluctuations in our operating results, the fluctuation of
our operating results due to seasonality, the risks of systems failures and
business interruptions, the risks of capacity constraints, the risks relating to
systems development, management of growth, the intensely competitive nature of
the electronic commerce industry, reliance on third parties and reliance on
manufacturers, distributors and suppliers. Readers are cautioned not to place
undue reliance on the forward-looking statements, which speak only as of the
date made. Except as required by law, we undertake no obligation to update any
forward-looking statement, whether as a result of new information, future events
or otherwise. Readers, however, should carefully review the factors set forth in
other reports or documents that we file from time to time with the Securities
and Exchange Commission.
Overview
Egghead.com is a leading online retailer of personal computer hardware,
software, peripherals, accessories and other related products. In addition to
computer-related products, Egghead.com sells consumer electronics and other
consumer and business goods.
Egghead, Inc. began operations primarily as a traditional software
reseller. The predecessor to Egghead, Inc., DJ&J Software Corporation, was
incorporated in Washington in 1983. Egghead, Inc. was incorporated in Washington
in 1984 and became the parent company to DJ&J Software Corporation. By 1992,
Egghead, Inc. had over 200 retail store locations and had begun a direct mail
division and a Corporate, Government and Educational Sales Division. On May 13,
1996, Egghead, Inc. sold the Corporate, Government and Educational Sales
Division for $45.0 million. In response to continuing retail store losses,
Egghead, Inc. closed 70 retail stores in February 1997 and recorded a related
$24.0 million restructuring and asset impairment charge. On August 14, 1997,
Egghead, Inc. acquired Surplus Software, Inc. ("Surplus Direct"). Surplus Direct
owned and operated two Web sites and a direct mail division which specialized in
excess, closeout and refurbished computer related merchandise. On February 28,
1998, we changed our name from Egghead, Inc. to Egghead.com, Inc., closed our
remaining retail stores and shifted our primary business emphasis to electronic
commerce. As part of this transition, we closed our distribution center in
Sacramento, California, combined our management and operations with those of
Surplus Direct and consolidated the majority of our operations in Vancouver,
Washington. In the fourth quarter of fiscal 1998, we recorded a $37.6 million
charge related to this closure of the retail stores and the related
restructuring.
Online Operations. Online net sales, online cost of sales, online gross
profit and online selling and
19
<PAGE>
marketing expenses consist of the results of our online shopping Web sites and
inbound telephone orders. Customers can purchase products via the Internet at
our online store. Alternatively, customers can browse through our online store
or review advertising flyers and then contact the inbound telephone center to
complete purchases. We offer discounts to businesses, educational institutions
and governmental entities that purchase large volumes for use or for resale.
Online Pro Forma. To provide meaningful comparisons for the nine months
ended December 27, 1997, we have disclosed, on an online pro forma basis, online
net sales, online cost of sales, online gross profit and online selling and
marketing expenses. The online pro forma amounts include the results of
operations of Surplus Direct before we acquired it on August 14, 1997. This
acquisition was recorded under the purchase method of accounting and the results
of operations of Surplus Direct are included in our historical financial results
from the date of the acquisition.
20
<PAGE>
Set forth below for the nine months ended December 27, 1997 are certain
online pro forma operations data:
<TABLE>
<CAPTION>
Amount As of Percentage of
Online Pro Forma Results
(in thousands) Online Pro Forma Net Sales
---------------------------------------------------------------------------------------------------------------
<S> <C>
Online net sales...............................$54,750 100.0%
Online cost of sales........................... 45,800 83.7
------------------ ----------------------------------------------
Online gross profit........................... 8,950 16.3
Online selling and marketing
expenses... $11,833 21.6%
</TABLE>
Retail Operations. Retail net sales, retail cost of sales and retail
selling and marketing expenses consist of the results of the retail stores and
the direct response and catalog/mail-order divisions. We completed the closure
of the retail stores and these divisions on February 28, 1998 and therefore they
did not contribute to revenues in the first nine months of fiscal 1999.
Anticipated Losses. We have incurred substantial losses in the
operation and closure of our former retail store network and in the operation of
our online store. As of December 26, 1998, we had a retained deficit of $96.4
million. We have not achieved profitability as an electronic commerce company
and expect to continue to incur substantial net losses through at least fiscal
2001. We plan to continue to enhance our brand name through marketing and
advertising programs, offer additional categories of merchandise for sale on our
online store and improve and enhance our technology, infrastructure and systems.
These initiatives will likely result in operating expenses that are higher than
current operating expenses. We will need to generate significantly higher
revenues to achieve profitability and maintain profitability if it is achieved.
Although our net sales from electronic commerce have grown in recent quarters,
such growth rates may not be sustainable. Because of these and other factors, we
believe that period-to-period comparisons of our historical results of
operations are not good indicators of our future performance.
21
<PAGE>
Results of Operations--Three and Nine Months Ended December 27, 1997 Compared to
Nine Months Ended
December 26, 1998
The following table shows the relationship of certain items relating to
continuing operations included in our Consolidated Statements of Operations
expressed as a percentage of net sales:
<TABLE>
<CAPTION>
Percentage of Net Sales
--------------------------------------------------------------------
Nine months ended Three months ended
--------------------------------- ----------------------------------
Dec. 27, 1997 Dec. 26, 1998 Dec. 27, 1997 Dec. 26, 1998
----------------- --------------- ---------------- -----------------
(unaudited) (unaudited) (unaudited)
Net Sales
<S> <C> <C> <C> <C>
Online ............................................... 15.2% 100% 23.9% 100.0%
Retail ............................................... 84.8 -- 76.1 --
--------------------------------- ----------------------------------
Total net sales .................................. 100.0 100.0 100.0 100.0
--------------------------------- ----------------------------------
Cost of sales(1)
Online ............................................... 84.7 90.5 86.4 92.0
Retail ............................................... 83.2 -- 83.5 --
--------------------------------- ----------------------------------
Total cost of sales .............................. 83.5 90.5 84.2 92.0
--------------------------------- ----------------------------------
Gross margin .............................................. 16.5 9.5 15.8 8.0
Selling and marketing expenses(2)
Online ............................................... 19.5 22.2 18.4 26.2
Retail ............................................... 16.1 -- 15.9 --
--------------------------------- ----------------------------------
Total selling and marketing expenses ............. 16.5 22.2 16.5 26.2
General and administrative expense ........................ 6.1 10.2 4.9 9.9
Depreciation and amortization expense ..................... 2.0 2.7 1.7 2.8
--------------------------------- ----------------------------------
Operating loss ............................................ (8.1) (25.6) (7.3) (30.9)
Other income, net ......................................... 1.1 5.3 0.6 9.7
--------------------------------- ----------------------------------
Loss before income taxes .................................. (7.0)% (20.3)% (6.7)% (21.2)%
--------------------------------- ----------------------------------
</TABLE>
(1) These percentages are calculated by dividing the online and retail cost of
sales by the respective net sales.
(2) These percentages are calculated by dividing the online and retail selling
and marketing expenses by the respective net sales.
22
<PAGE>
Net Sales. Total online net sales for the third quarter of fiscal 1999
increased 77% to $41.9 million as compared to $23.7 million for the third
quarter of fiscal 1998. Net sales through the online store during the third
quarter of fiscal 1999 increased 199% to $35.3 million from $11.8 million for
the third quarter of fiscal 1998. Total online net sales for the first nine
months of fiscal 1999 increased 94% to $106.4 million as compared to the online
pro forma net sales of $54.8 million for the first nine months of fiscal 1998.
Net sales through the online store during the first nine months of fiscal 1999
increased 255% to $83.0 million from $23.4 million (online pro forma) for the
first nine months of fiscal 1998. The increase in net sales through our online
store was partially due to an increase in the online customer base, significant
investments in marketing programs designed to promote and maintain brand
awareness, an increase in the number of daily and weekly online auctions, and an
increase in the categories and amount of merchandise offered. In addition, our
online net sales benefited from an increase in our customer accounts to over
750,000 as of December 26, 1998 from approximately 460,000 as of March 28, 1998.
As a result of a decrease in the frequency and volume of direct mail flyers, net
sales from inbound telephone orders during the third quarter and first nine
months of fiscal 1999 decreased to $6.6 million and $23.4 million, respectively,
from $11.9 million and $31.4 million (online pro forma) during the third quarter
and first nine months of fiscal 1998. Management intends to reduce the level of
emphasis on inbound telephone operations because these operations have higher
operating costs as a percentage of related sales as compared to online
operations.
Total net sales for the third quarter of fiscal 1999 decreased 58% to
$41.9 million from $99.1 million for the third quarter of fiscal 1998. Total net
sales for the first nine months of fiscal 1999 decreased 51% to $106.4 million
from $218.6 million for the first nine months of fiscal 1998. These decreases
were primarily due to the closure of the retail store chain, which accounted for
net sales of $185.4 million for the first nine months of fiscal 1998, and was
partially offset by the increase in online net sales.
Gross Profit. Gross profit consists of net sales minus cost of sales.
Cost of sales includes initial margin (net sales minus cost of products sold),
obsolete inventory charges and net shipping (shipping reimbursements less
shipping costs). The gross profit from online net sales for the third quarter of
fiscal 1999 increased to $3.4 million compared to the gross profit from online
net sales of $3.2 million for the third quarter of fiscal 1998. The gross margin
from online net sales for the third quarter of fiscal 1999 was 8.0% as compared
to 13.6 % for the third quarter of fiscal 1998. The gross profit from online net
sales for the first nine months of fiscal 1999 increased to $10.1 million
compared to the gross profit of $9.0 million (online pro forma) for the first
nine months of fiscal 1998. The gross margin from online net sales for the first
nine months of fiscal 1999 was 9.5% as compared to 16.3% (online pro forma) for
the first nine months of fiscal 1998. The fiscal 1999 gross margin reflects a
decrease in selling prices and an increase in inventory obsolescence expense
partially offset by an increase in net shipping revenue as compared to the first
nine months of fiscal 1998. The decrease in selling prices was primarily due to
an increase in net sales from online auctions and a decrease in inbound
telephone net sales, which typically carry higher margins than online sales.
Total gross profit for the third quarter of fiscal 1999 decreased to
$3.4 million as compared to $15.6 million for the third quarter of fiscal 1998.
Total gross profit for the first nine months of fiscal 1999 decreased to $10.1
million as compared to $36.2 million for the first nine months of fiscal 1998.
This decrease was primarily due to the closure of the retail store chain and was
partially offset by the increase in online net sales.
Initial margin is primarily affected by sales volume and the mix of
sales from each of our online stores' three shopping formats, and, to a lesser
extent, the mix of merchandise sold. We typically realize higher initial margins
on our Superstore sales than on our SurplusDirect liquidation center sales,
higher initial margins on our SurplusDirect liquidation center sales than on our
auction sales, and higher initial margins on software sales than on hardware
sales. Recently we experienced a shift towards lower initial margin auction
sales, which constituted approximately 55% and 52% of online net sales for the
third quarter and first nine months of fiscal 1999, respectively. If the
percentage of auction sales continues to increase, our initial margins may be
adversely affected.
Selling and Marketing Expenses. Selling and marketing expenses consist
primarily of operating expenses related to marketing, inbound telephone support,
online store support and distribution. Such operating expenses include
promotional agreements for online and offline advertising, credit card
processing costs, payroll and benefits, telecommunications, bad debts and
supplies, in addition to retail occupancy costs prior to the closure of the
retail
23
<PAGE>
store network. The selling and marketing expenses for the third quarter of
fiscal 1999 were $11.0 million as compared to online selling and marketing
expenses of $4.4 million for the third quarter of fiscal 1998. The selling and
marketing expenses as a percentage of online net sales increased to 26.2% for
the third quarter of fiscal 1999 as compared to 18.4% for the third quarter of
fiscal 1998. The selling and marketing expenses for the first nine months of
fiscal 1999 increased 100% to $23.7 million as compared to the selling and
marketing expenses of $11.8 million (online pro forma) for the first nine months
of fiscal 1998. Selling and marketing expenses as a percentage of online net
sales increased to 22.2% for the first nine months of fiscal 1999 as compared to
21.6% (online pro forma) for the first nine months of fiscal 1998. The increase
in selling and marketing expenses was primarily due to increased promotion
related to the shift in primary business emphasis to electronic commerce in
February 1998. Retail selling and marketing expenses were eliminated with the
closure of the retail stores in February 1998. We expect selling and marketing
expenses to increase significantly as we endeavor to enhance our brand name
recognition, expand our online shopping capabilities and increase our market
share. However, we cannot assure you that the increase in such expenses will
actually result in enhanced brand name recognition, expanded Web site
capabilities or increased market share.
The total selling and marketing expenses for the third quarter of
fiscal 1999 decreased 33% to $11.0 million as compared to $16.4 million for the
third quarter of fiscal 1998. The total selling and marketing expenses for the
first nine months of fiscal 1999 decreased 35% to $23.7 million as compared to
$36.3 million for the first nine months of fiscal 1998. This decrease was
primarily due to the closure of the retail store chain and was partially offset
by the increase in expenses related to the online store and expenses related to
acquired operations of Surplus Direct.
General and Administrative Expenses. General and administrative
expenses consist primarily of payroll and related expenses of headquarters
support functions, such as executive, merchandising, purchasing, engineering,
accounting, recruiting and facilities expenses and other general corporate
expenses. The general and administrative expenses for the third quarter of
fiscal 1999 decreased 15% to $4.1 million as compared to $4.9 million for the
third quarter of fiscal 1998. The general and administrative expenses for the
first nine months of fiscal 1999 decreased 18% to $10.9 million as compared to
$13.3 million for the first nine months of fiscal 1998. These decreases were
primarily due to the recapitalization of our wholly owned subsidiary Elekom
Corporation in November 1997. See Note 9 of Notes to Consolidated Financial
Statements. Prior to the recapitalization of Elekom, expenses of $2.2 million
were recorded in general and administrative expenses for the first nine months
of fiscal 1998. After the recapitalization, the results of Elekom were recorded
using the equity method of accounting. In addition, the expenses for the first
nine months of fiscal 1998 were affected by the costs related to the acquisition
of Surplus Direct in August 1997. See Note 7 of Notes to Consolidated Financial
Statements. General and administrative expenses as a percentage of net sales
increased to 9.9% for the third quarter of fiscal 1999 as compared to 4.9% for
the third quarter of fiscal 1998. General and administrative expenses as a
percentage of net sales increased to 10.2% for the first nine months of fiscal
1999 as compared to 6.1% for the first nine months of fiscal 1998. This increase
was due primarily to a reduction in net sales. We expect our general and
administrative expenses to increase as we continue to build our business and, in
particular, increase our information systems support.
Depreciation and Amortization Expenses. Depreciation and amortization
expenses primarily include depreciation of our capital equipment and
amortization of the goodwill recorded in connection with the acquisition of
Surplus Direct in August 1997. The depreciation expense for the third quarter of
fiscal 1999 decreased to $0.7 million as compared to $1.3 million for the third
quarter of fiscal 1998. The depreciation expense for the first nine months of
fiscal 1999 decreased to $1.6 million as compared to $3.7 million for the first
nine months of fiscal 1998. These decreases were primarily due to the closure of
the retail stores in February 1998. Amortization expense for the third quarter
of fiscal 1999 and fiscal 1998 was $0.4 million. Amortization expense for the
first nine months of fiscal 1999 increased to $1.3 million as compared to $0.6
million for the first nine months of fiscal 1998. This increase in amortization
expense reflects the goodwill recorded for the Surplus Direct acquisition. See
Note 7 of Notes to Consolidated Financial Statements.
Other Income, Net. Other income, net for the third quarter of fiscal
1999 increased to $4.0 million from $0.6 million for the third quarter of fiscal
1998. Other income, net for the first nine months of fiscal 1999 increased to
$5.7 million from $2.5 million for the first nine months of fiscal 1998. These
increases were primarily due to a gain of $3.3 million from the November 1998
sale of all our equity interest in Elekom Corporation. See Note 9 of
24
<PAGE>
Notes to Consolidated Financial Statements.
Income Taxes. Due to our net operating losses, we did not record a
provision for income taxes for the first nine months of fiscal 1999 or fiscal
1998. Given our recent losses, we have determined that our deferred tax assets
do not meet the realization criteria of Statement of Financial Accounting
Standards No. 109 (SFAS 109). Under SFAS 109, the realization of the deferred
tax assets depends on generating future taxable income. We have determined that
it is more likely than not that the deferred tax assets could not currently be
realized. Until we have determined that all of the existing net operating losses
are realizable, we will not record a tax charge or benefit for future operating
results. Our net operating losses can be recovered for tax purposes over a
15-year period from origin if profitability is achieved. See Note 3 of Notes to
Consolidated Financial Statements.
Liquidity and Capital Resources
In recent fiscal years, we have funded our operations through cash provided
by operations, asset sales, exercises of stock options and the proceeds relating
to the sale of the Corporate, Government and Educational Sales Division.
Cash and cash equivalents decreased to $59.0 million as of December 26,
1998 from $67.4 million at March 28, 1998. The decrease in the cash balance was
primarily due to the net operating loss of $21.6 million, the decrease in
restructuring liabilities of $9.3 million and the increase in merchandise
inventories of $1.7 million, partially offset by $14.3 million in stock
issuances under our stock option and stock purchase plans, net proceeds of $7.1
million from the sale of our former headquarters building and net proceeds of
$3.3 million on the sale of our interest in Elekom Corporation. Cash and cash
equivalents decreased $16.1 million from $83.5 million at the end of fiscal 1997
to $67.4 million at March 28, 1998. The decrease in the cash balance was
primarily due to a reduction in accounts payable and liabilities related to the
Corporate, Government and Educational Sales Division (CGE), partially offset by
a reduction in accounts receivable and merchandise inventories.
Cash used by operating activities of $27.4 million for the first nine
months of fiscal 1999 was primarily due to the net loss of $21.6 million, a
decrease in restructuring liabilities of $9.3 million and an increase in
merchandise inventories of $1.7 million, partially offset by a decrease in
accounts receivable of $4.0 million. Cash used by operating activities of $10.9
million for the year ended March 28, 1998 was primarily due to the net loss of
$50.2 million and reductions in accounts payable of $25.8 million, partially
offset by a reduction in accounts receivable of $12.2 million and a reduction in
merchandise inventories of $29.9 million. For fiscal 1997, operating activities
used $7.8 million in cash related to a reduction in accounts payable partially
offset by a decrease in accounts receivable and merchandise inventories.
Net cash provided by investing activities was $4.7 million for the first
nine months of fiscal 1999 and primarily consisted of net proceeds of $7.1
million from the sale of the former headquarters building and net proceeds of
$3.3 million from the sale of our equity interest in Elekom Corporation,
partially offset by capital expenditures of $5.7 million primarily related to
the upgrading of the Web site software platforms and related hardware. See Note
9 of Notes to Consolidated Financial Statements. Net cash used in investing
activities was $2.7 million for fiscal 1998 and primarily consisted of asset
purchases of $2.8 million, primarily for retail store leasehold improvements and
computer hardware. For fiscal 1997, investing activities provided net cash of
$41.7 million primarily related to the $45.0 million proceeds from the sale of
CGE, partially offset by capital expenditures of $5.1 million.
Cash provided by financing activities of $14.3 million for the first nine
months of fiscal 1999 consisted of proceeds from stock issuances under our stock
option and stock purchase plans. Cash used in financing activities of $2.5
million for fiscal 1998 consisted primarily of payment of notes payable relating
to the Surplus Direct acquisition of $6.0 million, partially offset by $3.6
million received from the exercises of stock options. For fiscal 1997, financing
activities provided $47,000 primarily due to exercises of stock options,
partially offset by payment on capital leases obligations.
As of December 26, 1998, our principal source of liquidity was $59.0
million of cash. In December 1998, we obtained a credit line of $5.0 million for
the financing of inventory. The credit line is fully secured by the inventory
purchased through an agreement with the lender, Finova Capital Corporation. As
of December 26, 1998 there were no borrowings outstanding under this line of
credit. As of December 26, 1998, our principal commitments consisted of
obligations in connection with operating leases and commitments for advertising
and promotional arrangements.
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Although we have no material commitments for capital expenditures, we anticipate
future purchases related to enhancements of our Web site to improve
functionality and navigation, incorporating features that are intended to
improve the customer shopping experience, and scalability and performance of the
site. We estimate capital expenditures through the end of fiscal 2000 to be at
least $12.5 million. See Note 6 of Notes to Consolidated Financial Statements.
Our future liquidity and capital requirements will depend upon numerous
factors. We believe that our current cash and cash equivalent balances will be
sufficient to meet our anticipated cash needs for working capital and capital
expenditures for the near future. In January 1999, our Board of Directors
approved a plan to issue additional shares of Common Stock in a public offering.
With the proceeds from this proposed offering, we believe that our cash and cash
equivalents would be sufficient for at least the next eighteen months. In
addition, we will, from time to time, consider the acquisition of or investment
in complementary businesses, products, services and technologies, which might
increase our liquidity requirements or cause us to issue additional equity or
debt securities. Although we believe that the net proceeds from this offering
combined with our current cash and cash equivalent balances would be sufficient
for at least the next eighteen months, we cannot assure you that the proposed
public offering will occur or that we will not require additional financing
within this time frame or that such additional funding, if needed, will be
available on terms acceptable to us or at all. We do not currently use
derivative financial instruments.
Impact of the Year 2000 Issue
The Year 2000 issue exists because many computer systems and applications
use two-digit fields to designate a year. Date-sensitive computer systems and
programs may fail to recognize or correctly process the year 2000 as the century
date change approaches or occurs. This inability to properly recognize or
address the year 2000 may cause systems errors or failures that could seriously
disrupt or prevent normal business operations.
As a company engaged in electronic commerce, we rely on computer programs
and systems in connection with our internal and external communication networks
and systems (including transmissions of information over the Internet), the
operation of our Web site, customer use of our Web site, order processing and
fulfillment, accounting and financial systems and other business functions.
Because our internal systems and software are relatively new, and the majority
are covered by maintenance agreements with third-party suppliers, we do not
expect that the Year 2000 costs relating to our own internal systems will be
significant. Our plan for addressing Year 2000 issues has three phases: (1)
identification and evaluation; (2) development of plans for addressing the
issues and prioritization of those plans; and (3) implementation of plans and
verification of effectiveness. We have already identified and evaluated our
major internal information technology and data processing systems for Year 2000
compliance. Certain critical internal information technology and data processing
systems have already been modified, upgraded or replaced to remedy Year 2000
issues. We are currently completing a plan to address our remaining significant
internal systems for Year 2000 compliance. We expect to substantially complete
the assessment and planning phase by the end of March 1999. Management intends
to complete the implementation and verification phases for our remaining
critical internal systems by November 1999.
Due to our electronic commerce focus, our reliance on significant
non-information technology systems is primarily limited to telecommunications
equipment, voicemail systems and property security systems. We have recently
replaced our telecommunications equipment and voicemail systems with systems
that the suppliers state are Year 2000 compliant. We are currently evaluating
our property security systems for Year 2000 compliance, but do not believe that
any problems with this system would materially affect our business operations.
As a result, we do not expect Year 2000 costs relating to our property security
systems to be material.
Any failure of third party networks, systems or services could have a
material adverse impact on our business. Our business depends on the
satisfactory performance and reliability of the external communication and
computer networks, systems and services integral to the Internet. These
networks, systems and services are maintained or provided by third parties and
affect the ability of customers to access and purchase products at our Web site.
We also rely on other systems and services that third parties provide to our
customers. As a result, the success of our plan to address the Year 2000 issues
depends in part on parallel efforts being undertaken by such other third
parties. We have begun to identify and initiate communications with those third
parties whose networks, systems or services are critical to our business to
determine the status of these entities' Year 2000 compliance. We cannot assure
you
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that all such parties will provide accurate and complete information, or that
all their networks, systems, or services will achieve full Year 2000 compliance
in a timely fashion. In an attempt to mitigate the risk of non-compliance by
certain critical service providers, we have begun to diversify our use of
certain services among several providers. However, we cannot assure you that
this diversification will mitigate the risk of noncompliance.
Costs related to our efforts to address Year 2000 issues have been expensed
as incurred and have not been material to date. We expect to fund the Year
2000-related costs through funds provided by operations and do not expect these
costs to have a material adverse effect on our liquidity or results of
operations. Our estimates of the cost of these efforts are partially based on
numerous assumptions about future events. We cannot assure you that these
estimates will be correct. Actual costs could differ materially from these
estimates.
Although we are taking steps to achieve Year 2000 compliance of our
internal systems and to evaluate the compliance of third-party service providers
on which our business depends, the most reasonably likely worst case scenario
resulting from possible Year 2000 noncompliance is that noncompliance by third
parties would disrupt, reduce or eliminate for a period of time the ability of
our customers to access and purchase products at our Web site. If such
occurrences are frequent or long in duration, they could materially adversely
affect our business. The Year 2000 compliance of third-party global, national
and local communications networks and the compliance of individual Internet
service providers is not within our control. Accordingly, a contingency plan for
this worst case scenario does not exist and we do not believe we will be able to
develop one. We have, however, begun to diversify our uses of certain services
among several providers to attempt to mitigate this risk. We cannot assure you,
however, that our attempt will mitigate the risk of non-compliance, and any
failure of third party networks, systems or services could materially adversely
affect our business.
We believe we are taking the necessary steps regarding Year 2000 compliance
with respect to matters within our control to seek to minimize the impact of
Year 2000 issues on our business. We currently expect our Year 2000 project to
be completed in 1999. However, not all of the systems on which we rely are Year
2000 compliant and we cannot assure you that these systems will be made Year
2000 compliant in a timely manner, that we will not incur significant additional
expenses for Year 2000 issues, that the third parties upon which our business
depends will achieve Year 2000 compliance, or that the Year 2000 problem will
not materially adversely affect our business, financial condition or results of
operations.
We rely on the quality of the products that manufacturers, distributors and
suppliers provide to us for sale to our customers. To the extent that the
products we sell are not Year 2000 compliant, we may be subject to claims by
customers that could materially adversely affect our business or damage our
reputation.
Recent Accounting Pronouncements
During June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative
Instruments and Hedging Activities. The new standard requires companies to
record derivatives on the balance sheet as assets or liabilities, measured at
fair value. Gains or losses resulting from changes in the values of those
derivatives would be accounted for depending on the use of the derivative and
whether it qualifies for hedge accounting. Because we do not use derivatives,
the new standard is expected to have no material impact on our financial
position or results of operations. SFAS 133 will be effective for fiscal 2001.
In April 1998, the American Institute of Certified Public Accountants
issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." SOP 98-1 provides guidance for
determining whether computer software is internal-use software and on accounting
for proceeds of computer software originally developed or obtained for internal
use and then subsequently sold to the public. It also provides guidance on
capitalization of the costs incurred for computer software developed or obtained
for internal use. We have not capitalized any costs that will need to be written
off to comply with SOP 98-1. Our current policies for capitalizing costs
incurred for computer software development or obtained for internal use comply
with SOP 98-1.
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Additional Factors That May Affect Future Results
Any of the following additional factors could materially adversely affect our
business, operating results and financial condition:
We have a limited online operating history which provides little information
with which to evaluate our electronic commerce business
In February 1998, we shifted our business emphasis to the Internet and
closed our remaining retail stores. We therefore have had only a limited
operating history as an electronic commerce company. As a result, there is
little information on which to evaluate our business and prospects as an
electronic commerce company. An investor in our common stock must consider the
risks and difficulties that early-stage companies frequently encounter in the
new and rapidly evolving market of electronic commerce. Such risks for us
include:
o our evolving and unpredictable business model;
o our competitors that have more established electronic commerce operations;
o our need and ability to manage growth; and
o the rapid evolution of technology in electronic commerce.
To address these risks and uncertainties, we must take several steps,
including:
o improving our customer service and providing outstanding order fulfillment;
o continuing to develop and upgrade our technology, infrastructure and systems
that support our online store;
o expanding the number of products and categories of merchandise offered at our
online store;
o increasing our customer base to achieve economies of scale;
o attracting, retaining and motivating qualified personnel; and
o making our online store more user-friendly and appealing to customers.
We may not be successful in implementing any of our strategies or in
addressing these risks and uncertainties. Even if we accomplish these objectives
we still may not be profitable in the future.
We have a history of losses and expect future losses
We have incurred substantial losses in the operation and closing of our
former retail store network and in the operation of our electronic commerce
business. As of December 26, 1998, we had a retained deficit of $96.4 million.
We have not achieved profitability as an electronic commerce company, and we
expect to continue to incur substantial net losses through at least the fiscal
year 2001. We plan to continue to enhance our brand name through marketing and
advertising programs, offer additional categories of merchandise for sale at our
online store and improve and enhance our technology, infrastructure and systems.
These initiatives will likely result in operating expenses that are higher than
current operating expenses. We will need to generate significant revenues to
achieve profitability and to maintain profitability if it is achieved. Although
our revenues from electronic commerce have grown in recent quarters, such growth
rates may not be sustainable and we may not become profitable in the future.
Our future revenues are unpredictable and our operating results may
fluctuate significantly
Because we have a limited operating history in electronic commerce and
because electronic commerce is a new, emerging market, we cannot accurately
forecast our revenues. Although our revenues from electronic commerce have grown
in recent quarters, you should not use these past results to predict our future
results. We base our current and future expenditures on our plans and estimates
of future revenues. Our expenses are, to a large degree, fixed. We may be unable
to adjust spending in a timely manner if we experience an unexpected shortfall
in our revenues.
We expect that our future quarterly operating results will fluctuate
significantly because of many factors, several of which we do not control. Such
factors include:
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o our ability to satisfy customers, retain existing customers and attract new
customers at a steady rate;
o our ability to acquire, price and market merchandise inventory such that we
maintain gross margins in our existing business and in future product lines
and markets;
o price competition;
o the level of traffic at our Web site;
o our ability to fulfill customer orders;
o the development, announcement or introduction of new sites, services or
products by us or by our competitors; o the amount the Internet is used
generally and, more specifically, for the purchase of consumer products such
as those that we offer;
o our ability to upgrade and develop our systems and infrastructure and
attract new employees;
o the occurrence of technical or communications failures, system downtime and
Internet disruptions;
o the amount and timing of operating costs and capital expenditures that we
incur to expand our business;
o governmental regulation and taxation policies;
o disruptions in service by common carriers such as United Parcel Service;
o unanticipated increases in shipping and transaction-processing costs; and
o general economic conditions and economic conditions specific to the
Internet, electronic commerce and the computer industry.
Our revenues depend on the number of times customers make purchases at our
online store and the level of sales and bidding activity at the Egghead Auctions
section of our online store. The amount of sales and bidding activity at our
online store depends in part on the number of customers and the availability of
merchandise from our suppliers. We cannot forecast the number of future
customers or the future availability of merchandise with any degree of
certainty. It is clear, however, that if the number of customers does not
increase or if the amount of merchandise available to us decreases
substantially, our business will suffer.
Because of these and other factors, we believe that period-to-period
comparisons of our historical results of operations are not a good indicator of
our future performance. If our future operating results are below the
expectations of securities analysts and investors, our stock price may decline.
Our operating results may fluctuate depending on the season, and such
fluctuations may affect our stock price
We expect to experience fluctuations in our operating results because of
seasonal fluctuations in traditional retail patterns. Retail sales in the
traditional retail industry tend to be significantly higher in the fourth
calendar quarter of each year than in the preceding three quarters. As a result
of such factors, our operating results in one or more future quarters may fall
below the expectations of securities analysts and investors, and consequently
our stock may decline.
We may suffer systems failures and business interruptions
Our success, especially our ability to receive and fulfill customer orders,
largely depends on the efficient and uninterrupted operation of our computer and
telephone communications systems. Almost all of our computer and communications
systems are located at a single leased facility in Vancouver, Washington. Our
systems are vulnerable to damage from fire, floods, power loss,
telecommunications failures, break-ins, earthquakes and other events. Although
we have implemented network security measures, our servers are vulnerable to
computer viruses, physical or electronic break-ins, attempts by third parties
deliberately to exceed the capacity of our systems and similar disruptions. Any
of these events could lead to interruptions or delays in service, loss of data
or the inability to accept and confirm customer orders. Generally, we do not
have redundant systems or a formal disaster recovery plan, and our coverage
limits on our property and business interruption insurance may not be adequate
to compensate us for losses that may occur.
We face risks of capacity constraints
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Our revenues depend to a significant degree on the number of customers who
use our online store to buy merchandise. We depend on the satisfactory
performance, reliability and availability of our Web site, transaction-
processing systems, network infrastructure, customer support center and delivery
and shipping systems. These factors are critical to our reputation, our ability
to attract and retain customers and to maintain adequate customer service
levels, and our operating results. Prior to the launch of our redesigned Web
site in November 1998, our online store experienced temporary capacity
constraints from time to time, and we continue to experience capacity
constraints at our customer support center primarily related to inbound customer
telephone inquiries. Capacity constraints could prevent customers from gaining
access to our online store or our customer support center for extended periods
of time and decrease our ability to fulfill customer orders or decrease our
level of customer acquisition or retention. Such constraints would also decrease
the appeal of our online store and decrease our sales. If the amount of traffic,
the number of orders or the amount of auction bidding at our redesigned Web site
increases substantially, we may experience capacity constraints and may need to
further expand and upgrade our technology, transaction-processing systems and
network infrastructure. We may be unable to sufficiently predict the rate or
timing of increases in the use of our online store to enable us to quickly
upgrade our systems to handle such increases. Also, we may be unable to increase
our capacity at our customer support center to handle the amount of current or
future customer telephone inquiries.
We face risks relating to systems development
We are heavily dependent on our technological systems, some of which were
not designed for electronic commerce but have been modified by us for that use.
Although we upgrade and expand these systems on an ongoing basis, in the near
future we will need to significantly upgrade and expand or replace our
transaction-processing systems to handle increased traffic at our online store
and to make certain elements of the systems Year 2000 compliant. We will also
need to upgrade and expand our systems for the Egghead Auctions format of our
online store, particularly to improve its scaleability. We also plan to upgrade
and expand our systems to add automated customer service, proactive email and
customer feedback features to provide enhanced customer service, more complete
customer data and better management reporting information. These efforts will
require us to integrate newly developed and/or purchased technologies into our
existing systems and to hire more engineering and information technology
personnel in the near future. If we are unable in a timely manner to hire
required personnel and to add new software and hardware or to develop and
upgrade our existing systems to handle increased traffic and increased sales
and auction bidding at our online store, we could experience unanticipated
system disruptions, slower response times, degraded customer service and a
decrease in our ability to fulfill customer orders.
We may be unable to manage our growth
Our ability to successfully implement our business plan in a rapidly
evolving market requires an effective planning and growth-management process. If
we are unable to manage our growth, we may not be able to implement our business
plan, and our business may suffer as a result. We expect that we will have to
expand our business to address potential growth in the number of customers, to
expand our product and service offerings and to pursue other market
opportunities. We expect that we will need to expand existing operations,
particularly those relating to information technology, customer service and
merchandising. We expect that we will also need to continue to improve our
operational, financial and inventory systems, procedures and controls, and will
need to expand, train and manage our workforce, particularly our information
technology staff. Furthermore, we expect that we will need to continue to manage
multiple relationships with various suppliers, freight companies, warehouse
operators, Web sites, Internet service providers, and other third parties to
keep control over our strategic direction as the electronic commerce business
evolves.
The electronic commerce market is intensely competitive
The electronic commerce industry is new, rapidly evolving and intensely
competitive. We may not be successful in competing against our current and
future competitors. It is not difficult to enter the electronic commerce market,
and current and new competitors can launch new electronic commerce Web sites at
relatively low cost. We expect competition in electronic commerce to increase as
retailers, suppliers, manufacturers and direct marketers who have not
traditionally sold computer products and consumer goods directly to consumers
through the
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Internet enter this market segment. Furthermore, competition may increase to the
extent that mergers and acquisitions result in electronic commerce companies
with greater market share and revenues. Increased competition or failure by us
to compete successfully is likely to result in price reductions, fewer customer
orders, reduced gross margins, increased marketing costs or loss of market
share, or any combination of these problems.
We currently compete with a variety of companies that sell personal computer
products and other consumer goods through a variety of sales channels to
customers. These competitors include:
o Catalog-based merchants with a significant electronic commerce offering, such
as CDW Computers Centers, Inc., Micro Warehouse, Inc., Insight Enterprises,
Inc., Multiple Zones International, Inc. and Creative Computers, Inc.;
o Companies with electronic commerce sites such as Beyond.com Corporation,
Buy.com Inc. and Cyberian Outpost, Inc., and electronic software distributors
such as Digital River, Inc.;
o Companies offering Internet auctions, such as ONSALE, Inc., uBid, Inc., Yahoo!
Inc., Internet Shopping Network, Inc. (the FirstAuction site), Micro
Warehouse, Inc. and eBay Inc.;
o Companies whose primary business is not online retailing but who derive
significant revenue from electronic commerce, including America Online, Inc.,
Yahoo! Inc. and QVC, Inc.;
o Traditional retailers of personal computer products such as CompUSA, Inc. and
Computer City;
o Manufacturers such as Dell Computer Corporation and Gateway 2000, Inc. that
sell directly to the consumer, including over the Internet;
o Mass merchandisers such as Wal-Mart Stores, Inc., Costco Wholesale Corporation
and Best Buy Co., Inc. that primarily sell through traditional retail channels
but also sell over the Internet; and .
o Office products retailers such as Office Depot Inc. and Staples, Inc. that
primarily sell through traditional retail channels but also sell over the
Internet.
We believe that the principal competitive factors affecting our market are
brand name recognition, competitive pricing, quality of customer service,
quality of product information, breadth of merchandise offerings, cost of
customer acquisition and ease of use of electronic commerce sites. Although we
believe we compete adequately with respect to such factors, we cannot assure you
that we can maintain our competitive position against current and potential
competitors, especially those with greater financial, marketing, customer
support, technical and other resources than us.
Current and potential competitors have established or may establish
cooperative relationships among themselves or directly with suppliers to obtain
exclusive or semi-exclusive sources of merchandise. New competitors or alliances
among competitors and suppliers may emerge and rapidly acquire market share.
Also, manufacturers might elect to sell or liquidate their products directly
over the Internet. Many of our current and potential competitors have
significantly greater financial, marketing, customer support, technical and
other resources than we do. As a result, they may be able to secure merchandise
from suppliers on more favorable terms than we can, and they may be able to
respond more quickly to changes in customer preference or to devote greater
resources to the development, promotion and sale of their merchandise than we
can.
We rely heavily on certain third parties, including Internet service providers
and telecommunications companies
Our operations depend on a variety of third parties for Internet access,
telecommunications, operating software, order fulfillment, merchandise delivery
and credit card transaction processing. We have limited control over these third
parties, and we cannot assure you that we will be able to maintain satisfactory
relationships with any of them on acceptable commercial terms. Nor can we assure
you that the quality of products and services that they provide will remain at
the levels needed to enable us to conduct our business effectively.
We rely on Internet service providers to connect our Web site to the
Internet. From time to time, we have experienced temporary interruptions in our
Web site connection and also our telecommunications access. Frequent or
prolonged interruptions of these Web site connection services could result in
significant losses of revenues. Our Web site software and internally developed
auction software depend on operating systems, data base and server
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software that were produced by and licensed from third parties. From time to
time, we have discovered errors and defects in such software and, in part, rely
on these third parties to correct these errors and defects promptly.
Third-party distribution centers fulfill a significant portion of the sales
for which we are responsible. Accordingly, any service interruptions
experienced by these distribution centers as a result of labor problems or
otherwise could disrupt or prevent the fulfillment of some of our customers'
orders. In addition, we use United Parcel Service and Airborne Express as the
primary delivery services for our products. Our business would suffer if labor
problems or other causes prevented these or any other major carriers from
delivering our products for significant time periods. Furthermore, First USA
Bank, through its relationship with First USA Paymentech, Inc. (Paymentech) is
our sole processor of credit card transactions. If computer systems failures or
other problems were to prevent Paymentech from processing our credit card
transactions, we would experience delays and business disruptions. Any such
delays or disruptions in customer service may damage our reputation or result
in loss of customers.
We rely heavily on certain manufacturers, distributors and suppliers
We depend entirely on certain manufacturers, distributors and suppliers to
supply us with merchandise for sale at our online store. We cannot assure you
that we will be able to develop and maintain satisfactory relationships with
such parties on acceptable commercial terms, or that we will be able to obtain
sufficient quality and quantities of merchandise at competitive prices. Also,
the quality of service provided by such parties may fall below the standard
needed to enable us to conduct our business effectively. We acquire products for
sale both directly from manufacturers and indirectly through distributors and
suppliers. Purchases from Ingram Micro Inc., a distributor of computers and
related products, accounted for approximately 9.3% of our aggregate merchandise
purchases for the nine months ended December 26, 1998. We have no long-term
contracts or arrangements with manufacturers, distributors or suppliers that
guarantee availability of merchandise for our online store. We cannot assure you
that current manufacturers, distributors and suppliers will continue to sell
merchandise to us or otherwise provide merchandise for sale by us or that we
will be able to establish new manufacturer, distributor or supplier
relationships that ensure merchandise will be available for sale by us. We also
rely on many of our distributors and suppliers to ship merchandise to customers.
We have limited control over the shipping procedures of these distributors and
suppliers, and such shipments have often been subject to delays. Most
merchandise sold by us carries a warranty from the manufacturer or the supplier,
and we are not obligated to accept merchandise returns. Nevertheless, we in fact
have accepted returns from customers for which we did not receive reimbursements
from our suppliers or manufacturers, and the levels of returned merchandise in
the future may exceed our expectations. We may also find that we have to accept
more returns in the future to maintain customer satisfaction.
We face the risks of expanding into new services and business areas
To increase our revenues, we will need to expand, over time, our operations
by promoting new or complementary products or by expanding the breadth and depth
of our product or service offerings. If we expand our operations in this manner,
we will require significant additional development resources and such expansion
may strain our management, financial and operational resources. We may not
significantly benefit in such expansion from the Egghead.com brand name or from
the early entry advantage that we have experienced in the online computer
products market. Gross margins attributable to new business areas may be lower
than those associated with our existing business activities. We cannot assure
you that our expansions into new product categories, online sales formats or
products or service offerings will be timely or will generate enough revenue to
offset their costs. Also, any new product category or product or service
offering that we launch that is not favorably received by consumers could damage
our reputation or the Egghead.com brand.
We depend on our key personnel, and we will need to attract and retain
additional personnel
Our performance is substantially dependent on the continued services and on
the performance of our executive officers and other key employees, particularly
George P. Orban, our Chief Executive Officer and Chairman of the Board. We do
not maintain "key person" life insurance policies. Although some of our
executive officers and key employees have entered into employment agreements,
none of these agreements prevents any of them from leaving Egghead.com. The loss
of the services of any of our executive officers or other key employees could
materially
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adversely affect our business. Additionally, we believe we will need
to expand significantly our information technology staff in the near future and
will need to identify, attract, hire, train and retain other highly- skilled
personnel to be successful. Competition for personnel in the electronic commerce
industry is intense. We cannot assure you that we will be able to expand our
information technology staff or successfully identify, attract, hire and retain
other highly-skilled personnel in a timely and effective manner.
We face risks relating to the relocation and consolidation of our facilities
We are moving our customer support and service center from its current
location in Hood River, Oregon to our corporate office in Vancouver, Washington.
We also plan to consolidate several of our distribution facilities into a single
distribution center in Vancouver, Washington. We anticipate that these changes
will be completed in the summer of 1999. During this period, we will have the
burden of operating multiple customer support and service sites and multiple
distribution facilities. We may also incur additional expenses related to the
relocations and consolidation. Finally, our customer support, service and
distribution could be disrupted during the transition, which could damage our
reputation and result in reduced customer satisfaction.
Electronic commerce poses security risks to us
A significant barrier to electronic commerce and communications is the
secure transmission of confidential information over public networks. We rely
upon encryption and authentication technology licensed from third parties to
provide secure transmission of confidential information. We cannot assure you
that our security measures will prevent security breaches, and such breaches
could expose us to operating losses, litigation and possible liability. Advances
in computer capabilities, new discoveries in the field of cryptography or other
events or developments may result in a compromise or breach of the algorithms
that we use to protect customer transaction data. A party who is able to
circumvent our security measures could steal proprietary information or
interrupt our operations. We may need to spend a great deal of money and use
other resources to protect against the threat of such security breaches or to
alleviate problems caused by such breaches. Concerns over the security of online
transactions and the privacy of users may also inhibit the growth of the
Internet generally, and the Web in particular, especially as a means of
conducting commercial transactions.
We face risks relating to our inventory
We directly purchase some of the merchandise that we sell at our online
Superstores and most of our off-price merchandise, including excess, close-out,
refurbished and reconditioned goods, that we sell at our online SurplusDirect
liquidation center and through Egghead Auctions. We assume the inventory risks,
inventory obsolescence risks and price erosion risks for products that we
purchase directly. These risks are especially significant because much of the
merchandise we sell at our online store (for example, computer hardware,
software and consumer electronics) is characterized by rapid technological
change, obsolescence and price erosion. In the recent past we have recorded
charges for obsolete inventory and have had to sell certain merchandise at a
discount or loss. It is impossible to determine with certainty whether an item
will sell for more than the price we pay for it. Because we rely heavily on
purchased inventory, our success will depend on our ability to liquidate our
inventory rapidly, the ability of our buying staff to purchase inventory at
attractive prices relative to its resale value, and our ability to manage
customer returns and the shrinkage resulting from theft, loss and misrecording
of inventory. If we are unsuccessful in any of these areas, we may be forced to
sell our inventory at a discount or loss.
We are dependent on intellectual property
Our performance and ability to compete are dependent to a significant
degree on our proprietary technology. We rely on a combination of trademark,
copyright and trade secret laws to establish and protect our proprietary rights.
Although we have applied for trademark protection for the Egghead.com name, this
name is not currently a registered trademark in the United States. We cannot
assure you that we will be able to secure significant protection for this
trademark and our other trademarks or service marks. It is possible that our
competitors or others will adopt product or service names similar to
"Egghead.com" or other service marks or trademarks of ours, thereby impeding our
ability to build brand identity and possibly confusing customers.
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Our proprietary software is protected by copyright laws. The source code
for our proprietary software also is protected under applicable trade secret
laws. We cannot assure you that the steps we take to protect our software will
prevent misappropriation of our technology or that the agreements we enter into
for that purpose will be enforceable. It might be possible for a third party to
copy or otherwise obtain and use our software or other proprietary information
without authorization, or to develop similar software independently. Policing
unauthorized use of our technology is difficult, particularly because the global
nature of the Internet makes it difficult to control the ultimate destination or
security of software or other data transmitted. The laws of other countries may
not adequately protect our intellectual property.
We may in the future receive notices from third parties claiming
infringement by our software or other intellectual property used in our
business. While we are not currently subject to any such claim, any future
claim, with or without merit, could result in significant litigation costs and
distraction of management, and could require us to enter into costly and
burdensome royalty and licensing agreements. Such royalty and licensing
agreements, if required, may not be available on terms acceptable to us, or may
not be available at all. In the future, we may also need to file lawsuits to
defend the validity of our intellectual property rights and trade secrets, or to
determine the validity and scope of the proprietary rights of others. Such
litigation, whether successful or unsuccessful, could result in substantial
costs and diversion of resources.
We also rely on a variety of technologies that we license from third
parties such as the database and Internet commerce server applications that we
license from Oracle Corporation. We cannot assure you that these third-party
technology licenses will continue to be available to us on commercially
reasonable terms. If we lose any such licenses, or if we are unable to maintain
or obtain upgrades to any of these licenses, it could delay completion of our
proprietary software enhancements until equivalent technology is identified,
licensed or developed, and integrated.
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We are vulnerable to the rapid evolution of electronic commerce and related
technology
The Internet and the electronic commerce industry are characterized by
rapid technological change, changes in user and customer requirements, frequent
new service or product introductions embodying new technologies, and the
emergence of new industry standards and practices. Changes in the Internet,
electronic commerce and the related technology could render our Web site and
technology obsolete. To remain competitive, we must continue to enhance and
improve the customer service features, responsiveness and functionality of our
Web site. Our success in achieving these goals depends on our ability to develop
or license new technologies and respond promptly and cost-effectively to
technological advances and emerging industry standards and practices. The
development and licensing of technologies relating to the Internet and
electronic commerce involves significant technical, financial and business
risks. We may not be successful in developing, licensing or integrating new
technologies or promptly adapting our Web site, proprietary technology and
transaction-processing systems to customer needs or emerging industry standards.
We are dependent on the continued development of the Internet infrastructure
We depend almost entirely on the Internet for revenue and the increased use
of the Internet for commerce is essential for our business to grow. Accordingly,
our success depends in large part on the continued development of the
infrastructure for providing Internet access and services. The Internet could
lose its viability or its usage could decline due to many factors, including:
o delays in the development of the Internet infrastructure;
o power outages;
o disruptions due to the inability of computer systems to recognize the year
2000;
o the adoption of new standards or protocols for the Internet; or .
o changes or increases in governmental regulation.
o
We cannot be certain that the infrastructure or complementary services
necessary to maintain the Internet as a useful and easy means of buying goods
will be developed or that, if they are developed, the Internet will remain a
viable marketing and sales channel for the types of products and services that
we offer at our online store.
Electronic commerce may not gain market acceptance
The market for Internet products and services has only recently begun to
develop and is rapidly changing. If this market fails to develop, develops more
slowly than expected or becomes saturated with competitors, or if our online
store does not achieve market acceptance, our business may suffer. As is
typical for a new and rapidly evolving industry, demand and market acceptance
for recently introduced services and products over the Internet are subject to
a high level of uncertainty and there exist few proven services and products.
The success of our online store depends upon the adoption of the Internet as a
medium for commerce by a broad base of customers and suppliers. We cannot
assure you that widespread acceptance of electronic commerce in general, or of
our online store in particular, will occur. In the past we have relied on
customers and suppliers who have historically used traditional means of
commerce to purchase and sell merchandise. If we are to be successful, these
customers and suppliers must accept and use new ways of conducting business and
exchanging information, and suppliers must be persuaded to adopt new selling
models. We cannot assure you that there will be broad acceptance of the
Internet as an effective medium for commerce by consumers and suppliers or that
the markets for our online store will develop successfully.
We face risks associated with maintaining the value of our domain names
We currently hold various Web domain names relating to our brand, including
the Egghead.com, Surplusdirect.com and Surplusauction.com domain names. We
cannot assure you that we will be able to acquire or maintain relevant domain
names in all jurisdictions in which we conduct business. The acquisition and
maintenance of domain names generally is regulated by governmental agencies and
their designees. The regulation of domain
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names in the United States and in foreign countries is subject to change.
Governing bodies may establish additional top-level domains, appoint additional
domain name registrars or modify the requirements for holding domain names. The
relationship between regulations governing domain names and laws protecting
trademarks and similar proprietary rights is unclear. Therefore, we may be
unable to prevent third parties from acquiring domain names that are similar to,
infringe on or otherwise decrease the value of our brand and our trademarks and
other proprietary rights.
We face risks associated with potential acquisitions
We intend to make investments in complementary businesses, products,
services or technologies on an opportunistic basis when they will assist us in
carrying out our business strategy. If we buy a company, we could have
difficulty in assimilating that company's personnel and operations. In addition,
the key personnel of the acquired company may decide not to work for us. If we
acquire products, services or technologies, we could have difficulty in
assimilating them into our operations. These difficulties could disrupt our
ongoing business, distract our management and employees and increase our
expenses. Furthermore, we may have to incur debt or issue equity securities to
pay for any future acquisitions, the issuance of which could be dilutive to our
existing shareholders.
We face risks associated with the closing of our retail network
On January 28, 1998, we announced that we were changing our name to
Egghead.com, Inc. and shifting our entire business emphasis to electronic
commerce. During the subsequent transition, we closed our remaining retail store
network and our distribution center in Sacramento, California. In addition, we
combined our management and operations with those of Surplus Software, Inc.
("Surplus Direct"), a subsidiary that we acquired in August 1997. Although we
have recorded reserves for liabilities associated with the closure of the retail
store network, we cannot assure you that these reserves will be adequate to
cover any remaining obligations or liabilities.
We are subject to government regulation and legal uncertainties
We are currently subject to regulations applicable to businesses generally,
as well as laws or regulations directly applicable to communications or commerce
over the Internet. The adoption or modification of laws or regulations relating
to the Internet could adversely affect our business. The law of the Internet,
however, remains largely unsettled, even in areas where there has been some
legislative action. It may take years to determine whether and how existing laws
such as those governing intellectual property, privacy, libel and taxation apply
to the Internet. In addition, due to the increasing popularity and use of the
Internet, it is possible that a number of laws and regulations may be adopted
with respect to the Internet or other online services covering issues such as
user privacy, security, pricing, content, copyrights, distribution, taxation and
characteristics and quality of products and services. Furthermore, the growth
and development of electronic commerce may prompt calls for more stringent
consumer protection laws that may impose additional burdens on electronic
commerce companies.
We are vulnerable to additional tax obligations
We currently collect sales tax only on sales of products delivered to
residents in the state of Washington. However, other states or foreign countries
may seek to impose sales tax collection obligations on us and other electronic
commerce companies. A number of proposals have been made at the state and local
levels that would impose additional taxes on the sale of goods and services
through the Internet. These proposals, if adopted, could substantially impair
the growth of electronic commerce and cause purchasing at our online store to be
less attractive to customers as compared to traditional retail purchasing. The
U.S. Congress has passed legislation limiting for three years the ability of the
states to impose taxes on Internet-based transactions. Failure to renew this
legislation could result in the imposition by various states of taxes on
electronic commerce.
Our stock price may be extremely volatile
The market price of our common stock has fluctuated substantially in the
past and is likely to fluctuate substantially in the future. In addition, the
securities markets have experienced significant price and volume fluctuations
and the market prices of the securities of Internet-related companies have been
especially volatile. In the past, companies that have experienced volatility in
the market price of their stock have been subject to securities class action
litigation. A securities class action lawsuit against us could result in
substantial costs and a diversion of management's attention and resources.
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Part II. OTHER INFORMATION
ITEM 1. Legal Proceedings
None.
ITEM 4. Submission of Matters to a Vote of Security Holders
None.
ITEM 5. Other Information
None.
ITEM 6. Exhibits and Reports On Form 8-K
a. Exhibits
<TABLE>
<S> <C>
10.1* Amended and Restated 1993 Stock Incentive Compensation Plan
10.2* Restated Nonemployee Director Stock Option Plan
10.3* Settlement Agreement and Release dated December 21, 1998
10.4* Amended Executive Employment Agreements with each of Tommy Collins,
Norman Hullinger and James Kalasky dated January 28, 1999.
27.1* Financial Data Schedule
</TABLE>
- ---------
* Previously filed.
b. Reports on Form 8-K
A report on form 8-K was filed by the Company on October 1, 1998 to
report, under Item 5 of Form 8-K, that elected to the Board of
Directors of Egghead.com, Inc. on September 5, 1998 were three new
directors, C. Scott Gibson, Robert T. Wall and Karen White, and that
Richard P. Cooley and Samuel N. Stroum retired from the Board of
Directors of the Company on September 2, 1998.
SIGNATURES
Pursuant to the requirements of the section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, in the
city of Vancouver, State of Washington, on the 4th day of March, 1999.
EGGHEAD.COM, INC.
By: /s/ George P. Orban
---------------------------------
George P. Orban
Chairman of the Board and
Chief Executive Officer
By: /s/ Brian W. Bender
---------------------------------
Brian W. Bender
Chief Accounting Officer and
Chief Financial Officer
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