10-Q 1 d10q.txt FORM 10-Q DATED SEPTEMBER 29, 2001 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ----------------------------- FORM 10-Q (Mark One) [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 29, 2001 OR [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from to Commission File No. 000-29715 eMachines, Inc. (Exact Name of Registrant as Specified in its Charter)

14350 Myford Road, Suite 100, Irvine, California 92606 (714) 481-2828 (Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] As of November 1, 2001, there were 145,511,579 shares of the Registrant's Common Stock outstanding. eMachines, Inc. INDEX PART I--FINANCIAL INFORMATION

In this report, "eMachines," the "Company," "we," "us" and "our" collectively refer to eMachines, Inc. and its wholly-owned subsidiaries, unless the context otherwise requires. 2 PART I - FINANCIAL INFORMATION Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS eMachines, Inc. CONDENSED CONSOLIDATED BALANCE SHEETS September 29, 2001 and December 30, 2000 (in thousands, except share information)

The accompanying notes are an integral part of these consolidated financial statements. 3 eMachines, Inc. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS Quarters Ended and Nine Months Ended September 29, 2001 and September 30, 2000 (in thousands, except share information)

The accompanying notes are an integral part of these condensed consolidated financial statements. 4 eMachines, Inc. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months Ended September 29, 2001 and September 30, 2000 (in thousands)

Supplemental disclosure of non-cash financing activities: In March 2000, in connection with the Company's initial public offering of its common stock, all of the Company's preferred stock converted into common stock. The preferred stock had a book value of $152,360 on the conversion date. See Note 4--Stockholder's Equity. In January 2000, the Company acquired FreePC, Inc. in a non-cash transaction by issuing equity securities and assuming stock options with an aggregate value of approximately $150,000. The total purchase price of $150,083 was allocated to the net assets acquired and intangible assets as described in Note 3--Business Combination. The accompanying notes are an integral part of these condensed consolidated financial statements. 5 eMachines, Inc. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (in thousands, except share information) NOTE 1--BASIS OF PRESENTATION The condensed consolidated financial statements include the accounts of eMachines, Inc. and its subsidiaries (the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation. The interim condensed consolidated financial statements are unaudited. In the opinion of management, the interim condensed consolidated financial statements include all adjustments, consisting of only normal, recurring adjustments, necessary for a fair presentation of the Company's financial position, results of operation and cash flows. In the fourth quarter of 1999, the Company adopted a fiscal-year convention for its year-end and quarter ends. Accordingly, the fiscal year-end is the 52 or 53-week period ending on the Saturday nearest December 31, and each fiscal quarter ends on the thirteenth Saturday of the quarterly period. This Quarterly Report on Form 10-Q should be read in conjunction with the Company's audited financial statements contained in the Company's annual report on Form 10-K filed (File No. 000-29715) on March 30, 2001. The interim results presented herein are not necessarily indicative of the results of operations that may be expected for the full fiscal year ending December 29, 2001, or any other future period. NOTE 2--EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS In August 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 143 "Accounting for Asset Retirement Obligations", which establishes financial accounting and reporting requirements for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The provisions of SFAS No. 143 apply to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset, except for certain obligations of lessees. This statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. The Company is currently evaluating the impact that the adoption of this statement will have on its consolidated financial statements. The FASB issued SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets", in October 2001. SFAS No. 144 addresses the recognition of impairment losses on long-lived assets to be held and used or to be disposed of by sale. This statement supersedes FASB SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of", and the accounting and reporting provisions of Accounting Principals Board Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions". The Company is currently evaluating the impact that the adoption of this statement will have on its consolidated financial statements. The statement is effective for financial statements issued for fiscal years beginning after December 15, 2001. NOTE 3--BUSINESS COMBINATION Effective January 14, 2000, the Company acquired FreePC, Inc. ("FreePC"). To consummate the merger the Company issued 3,995,633 shares of common stock, 10,175,516 shares of Series B preferred stock, 7,458,370 shares of Series C preferred stock, and warrants to purchase 9,269,834 shares of the Company's common stock, in exchange for all of the outstanding shares of capital stock of FreePC. In addition, the Company reserved 4,130,342 shares of its common stock for issuance upon the exercise of 2,891,275 FreePC and Guide.com (a predecessor of FreePC) common stock options assumed in connection with the acquisition, plus 1,239,067 warrants issuable upon exercise of the options. The exchange ratio was approximately 1.1 shares of the Company's capital stock and warrants to purchase approximately 0.47 shares of the Company's common stock. The transaction was accounted for using the purchase method of accounting. The purchase price, based on an independent valuation, was approximately $150,083, including approximately $83 for professional fees. The fair value of the securities exchanged or assumed in connection with the acquisition was as follows: Common and preferred stock................................... $135,600 Common stock warrants........................................ 1,100 Options assumed, including warrants issuable upon exercise... 13,300 -------- $150,000 ========

6 With respect to the options assumed as part of the acquisition, all vested and unvested FreePC options exchanged for Company options are included as part of the purchase price. The total estimated purchase price for the FreePC acquisition was allocated as follows to assets and liabilities based on management's best estimates of their fair value with the excess costs over the net assets acquired of $141,527 being allocated to goodwill. Workforce..................... $ 5,300 Goodwill...................... 141,527 Fair value of net assets...... 3,256 -------- $150,083 ========

The intangible assets resulting from the purchase transaction were amortized over their estimated useful lives of three years using the straight-line method. During the second quarter of 2000 the Company wrote-off $2,754 of the workforce intangible asset as a result of a reduction in the workforce acquired from FreePC. During the fourth quarter of 2000, the Company re-evaluated the carrying value of the intangible assets acquired from FreePC and recorded an impairment charge of $85,784 since the estimated fair value of the intangible assets was less than the recorded amount. During the second quarter of 2001, the Company recorded an impairment charge for the remaining $9,006 of intangible assets, as a result of lowered expectations for FreePC-related internet revenues. The fair value of the intangible assets was estimated utilizing valuation principles and methodologies consistent with those used in the independent valuation of the FreePC purchase price. The operating results of FreePC are included in the Company's condensed consolidated financial statements from the date of acquisition. The unaudited pro forma consolidated information set forth below presents the consolidated results of operations as if the acquisition had occurred at the beginning of the period presented. These unaudited pro forma consolidated results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred if the acquisition had taken place at the beginning of the period presented or the results that may occur in the future. Unaudited pro forma consolidated results of operations for the nine months ended September 30, 2000 are as follows:

NOTE 4--STOCKHOLDERS' EQUITY On March 29, 2000 the Company completed its initial public offering of 20,000,000 shares of the Company's common stock for proceeds of $180,000 before $15,018 in offering costs. Upon completion of the offering, all outstanding shares of preferred stock, totaling 41,913,255 shares, were converted one for one into common shares. The outstanding preferred stock included 24,279,369 shares of Series A preferred stock issued in connection with the Company's private placement financing and 10,175,516 shares of Series B preferred stock and 7,458,370 shares of Series C preferred stock issued for the acquisition of FreePC. All of the warrants issued to the former shareholders of FreePC to purchase shares of the Company's common stock had an exercise price of $17.13 per share and expired unexercised on March 29, 2001 (the first anniversary date of the Company's IPO). As of September 29, 2001, the Company is no longer obligated to issue any such additional warrants. NOTE 5--EARNINGS PER SHARE The Company computes net income (loss) per share in accordance with SFAS No. 128, "Earnings Per Share" which requires dual presentation of basic earnings per share ("EPS") and diluted EPS. Basic EPS is computed using the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed using the weighted average number of shares of common stock and potentially dilutive shares of common stock outstanding during the period. Potential shares of common stock consist of shares issuable upon the exercise of stock options and warrants using the treasury stock method and convertible preferred stock. Potentially dilutive shares of common stock are excluded from the computation in loss periods as their effect would be antidilutive. The following table sets forth the potentially dilutive securities that were excluded in the computation of diluted net loss per share in the periods presented, as their effect would have been antidilutive. 7

NOTE 6--LITIGATION In July 1999, Compaq Computer Corporation filed a complaint against the Company, TriGem Computer, TriGem America and Korea Data Systems as defendants in the U.S. District Court for the Southern District of Texas based on the defendants' alleged infringement of 13 patents held by Compaq related to improved system processing speed, enhanced video graphics, peripheral compatibility and overall system architecture. The complaint seeks an accounting, treble damages, a preliminary and permanent injunction from further alleged infringement, attorneys' fees and other unspecified damages. The Company filed a response in September 1999, seeking declaratory judgment of non- infringement and invalidity of Compaq's patents and asserting counterclaims against Compaq that included false and misleading advertising under the Lanham Act, business disparagement and unfair competition under Texas common law. Discovery in this case has been completed. The Company is currently unable to estimate total expenses, possible loss or range of loss that may be ultimately connected with these allegations. The Company is indemnified against liability under the terms of its PC supply agreement. The Company cannot assure you that Compaq will not succeed in obtaining monetary damages or an injunction against the production of its PC products. The Company's defense of the claims could result in significant expenses and diversion of management's attention and other resources. Although the Company believes its direct financial exposure is limited under its indemnification arrangements, the results of complex litigation of this sort are inherently uncertain and difficult to predict, and the Company cannot guarantee that the results of this litigation will not significantly harm its business, particularly if the results affect production of its PCs. Packard Bell filed a complaint against the Company on October 6, 1999 in the U.S. District Court for the Eastern District of California, alleging patent infringement of Packard Bell patents that it asserts relate to the graphics controller, parallel port controller, and bus interface of the Company's eTower(R) machine. The Company filed a response in January 2000 disputing infringement and asserting that the patents at issue are invalid. In August 2000, NEC Corporation (NEC) substituted in as plaintiff in the case. After substitutions the Court granted NEC's motion to amend the complaint in September 2000 to add an additional claim of patent infringement against the now discontinued eSlate related to a sleep mode feature for laptop computers. The parties have reached a final settlement agreement that is expected to have no material impact on the Company and both parties have requested dismissal of the case with prejudice. In October 1999, David Packard, on behalf of a putative nationwide class, filed a complaint against the Company as a defendant in the U.S. District Court for the Eastern District of Texas based on its alleged sale of defective goods. Essentially identical complaints were filed contemporaneously against Compaq, Hewlett Packard and Packard Bell. The complaints claimed that a chip in the defendants' respective PC products contains a defect that may cause an error to occur when information is written to a floppy disk. On June 12, 2001, the District Court granted the Company's motion for summary judgment on the federal law issues in the case and dismissed the action. On July 11, 2001, plaintiffs filed a complaint against the Company alleging nearly identical claims under state law in the state district court for Jefferson County in Texas. The complaint seeks unspecified monetary damages, injunctive relief and declaratory relief. The lawsuit against the Company is in the early stages. The Company has answered the complaint denying the plaintiff's claims, and the parties have begun the discovery process. Although the Company believes that it has meritorious defenses and intends to vigorously defend itself in this action, this type of litigation is inherently complex and unpredictable. The Company cannot assure you that the suit will not result in obtaining monetary damages, injunctive or declaratory relief against the production of its PC products. The Company's defense of the claims could result in significant expenses and diversion of management's attention and other resources. The Company cannot guarantee that the results of this litigation will not significantly harm its business. In September 2000, Monster Cable Products, Inc., filed a complaint against the Company in the U.S. District Court for the Northern District of California. The complaint alleged trademark infringement and dilution and unfair competition arising out of the Company's use of the mark "EMONSTER". Monster Cable Products sought injunctive relief and monetary damages in excess of $30 million. The parties have reached a final settlement agreement that is not expected to have a material impact on the Company and the case has been dismissed with prejudice. Various other lawsuits, claims and proceedings have been or may be asserted against the Company, including, without limitation, those related to product liability, intellectual property, Internet content, privacy, safety and health and employment matters. Litigation is expensive and time consuming regardless of the merits of the claim and could divert management's attention from the Company's business. The Company cannot predict the outcome of any 8 litigation. Some lawsuits, claims or proceedings may be disposed of unfavorably to it, and the Company may incur significant costs defending itself. NOTE 7--CURRENT DEVELOPMENTS Relationship with America Online, Inc. - On September 12, 2001, the Company notified America Online, Inc. ("AOL") that it intends to terminate its June 17, 1999 Marketing Agreement, as amended, with AOL. As a result, the Company and AOL initiated discussions to modify the agreement and both parties are continuing to operate under the terms of the agreement. Tender Offer Proposal - On November 9, 2001 the Company announced it had received a letter from EM Holdings, Inc., relating to a proposal to purchase the Company for $0.78 per share in cash by means of a cash tender offer. According to the letter, substantially all of the capital stock of EM Holdings, Inc. is held by Lap Shun (John) Hui. Mr. Hui is a director of the Company. Retention of Credit Suisse First Boston Corporation - On November 9, 2001 the Company announced it had retained Credit Suisse First Boston Corporation as its financial advisor to assist the Company in evaluating strategic alternatives, including a possible sale of the Company. Among other things, Credit Suisse First Boston Corporation is assisting the Company's board of directors in its continuing assessment of the EM Holdings, Inc. proposal and the financing required for its completion. There can be no assurance that the Company will proceed with a transaction with EM Holdings, Inc. or any of the other strategic alternatives considered or when any resulting transaction would occur. 9 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, including but not limited to statements based on the Company's current expectations, estimates and projections about the Company's industry, management's beliefs and certain assumptions made by the Company. Words such as "anticipate," "expect," "intend," "plan," "believe," "may," "will" or similar expressions are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, the Company's actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. The section entitled "Risks That Could Affect the Company's Financial Condition and Results of Operations" set forth in this Form 10-Q and similar discussions in the Company's annual report on Form 10-K (File No. 000- 29715) discuss some of the important risk factors that may affect the Company's business, results of operations and financial condition. You should carefully consider those risks, in addition to the other information in this report and in the Company's other filings with the SEC, before deciding to invest in the Company or to maintain or increase your investment. The Company undertakes no obligation to revise or update publicly any forward-looking statements for any reason. The information contained in this Form 10-Q is not a complete description of the Company's business or the risks associated with an investment in the Company's common stock. The Company urges you to carefully review and consider the various disclosures made in this report and in other reports filed with the SEC that discuss the Company's business in greater detail. Overview The Company sells high-quality, low-priced personal computers, or PCs. Since the Company's first PC shipment in November 1998, the Company has sold over 4.2 million PCs as of September 29, 2001. In January 2000, the Company acquired FreePC, Inc., a provider of PC-based Internet advertising services and software. Due to the decline in the Internet advertising market, in March 2001 the Company refocused its efforts away from Internet advertising to selling high- quality, low-priced PCs. In March 2000, the Company successfully completed the initial public offering of its common stock generating net proceeds to the Company of approximately $165.0 million. In the third quarter of 2000, the Company began selling PCs in the United Kingdom through the Company's alliance with Dixons, a European retailer. The Company was incorporated in Delaware in September 1998 by its founding stockholders, Stephen A. Dukker, TriGem Corporation and Korea Data Systems America. In April 2000, TriGem Corporation, a U.S. subsidiary of TriGem Computer, merged with TriGem America Corporation, another U.S. subsidiary of TriGem Computer, with TriGem America being the surviving corporation. The discussion in this Form 10-Q of the Company's relationships with TriGem Corporation and TriGem America reflects the merger. TriGem Computer is the Korea-based manufacturer of all of the Company's current PC offerings. Korea Data Systems America is a wholly-owned U.S. subsidiary of Korea Data Systems Co., Ltd., the Korea-based company that historically manufactured the Company's eOne PCs, eSlate notebook PCs and monitors, as well as a limited number of its eTower/(R)/ PCs for TriGem Computer. The Company currently purchases monitors from different manufacturers. The Company's PCs have current retail prices ranging from $399 to $999 after rebates. The Company outsources the design and manufacturing of its PCs and monitors as well as customer service and technical support, warehouse staffing, inspection, repair and repackaging of returned PCs and administration of its rebate program to third parties. As a result, the Company has a relatively small internal organization that consisted of 118 employees at November 1, 2001. The Company's hardware outsourcing strategy enables it to minimize capital investment and maintain a low product cost structure. The Company plans to continue to establish supply relationships with other PC and monitor manufacturers to reduce its dependence on its current suppliers. As of September 29, 2001, we had an accumulated deficit of $301.1 million. Despite the recent economic downturn, the Company anticipates an increase in its sales and revenues in the fourth quarter of 2001. A portion of this increase is expected to be attributable to the October 25, 2001 launch of Microsoft/(R) /Windows/(R) /XP and the uncertainties associated with the merger of Hewlett Packard and Compaq. As a result of seasonal fluctuations in the PC market, the Company typically expects that net revenues from its PC business may be greater in the fourth quarter and lower in the first and second quarters of each year. These trends did not materialize in 2000 and the first three quarters of 2001, but the Company expects net revenues to return 10 to anticipated cycles beginning in the fourth quarter of 2001. In addition, in a generally weak economic environment in which the PC market is adversely affected, the pricing of PCs becomes more competitive. The Company expects this to be the case through at least the beginning of 2002. Recent Developments On September 12, 2001, the Company notified America Online, Inc. ("AOL") that it intends to terminate its June 17, 1999 Marketing Agreement, as amended, with AOL. As a result, the Company and AOL initiated discussions to modify the agreement and both parties are continuing to operate under the terms of the agreement. In September 2001, the Company began centralizing its customer service functions with a single outsourcing partner, DecisionOne, based in Grove City, Ohio. The goal of this change is to improve customer loyalty, reduce product returns and improve efficiencies in the customer service process. The Company intends to continue to use Alorica, Inc. as its primary customer contact center. As a result of these changes to the Company's customer service operations, the Company anticipates incurring increased technical support costs that are expected to be offset by reduced product return costs. On November 9, 2001 the Company announced it had received a letter from EM Holdings, Inc. relating to a proposal to purchase the Company for $0.78 per share in cash by means of a cash tender offer. According to the letter, substantially all of the capital stock of EM Holdings, Inc. is held by Lap Shun (John) Hui. Mr. Hui is a director of the Company. On November 9, 2001 the Company announced it had retained Credit Suisse First Boston Corporation as its financial advisor to assist the Company in evaluating strategic alternatives, including a possible sale of the Company. Among other things, Credit Suisse First Boston Corporation is assisting the Company's board of directors in the continuing assessment of the EM Holdings, Inc. proposal and the financing required for its completion. There can be no assurance that the Company will proceed with a transaction with EM Holdings, Inc. or any of the other strategic alternatives considered or when any resulting transaction would occur. Results of Operations The following table sets forth for the quarters ended and nine months ended September 29, 2001 and September 30, 2000, the percentage of consolidated net revenues represented by certain items in the Company's consolidated statements of operations.

Net Revenues Net Hardware Revenues. To date substantially all of the Company's hardware revenues have been derived from sales of its PCs and monitors. The Company sells a variety of PC configurations and monitor models to its retail customers. The Company's net hardware revenues decreased to $91.7 million for the quarter ended September 29, 2001 from $172.2 million for the prior year quarter. This represents a 46.7% decrease and was primarily due to planned inventory reductions in preparation for the launch of Microsoft/(R)/ Windows/(R)/ XP compatible products in the fourth quarter of 2001 and lower demand for PCs during the quarter ended September 29, 2001 due to overall slowdown in the PC market. PC unit shipments for the quarter ended September 29, 2001 were 195,000 units and included 24,000 units sold through a distribution and marketing program with Dixons Group for distribution throughout the United Kingdom. For the nine months ended September 29, 2001, net hardware revenues decreased to $340.7 million from $539.9 million for the nine months ended September 30, 2000. This represents a 36.9% decrease and was primarily due to a 40.4% percent decrease in unit shipments due to 11 lower demand compared to the prior year period. Net revenue from extended service contracts and technical support during these periods was minimal and reported with net hardware revenues. Internet Revenues. Internet revenues for the quarter ended September 29, 2001 consists primarily of ISP fees. Internet revenues decreased to $1.6 million for the quarter, as compared to $2.8 million for the prior year quarter, which consisted of ISP fees, upfront bundling fees, registration fees, bounty fees, click fees and revenue sharing programs. For the nine months ended September 29, 2001, Internet revenues decreased to $4.7 million from $9.5 million for the nine months ended September 30, 2000. These revenue decreases, which represent a 42.9% and 50.5% decrease over the prior year quarter and nine month period, respectively, are the result of the decline in the Internet advertising market and the Company's restructuring strategy, announced in March of 2001, to eliminate resources dedicated to its proprietary Internet products. A non-recurring restructuring charge of $3.7 million was incurred during the first quarter of 2001. The Company's remaining source of Internet revenue is primarily ISP related. Cost of Revenues Cost of revenues consists primarily of the cost of PCs and monitors, Microsoft software licensing costs, inbound shipping costs and inventory valuation charges. Cost of revenues decreased to $91.2 million for the quarter ended September 29, 2001 from $167.5 million for the prior year quarter. This decrease was primarily due to decreased unit shipments. For the nine months ended September 29, 2001, cost of revenues decreased to $361.8 million from $559.9 million for the nine months ended September 30, 2000. This decrease was primarily due to decreased unit shipments and decreased inventory write-downs. Total inventory write-downs for the nine months ended September 29, 2001 were $11.8 million compared to $21.6 million for the nine months ended September 30, 2000. Gross Margin Gross margin was 2.3% or $2.1 million for the quarter ended September 29, 2001 compared to 4.3% or $7.5 million for the prior year quarter. For the nine months ended September 29, 2001, as a result of inventory write-downs and promotional discounts, cost of revenues exceeded net revenues from sales resulting in a negative gross margin of 4.7% or $16.4 million. This compares to a negative gross margin of 1.9% or $10.5 million for the nine months ended September 30, 2000. Operating Expenses Sales and Marketing. Sales and marketing expenses were $2.5 million or 2.7% of net revenues for the quarter ended September 29, 2001, compared to $4.9 million or 2.8% of net revenues for the prior year quarter. For the nine months ended September 29, 2001, sales and marketing expenses decreased to $8.3 million or 2.4% of net revenues from $15.6 million or 2.8% of net revenues for the nine months ended September 30, 2000. These decreases were primarily due to decreased co-op advertising costs, termination of certain outside sales contracts and a reduction of the Company's Internet-related sales and marketing activities. Offsetting these reductions were additional selling and marketing expenses related to the Company's distribution and marketing program with Dixons Group. The Company expects sales and marketing expense to increase as sales volumes increase. Customer Service and Technical Support. The Company outsources its customer service and technical support. Customer service and technical support expenses decreased to $1.5 million or 1.6% of net revenues for the quarter ended September 29, 2001, from $4.1 million or 2.3% of net revenues for the prior year quarter. For the nine months ended September 29, 2001, customer service and technical support expenses decreased to $6.0 million or 1.7% of net revenues from $14.3 million or 2.6% of net revenues for the nine months ended September 30, 2000. These decreases were the result of decreased call volumes due to decreased unit shipments and decreased Internet related services. Customer service and technical expenses for the quarter and nine months ended September 30, 2000 included expenses incurred in transitioning the outsourcing of the Company's customer service and technical support to Alorica from its previous provider. General and Administrative. General and administrative expenses consist primarily of payroll and related expenses for management and administrative personnel, outsourced warehousing activities, facilities expenses, professional service fees, travel and other general corporate expenses. General and administrative expenses increased to $8.1 million or 8.7% of net revenues for the quarter ended September 29, 2001, from $7.9 million or 4.5% of net revenues for the prior year quarter. Excluding the non-recurring charges for CEO transition and the Internet business restructuring of $7.5 million incurred in the first quarter of 2001, general and administrative expenses increased to $23.9 million, or 6.9% of net revenues for the nine months ended September 29, 2001, from $21.6 million, or 3.9% of net revenues, for the nine months ended September 30, 2000. The $2.3 million increase in general and administrative 12 expenses for the nine months ended September 29, 2001, over the prior year period was primarily due to increased legal fees related to ongoing litigation, reorganization expenses, and a $1.2 million PC related engineering charge paid to TriGem. Amortization and Impairment of Intangible Assets. The intangible assets resulting from the purchase of FreePC were initially being amortized over their estimated useful lives of three years using the straight-line method. The impairment charge of $9.0 million in the second quarter of 2001 reduced the carrying value of the FreePC intangible assets to zero, resulting in no amortization expense for the quarter ended September 29, 2001, compared to $12.0 million for the prior year quarter. Amortization decreased to $2.9 million for the nine months ended September 29, 2001, from $37.2 million for the nine months ended September 30, 2000. Amortization expense decreased during these periods as a result of reductions in the related intangible asset carrying values, which reductions amounted to a $2.7 million write-off in the second quarter of 2000, a $85.8 million impairment charge in the fourth quarter of 2000 and a $9.0 million impairment charge in the second quarter of 2001. The carrying amounts of the intangibles were reduced during these periods as a result of the reduction of the workforce acquired from FreePC in the second quarter of 2000, reduced expectations of our Internet business following the significant declines in the value of Internet companies experienced in year 2000, and from the Company's lowered expectations for FreePC-related Internet revenues in the second quarter of 2001. Interest and Other Income, net. Interest and other income, net, decreased to $1.9 million for the quarter ended September 29, 2001 from $3.2 million for the prior year quarter due to lower interest rates. For the nine months ended September 29, 2001, net interest and other income decreased to $6.6 million from $9.0 million for the nine months ended September 30, 2000 due to a lower average cash balance and the decline in interest rates during the nine months ended September 29, 2001. Net interest income is earned from interest-bearing cash equivalents and other interest bearing short-term investments. Interest expense was insignificant for the quarters and the nine months ended September 29, 2001 and September 30, 2000. Liquidity and Capital Resources The Company has financed its operations primarily through the sale of its capital stock and payment terms on its related party accounts payable. On March 29, 2000, the Company completed its initial public offering of 20,000,000 shares of its common stock, providing the Company with net proceeds of $165.0 million. As of September 29, 2001 the Company had working capital of $167.3 million. Of this amount, $191.3 million consisted of cash (including restricted cash of $2.2 million) and cash equivalents. Net cash provided by operating activities was $80.0 million for the nine months ended September 29, 2001 and net cash used by operating activities was $76.5 million for the nine months ended September 30, 2000. As of September 29, 2001 cash and cash equivalents increased by $38.3 million from June 30, 2001. For the nine months ended September 29, 2001, the primary sources of cash were reductions in inventories and collections of accounts receivable. For the nine months ended September 30, 2000, the primary uses of cash were operating losses and purchases of inventories. Net cash provided by investing activities was $12.2 million for the nine months ended September 29, 2001 and $683,000 for the nine months ended September 30, 2000. A primary source of cash in both of these periods was the maturity of short-term investments. During the three months ended March 31, 2001, the Company sold its investment in foreign securities for $6.7 million. Part of this sale was recorded as a return of capital and the realized gain as income. During the nine months ended September 30, 2000, the Company used cash to purchase $5.8 million in foreign securities and acquired $5.7 million of cash in connection with its acquisition of FreePC, Inc. Net cash provided by financing activities for the nine months ended September 29, 2001 was minimal. For the nine months ended September 30, 2000, cash provided by financing activities was $165.2 million, consisting of the net proceeds from the Company's initial public offering of common stock and proceeds from exercise of common stock options. The Company currently believes that its available funds as of September 29, 2001 will be sufficient to meet its anticipated liquidity requirements for at least the next 12 months. If additional funds are required, financing may not be available on acceptable terms, if at all, and may be dilutive to our stockholders. 13 Recent Accounting Pronouncements A discussion of recent accounting pronouncements appears in Note 2 to the Company's Condensed Consolidated Financial Statements included with this report on Form 10-Q. RISKS THAT COULD AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS In addition to the factors discussed in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section and in the Company's Form 10-K, the Company's business, financial conditions and results of operations could be impacted by a number of factors, including without limitation the following factors. Risks Related to Our Business Because we have operated for a limited period of time and our business is still rapidly changing, there is limited information for us to use to manage our operations and for you to evaluate our business. We were incorporated in September 1998 and sold our first PC in November 1998. Most of our revenues have been derived from the sale of PCs and monitors. Our limited operating history makes it difficult for us to accurately identify all of the factors that may affect our business and to plan our operations accordingly, and to evaluate or predict our future business prospects. We have incurred significant net losses and may incur additional losses. We have incurred significant net losses, and at September 29, 2001, we had an accumulated deficit of $301.1 million. We cannot assure you that we will be able to increase our revenue or operating efficiencies and achieve and maintain profitability. If we are unable to achieve and maintain profitability, we could be adversely affected. Our quarterly operating results are subject to fluctuations and seasonality that make it difficult to predict our future performance. We expect our quarterly operating results to fluctuate. Because our PC business generates low operating margins, slight variations in the prices of its PCs, component or manufacturing costs or operating costs could significantly affect our future operating results. Other factors that could affect our quarterly operating results include: . Changes in consumer acceptance of and demand for PCs; . Our ability or our suppliers' ability to effectively develop and support new PC models; . Reductions in the prices of PC products through discounts and rebates, and new product introductions by us or our competitors to stimulate sales; . Fluctuations in the amount of, and the number of our PC buyers claiming, product rebates; . Popularity of the PCs and monitors we sell, and changes in our mix of products; . Achieving and maintaining a low-cost business model in our PC business and managing the third-party relationships necessary to do so; . The cost of our PC products, including our key suppliers' component costs and ability to obtain sufficient supply; . Our key suppliers' ability to manufacture and deliver sufficient quantities of our PC products, and to maintain the quality of our PC products; . Our ability to manage inventory supply, liquidate excess inventory and accurately predict consumer demand for our PC products; . Our ability to adequately reserve for product returns or warranty claims; and . Our ability to effectively enter new markets, including direct Internet sales and international markets. If our operating results in any future quarter do not meet the expectations of securities analysts or investors, the price of our common stock could decline further. Seasonal fluctuations may also affect our quarterly operating results. Historically, demand for PCs and 14 PC-related services and consumer retail sales have been significantly stronger in the fourth quarter of each year and weaker in the first and second quarter of each year. We believe that the seasonal impact on our business of these cycles may increase as PCs become more consumer-oriented or entertainment-driven products. Because we depend on one manufacturer for our PCs, if supply is reduced or discontinued, our sales would be reduced. TriGem Computer manufactures all of our PCs under a supply agreement. Under the supply agreement, TriGem Computer has agreed to reserve a portion of its manufacturing capacity at its facilities to meet our supply requirements. TriGem Computer provides other vendors with PCs. As a result, we may not benefit from any increased production capacity or its promised capacity. If we are unable to obtain a sufficient supply of PCs to meet the demand for our products, our sales, revenues and market share would decline. Some of the terms of our supply agreement with TriGem Computer are subject to periodic adjustment. We are in the process of renegotiating the warranty and return policies of our supply agreement with TriGem and there is no assurance that renegotiation of those terms will be favorable to us or that such renegotiation will not increase our supply costs and harm our financial performance. We plan to establish supply relationships with other PC manufacturers. We cannot assure that we will be able to obtain PCs from other manufacturers on terms acceptable to us. Because we depend on a limited number of large retailers for a significant portion of our revenues, the loss of these retailers could significantly harm our financial results. Since we began selling products, we have derived a significant portion of our gross revenues from sales of our PCs and monitors to a limited number of large retailers. For the quarter ended September 29, 2001, approximately 70.8% of our gross revenues were from sales of PCs and monitors to Best Buy, Circuit City and Fry's Electronics, our three largest retail customers. We expect to continue to derive a significant percentage of our gross revenues from sales of PCs and monitors to a limited number of leading retailers. Our retail customers are not contractually committed to future purchases of our products and could discontinue carrying our products at any time. Any significant disruption of our relationship with any of these major retailers, any significant reduction in purchases by them or any significant delays in payments by them, could affect our revenues and results of operations. If we extend credit to retailers that do not repay us, or that pay late, we may have unexpected losses, which would significantly harm our business. We extend credit to our retail customers, which exposes us to credit risk. Most of our outstanding accounts receivable are from a limited number of large retailers. At September 29, 2001, our five largest outstanding accounts receivable balances totaled $26.8 million, representing 90.7% of our gross accounts receivable, with one customer accounting for $16.0 million, representing 54.3% of our gross accounts receivable. If we fail to monitor and manage effectively the resulting credit risk and a material portion of our accounts receivable is not paid in a timely manner or becomes non-collectible, our business would be significantly harmed, and we could incur a significant loss associated with any outstanding accounts receivable. On March 19, 2001, one of our retailers, Nationwide Computers & Electronics, Inc., filed for bankruptcy protection in the Southern District of New York. As an unsecured creditor, we filed a claim for $544,000. If we lose key personnel or are unable to attract and retain additional personnel when needed, we may not be able to successfully operate our business. Our success depends on the skills, experience and performance of our senior management and key personnel, especially that of our President and Chief Executive Officer, Wayne R. Inouye. We must retain our senior management and key personnel and be able to attract and retain additional key personnel when needed. Competition in the PC market for these types of individuals with business and technical expertise is high. All of our senior management and key personnel are at-will employees and may terminate their employment with us at any time without warning. We do not maintain "key man" life insurance on any of our employees. If we lose key personnel, especially Mr. Inouye, or if we are not able to attract and retain additional personnel when needed, we may be unable to successfully introduce new products and services or otherwise implement our business strategy. If we are unable to manage our growth successfully and retain and integrate our new senior management team, our business could be significantly harmed. 15 Our total number of employees has grown from 10 at December 31, 1998 to 118 as of November 1, 2001. Our growth has placed, and will continue to place, a significant strain on our management systems, infrastructure, resources and planning and management processes. As we continue to operate, we will need to assimilate new employees, as well as expand, train and manage our workforce. All new employees must spend a significant amount of time learning our management systems and our historical business model. Further, our senior management team has limited experience in the management and administration of a public company. If our senior management team is unable to effectively manage our operations, integrate new employees into our business and work together as a management team, we may be unable to manage our business causing substantial harm to our business. Because our business depends on outsourcing a substantial portion of our PC operations, if we were unable to do so in the future, we could incur significantly higher costs that would reduce our revenues and negatively impact our operating results. Historically, we have had relatively low manufacturing and operating costs because we outsource most of our operating and manufacturing functions, including system assembly, warehouse labor, distribution, research, product design, warranty services, rebate services and customer support. We have had relatively low distribution costs because we distribute our products primarily through a limited number of large retailers. We may not be successful in managing our relationships with any of these third parties, and if existing third-party suppliers cannot provide these services at commercially reasonable prices, or at all, and we are not able to find suitable alternative suppliers, our operating costs will increase significantly. Moreover, we may not be able to monitor or control effectively the quality of the PCs and monitors manufactured by our suppliers. Low-quality products, poor customer service, or similar inadequacies may harm our brand name, which would reduce our revenues and negatively impact our operating results. Because our suppliers depend on a limited number of key suppliers for microprocessors and other components used in our products, our business is subject to supply shortages and sudden price increases. Our suppliers depend on a limited number of key suppliers for microprocessors and other components. If our suppliers cannot obtain sufficient quantities of microprocessors or other components from their suppliers or elsewhere, or if their suppliers stop producing microprocessors or other components that meet their needs, our suppliers could experience increases in component costs or delays in product shipments. Even where multiple vendors are available, our suppliers' strategy has been to concentrate purchases from a single source to obtain favorable pricing. Our profit margins may decline and our business would be significantly harmed if supply shortages led to price increases or production delays for our products. If we do not maintain our reputation and expand our name recognition, we may lose customers. Developing and maintaining awareness of our "EMACHINES" brand name is critical to achieving widespread acceptance of our PC offerings. Promotion and enhancement of our brand will depend largely on whether we cost-effectively provide reliable and desired products and services to consumers and advertisers and the effectiveness of our marketing efforts. Currently, retailers are our first points of contact with consumers. If these retailers reduce or cease advertising our products, we may need to increase our own sales and marketing expenses to create and maintain brand awareness among potential consumers. If consumers do not perceive our products to be of high quality, our brand name and reputation could be significantly harmed. The importance of brand recognition will increase as competition in the PC market increases. If we fail to successfully promote our brand name, we may lose PC sales. We may incur significant expenses promoting and maintaining our brand name. We have limited experience marketing and selling our products internationally. We intend to expand our operations internationally, and our operating results will suffer if we do not generate revenue from international operations that exceeds the cost of establishing and maintaining the operations. As part of our efforts to expand our operations into international markets, we are part of in an alliance with Dixons, a European consumer electronics retailer. Because our international sales are made through our alliance with Dixons, they depend on Dixons' ability to distribute and market our products and our ability to manage our relationship with Dixons. Because we have granted Dixons exclusive distribution rights in several European countries, our relationship with Dixons may make establishing relationships with other European distributors more difficult. If we become dependent on Dixons for distribution of our products in Europe and, if our relationship with Dixons ends, 16 we may not be able to find distributors to replace Dixons in those markets. Our strategic alliance with Dixons will not be considered a success if it does not generate a significant amount of PC sales in Europe and does not expand our business internationally. We have limited experience in marketing, selling and distributing our PCs internationally. International sales are subject to certain inherent risks, including unexpected changes in regulatory requirements and tariffs, difficulties in managing foreign operations, longer payment cycles, problems in collecting accounts receivable and potentially adverse tax consequences. Because our international sales are expected to be denominated in U.S. dollars, the strengthening of the U.S. dollar relative to the currencies of other countries into which we sell our products and services could make our products and services relatively more expensive, thereby decreasing the price-competitiveness of our products and services. If we are unable to expand our international sales in a timely and cost-effective manner, our revenues could be reduced. Because we have relied on retailers to sell substantially all of our products, our efforts to develop other methods for selling our products may not be successful. We intend to sell products directly to consumers through the use of our Internet website. We do not have experience developing and implementing direct marketing programs. The success of our direct marketing efforts will depend on our ability to develop the internal infrastructure to effectively market our products and fill customer orders. If we are unable to generate revenue from our direct marketing operations that exceeds the cost of establishing and maintaining these operations, our operating results will suffer. The international operations of our suppliers of PC and monitors exposes us to currency, trade, regulatory, political and other risk. All of our PCs and monitors are manufactured in Korea, China, Taiwan and Malaysia. Our international suppliers' operations, and in turn our operating results, may be affected by: . Fluctuations in currency values, export duties, import controls and trade barriers; . Restrictions on the transfer of funds; . The ability of our international suppliers to timely deliver products to us and to Dixons, which could be affected by, among other things, adverse weather conditions and shortages of shipping containers; . Political and economic instability; and . Compliance with foreign laws. If we are unable to monitor and manage our product rebate programs, our costs could increase. We currently offer product rebates to buyers of our PCs. We use our historical data to assist us in determining the percentage of consumers who will claim these product rebates. At the same time, we must estimate future product rebate redemptions to price our products effectively. If an unexpectedly large number of PC buyers redeemed our product rebates to which they were entitled, the effective average selling price of our products would be reduced below the level anticipated and our costs would increase. We rely on a third party over which we have limited control to manage our rebate programs. If rebate claims are not properly handled or if rebates are not paid promptly, our reputation may be harmed and sales of our PCs may decline. We are involved in litigation that may be costly and time-consuming. In July 1999, Compaq Computer Corporation filed a complaint against us, TriGem Computer, TriGem America and Korea Data Systems as defendants in the U.S. District Court for the Southern District of Texas based on the defendants' alleged infringement of 13 patents held by Compaq related to improved system processing speed, enhanced video graphics, peripheral compatibility and overall system architecture. The complaint seeks an accounting, treble damages, a preliminary and permanent injunction from further alleged infringement, attorneys' fees and other unspecified damages. We filed a response in September 1999, seeking declaratory judgment of noninfringement and invalidity of Compaq's patents and asserting counterclaims against Compaq that included false and misleading advertising under the Lanham Act, business disparagement and unfair competition under Texas common law. Discovery in this case has been completed. We are currently unable to estimate total expenses, possible loss or range 17 of loss that may be ultimately connected with these allegations. We are indemnified against liability under the terms of its PC supply agreement. We cannot assure that Compaq will not succeed in obtaining monetary damages or an injunction against the production of its PC products. Our defense of the claims could result in significant expenses and diversion of management's attention and other resources. Although we believe our direct financial exposure is limited under its indemnification arrangements, the results of complex litigation of this sort are inherently uncertain and difficult to predict, and we cannot guarantee that the results of this litigation will not significantly harm our business, particularly if the results affect production of our PCs. Packard Bell filed a complaint against us on October 6, 1999 in the U.S. District Court for the Eastern District of California, alleging patent infringement of Packard Bell patents that it asserts relate to the graphics controller, parallel port controller, and bus interface of our eTower/(R)/ machine. We filed a response in January 2000 disputing infringement and asserting that the patents at issue are invalid. In August 2000, NEC Corporation (NEC) substituted in as plaintiff in the case. After substitutions the Court granted NEC's motion to amend the complaint in September 2000 to add an additional claim of patent infringement against the now discontinued eSlate related to a sleep mode feature for laptop computers. We reached a final settlement agreement that is not expected to materially impact us and both parties have requested dismissal of the case with prejudice. In October 1999, David Packard, on behalf of a putative nationwide class, filed a complaint against us as a defendant in the U.S. District Court for the Eastern District of Texas based on our alleged sale of defective goods. Essentially identical complaints were filed contemporaneously against Compaq, Hewlett Packard and Packard Bell. The complaints claimed that a chip in the defendants' respective PC products contains a defect that may cause an error to occur when information is written to a floppy disk. On June 12, 2001, the District Court granted us motion for summary judgment on the federal law issues in the case and dismissed the action. On July 11, 2001, plaintiffs filed a complaint against us alleging nearly identical claims under state law in the state district court for Jefferson County in Texas. The complaint seeks unspecified monetary damages, injunctive relief and declaratory relief. The lawsuit against us is in the early stages. We have answered the complaint denying the plaintiff's claims and the parties have begun the discovery process. Although we believe that we have meritorious defenses and intend to vigorously defend ourselves in this action, this type of litigation is inherently complex and unpredictable. We cannot assure that the suit will not succeed in obtaining unspecified monetary damages, injunctive or declaratory relief against the production of our PC products. Our defense of the claims could result in significant expenses and diversion of management's attention and other resources. We cannot guarantee that the results of this litigation will not significantly harm our business. In September 2000, Monster Cable Products, Inc., filed a complaint against us in the U.S. District Court for the Northern District of California. The complaint alleged trademark infringement and dilution and unfair competition arising out of the Company's use of the mark "EMONSTER" Monster Cable Products sought injunctive relief and monetary damages in excess of $30 million. The parties have reached a final settlement agreement that is not expected to have a material impact on us and the case has been dismissed with prejudice. Various other lawsuits, claims and proceedings have been or may be asserted against us, including, without limitation, those related to product liability, intellectual property, Internet content, privacy, safety and health and employment matters. Litigation is expensive and time consuming regardless of the merits of the claim and could divert management's attention from our business. We cannot predict the outcome of any litigation. Some lawsuits, claims or proceedings may be disposed of unfavorably to us, and we may incur significant costs defending ourselves. Our servers and hardware systems are located at a single site and, if a natural disaster or other interruption occurs, our software would not operate. We depend on the efficient and uninterrupted operations of our Web servers and other hardware systems. Our Web servers and other hardware systems are located in Irvine, California. Our Web servers and other hardware systems are vulnerable to interruption or damage caused by earthquakes, fire, floods, power loss, telecommunications failures or similar events not within our control. If any of these events damage or interrupt our Web servers or other hardware systems, our operations, could be harmed until the damage is repaired or the interruption remedied. If this occurs, we may lose customers and could experience negative impact in our business process which may result in lost or cancelled sales orders if we do not have a back-up in place. Risks Principally Related to Our Industry Because average selling prices of PCs decline rapidly, if we fail to properly manage our inventory, we may be unable to meet consumer demand or we could have excess inventories. The average selling prices of PCs are subject to rapid declines. To address the problems created by excess inventory in the face of rapid price decreases, PC vendors must carefully manage their inventory. Additionally, due to our narrow margins, we must manage our inventory more efficiently than traditional PC vendors. From time to time in the past, our inventory has been limited by the capacity of our manufacturers and may be limited in the future. Because our business depends on our ability to quickly sell our PC products through the retail and international channels, we 18 must carefully monitor the demand for, and supply of our products in an effort to match supply to consumer demand. If we overestimate the supply needed to meet consumer demand, we could have excess inventory and may need to liquidate such inventory, which could harm our operating results. If we underestimate needed supply or otherwise maintain too little inventory, we may be unable to react quickly to sudden increases in market demand for a given product. Retailers generally have the right to return a portion of excess inventory purchased in the prior quarter within a limited period of time. Increased inventory levels in our distribution channels, whether due to a decrease in consumer demand for our products, lower-than-anticipated demand for PCs in general, problems in managing product transitions or component pricing movements could significantly harm our profitability. Production delays at the beginning of a new PC product cycle could affect our sales of newer products and how we manage the sale of older PC product inventory held by retailers. If we are unable to sell our aging products at anticipated prices, our margins would be reduced. If demand for our PCs does not continue to grow, we could have excess inventory that could result in write-offs. The success of our business depends on continued strong demand for PCs. Although we focus our efforts on selling high-quality, low-priced PC products, we expect consumer demand for more powerful PCs to increase with advances in technology and declines in prices. To meet these demands, we must successfully gauge the level and timing of consumer demand for PCs and plan our inventory accordingly. The PC market is characterized by rapid new product and technology introductions and generally declining prices for existing products. Demand for PCs might be significantly reduced if consumers perceive little technological advantage in new products or believe that the price of a new product is not worth the perceived technical advantage. Further, if consumers view anticipated changes as significant, such as the introduction of a new operating system or microprocessor architecture, overall market demand for PCs may decline because potential consumers may postpone their purchases until release of the new product or in anticipation of lower prices on existing products following the introduction of new models. Reduced demand could result in excessive inventories that could lead to write-offs of some or all of the excess inventories and could take several quarters to correct. Our success depends on our ability to compete successfully in the PC industry. The PC industry is highly competitive and we expect this competition to increase significantly, particularly in the low-priced PC market. We have been able to gain market share by selling high-quality PCs at prices significantly lower than those offered by established PC vendors. We expect pricing pressures in the PC market to continue. In addition, in a generally weak economic environment in which the PC market is adversely affected, pricing of PCs becomes more competitive. We expect this to be the case through at least the beginning of 2002. PC vendors may continue to reduce their prices to compete with us at our low price points. Large PC vendors such as Dell, Compaq, Gateway, Hewlett Packard and IBM have significantly greater financial, marketing and technical resources than we do and may decide to accept lower margins or losses on a sustained basis on their low-priced PC sales to regain market share. Continued consolidation among our competitors in the PC industry may have unknown impact on our ability to compete successfully. The introduction of low-priced PCs combined with the brand strength, extensive distribution channels and financial resources of the larger PC vendors may cause us to lose market share. There are relatively few barriers preventing competitors from entering our market. As a result, new market entrants pose a threat to our business. We do not own any patented technology that precludes or inhibits competitors from entering the low-priced PC market. Existing or future competitors may develop or offer products or services that are comparable or superior to ours at a lower price, which could erode our competitive position. Some PC vendors are trying to increase their sales of higher-priced PCs by offering additional services, such as free Internet access for a limited period of time. In addition, other PC vendors have adopted programs similar to ours that rebate a portion of the purchase price of PCs in exchange for entering into multi-year Internet access service contracts. Our PC and monitor suppliers have only limited obligations to meet our demand for products and can divert some or all of their output to others, including our competitors, or sell directly to the retail channel. If any of these events occurred, our market share could be reduced unless we are able to successfully compete with these parties and obtain high quality PCs and monitors from other low-cost manufacturers. If we do not regularly introduce new products and services to keep pace with rapid technological change in the PC industry, we may not be competitive and could experience a decline in sales and loss of market share. 19 The PC market is characterized by rapid ongoing technological change, changes in user requirements and preferences, frequent new service introductions embodying new processes and technologies and evolving industry standards and practices that could render our existing products and services obsolete. We must regularly introduce new products, including new PC configurations to maintain retailer, consumer and advertiser interest in our products and services. Any new PCs or other products that we introduce may not be successful. The successful introduction of new products or services by our competitors or us may significantly harm the sale of, or gross margins on, our existing products or services. We may not be able to quickly adapt to future changes in the PC industry because we do not maintain a PC research and development group. If we do not have access to new technology, we may be unable to deliver new products or features in a timely and cost-effective manner. Because we have limited experience in selling products other than PCs and monitors, our efforts to broaden our product line may not be successful. To increase our revenues, we may expand our PC product line or produce other non-PC products. We do not have significant experience developing or selling products other than PCs and monitors. The success of our efforts to broaden our product line will depend on our ability to establish relationships with third parties who can effectively develop, manufacture and market these products and fill customer orders for us. If we are unable to generate revenue from the sale of new products that exceeds the cost of developing and marketing these products, our operating results will suffer. Products that contain, or are rumored to contain, defects could result in significant costs to us, decreased sales of our products, damage to our brand and lawsuits. The design and production of PC components is highly complex. Because we do not design or produce our own PC products, we must rely on suppliers and component manufacturers to provide us with high-quality products. If any of our PC products contain defective components, we could experience delays in shipping these products and increased costs. The design of software is highly complex, and software often contains defects that may be undiscovered for long periods of time. If we or our software suppliers, who have bundled their software on our computers, are not successful in designing this software, or if defects in our software, PC products or our software suppliers' software are discovered after we have shipped the affected software or PC products in volume, we could be harmed in the following ways: . Upgrades, replacements or recalls could impose substantial costs on us; . Rumors, false or otherwise, could be circulated by the press and other media, which could reduce sales of our products and significantly damage our brand; and . Our PC buyers could sue us for damages caused by defective products. For example, in October 1999, David Packard, on behalf of a putative nationwide class, filed complaints against Hewlett Packard, Compaq and us in the U.S. District Court for the Eastern District of Texas based on the alleged sale of defective goods. The complaint alleged that a chip in the respective defendants' PC products contains a defect that causes an error to occur when information is written to a floppy disk. The plaintiffs also filed a suit alleging nearly identical claims under state law in the state district court in Jefferson County in Texas. For a discussion of these complaints and the risks associated with the lawsuit against us, see the risk factor "We are involved in litigation that may be costly and time-consuming" above. We may not compete effectively if we are unable to protect our intellectual property. Monitoring and preventing the unauthorized copying of aspects of our products and use of our intellectual property is difficult. The trademark, trade secret, patent and copyright law and contractual restrictions on which we rely to protect our intellectual property may be of limited value. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of the proprietary rights of others. Any litigation could result in substantial costs and diversion of our resources and could seriously harm our business and operating results. Our inability to protect our intellectual property may harm our business and financial prospects. Because we depend on licenses of intellectual property from third parties to produce our PC products, the loss of any of these licenses would significantly harm our financial results. 20 We are required to obtain licenses from software providers to market and sell our products and services. We pre-install Microsoft(R) Windows(R) on our PCs. If we are unable to maintain our license with Microsoft, or obtain the necessary licenses in the future, we may be forced to market products without Microsoft(R) Windows(R). We also may have to discontinue sales of our products that incorporate allegedly protected technology for which we have no license or defend legal actions taken against us relating to our use of the allegedly protected technology. Our inability to obtain licenses on competitive terms necessary to sell PCs at a profit would significantly harm our financial results. Global military conflicts may adversely affect our financial condition. The September 11, 2001 terrorist attacks in New York City and Washington, D.C. could have an adverse effect on our revenues, results of operations, and financial condition. At the time of the attacks, capital investment by businesses, particularly capital investment in technology, had been experiencing substantial weakness. Economic and political uncertainty resulting from these attacks could result in further declines in new technology investments. We do not know what effect these events, or any resulting military actions by the United States, could have on our business, revenues, or results of operations. If consumers decide to defer or cancel purchases of new PCs, our revenues will be adversely affected, which would have an adverse effect on our results of operations and could have an adverse effect on our financial condition. Risks Related to the Company's Common Stock Our principal stockholders can exercise a controlling influence over our business and affairs. Our four principal stockholders, TriGem America Corporation, Korea Data Systems America, Bill Gross and his affiliated entities and America Online beneficially owned approximately 51.6% of our common stock at November 1, 2001. If these stockholders acted or voted together, they would have the power to elect our directors and to exercise a controlling influence over our business and affairs. In addition, this concentration of ownership could prevent a change in control that might otherwise be beneficial to our stockholders. We may have potential conflicts of interest with our principal stockholders that could be resolved in a manner that is inconsistent with other stockholders' interest. Conflicts of interest may arise between us and our principal stockholders in a number of areas relating to our present and ongoing relationships, which could be resolved in a manner that is inconsistent with our other stockholders' interests. Conflicts of interests that may arise include: . The ongoing supply relationship between us and TriGem Computer and any future supply relationship between us and our principal corporate stockholders that may result in terms that are not as favorable to us as arrangements we could negotiate at arm's length between unrelated parties; . Disagreement with America Online regarding the termination of our marketing agreements; . Potential competitive business activities, such as sales of monitors by KDS USA; . Potential acquisitions or financing transactions; . Sales or other dispositions by these principal stockholders of shares of our common stock; and . Tax and intellectual property matters. Our charter documents and Delaware law could make it more difficult for a third party to acquire us and discourage a takeover. Our certificate of incorporation and bylaws are designed to make it difficult for a third party to acquire control of us, even if a change in control would be beneficial to stockholders. As a Delaware corporation, we are also subject to the Delaware anti-takeover statute contained in Section 203 of the Delaware General Corporation Law. These provisions could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. Our stock price may be volatile. 21 The market price for our common stock has been and may continue to be highly volatile and subject to wide fluctuations in response to factors including those set forth in the items under "Risks That Could Affect our Financial Condition and Results of Operations." The stock markets in general, and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of such companies. These broad market and industry factors may seriously impact the market price of our common stock, regardless of our actual operating performance. Listing on the Over-The-Counter Bulletin Board may affect the liquidity of our trading market and the market price of our common stock. Our common stock is quoted on the Over-the-Counter Bulletin Board. Our shareholders could find it difficult to dispose of, or to obtain accurate quotations as to the market value of, our common stock. In addition, delisting from the Nasdaq National Market may make our common stock ineligible for use as, or make our common stock substantially less attractive as, collateral for margin and purpose loans, for investment by financial institutions under their internal policies or state legal investment laws, as consideration in the financing of future acquisitions of businesses or assets by us, and for issuance by us in future capital raising transactions any of which could cause the market price of our common stock to decrease. Delisting subjects our common stock to the "penny stock rules" contained in Section 15(g) of the Securities Exchange Act of 1934. Substantial future sales of our common stock in the public market may depress our stock price. As a result of the limited trading market for our common stock and the large number (relative to such trading markets) of shares of our common stock available for sale in the public market by our current stockholders pursuant to Rule 144 under the Securities Act of 1933, sales of a substantial number of shares of our common stock in the future could cause our stock price to fall. The sale of these shares could impair our ability to raise capital through the sale of additional stock. 22 Item 3. QUANTITATIVE AND QUALITATIVE DISCUSSION OF MARKET RISK The Company is exposed to fluctuations in interest rates and market values of its investments. The Company's exposure to fluctuations in interest rates and market values of its investments relates primarily to its short-term investment portfolio, which is included in cash and cash equivalents and short-term investments. The Company has not used derivative financial instruments in its investment portfolio. The Company invests its excess cash in highly liquid commercial paper and U.S. Government debt securities with maturities of less than one year, and, by policy, the Company limits the amount of credit exposure to any one issuer. Due to the short-term nature of the Company's investments, the impact of interest rate changes would not be expected to have a significant impact on the value of these investments. The effect of interest rate and investment risk on the Company has not been significant. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. The Company's fixed rate debt consists of a $290,000 note, bearing interest at 5.79 percent, payable to a stockholder. The Company generally limits its investments to short-term, highly rated, fixed income facilities such as repurchase agreements collateralized by government securities and A-1/P-1 commercial paper. The Company intends to maintain its current investment policy, which is designed to preserve principal while at the same time maximizing the after-tax income it receives from its investments without significantly increasing risk. Some of the securities that the Company may invest in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if the Company holds a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of the Company's investment may decline. To minimize this risk in the future, the Company generally intends to maintain its portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities. However, the Company may, when and if the opportunity arises, acquire or invest in complementary businesses, products and technologies. Such investments may be illiquid for an indefinite period of time, or otherwise subject to greater risk than that allowed for the Company's remaining cash assets. The Company currently has no floating rate indebtedness, holds no derivative instruments and does not earn significant foreign-source income. Accordingly, changes in interest rates or currency exchange rates do not generally have a direct effect on the Company's financial position. The Company's sales are primarily to customers in the United States, Canada and the United Kingdom. All purchases and sales to date have been made in U.S. dollars. Foreign currency exchange rates, however, may affect the cost of the Company's PCs and monitors purchased from the Company's foreign suppliers, thereby indirectly affecting consumer demand for their products and their net revenues. The strengthening of the U.S. dollar vis-a-vis the currencies of those countries into which the Company sells its products and services in the future could make its products and services relatively more expensive, thereby decreasing the price-competitiveness of the Company's products and services. In addition, to the extent that changes in interest rates and currency exchange rates affect general economic conditions, the Company would also be affected by such changes. 23 PART II.--OTHER INFORMATION ITEM 1: Legal Proceedings A discussion of legal proceedings in which the Company is involved appears in Note 6 to the Company's Condensed Consolidated Financial Statements contained in Item 1 of Part I of this report on Form 10-Q and in the section entitled "Risks That Could Affect The Company's Financial Condition and Results of Operations--The Company is involved in litigation that may be costly and time- consuming" contained in Item 2 of Part I of this report on Form 10-Q, both of which are incorporated by reference in this item. ITEM 2: Changes in Securities and Use of Proceeds Use of Proceeds of The Company's Initial Public Offering The Company filed a registration statement on Form S-1 (File No. 333-86219) with the Securities and Exchange Commission registering a total of 20,000,000 shares of the Company's common stock with a maximum aggregate offering price of $180.0 million. The SEC declared the registration statement effective on March 23, 2000. On March 24, 2000, trading in the Company's shares began, and on March 29, 2000, the Company completed the sale of all 20,000,000 registered shares of common stock at a price of $9.00 per share in its initial public offering pursuant to the registration statement. In connection with the offering, the Company paid an aggregate of $12.5 million in underwriting discounts and commissions and paid other expenses of approximately $2.5 million, none of which were paid directly or indirectly to any of the Company's directors or officers, any person owning 10% or more of any class of the Company's equity securities, or any of the Company's affiliates. After deducting the underwriting discounts and commissions and other expenses, the Company received aggregate proceeds from the offering of approximately $165.0 million. To date, the Company has used a portion of the proceeds from the offering to finance losses from operations. As of September 29, 2001, the remaining proceeds of approximately $103.8 million were invested in short-term, interest-bearing, and investment-grade securities. None of the net proceeds of the offering were paid directly or indirectly to any of the Company's directors or officers, any person owning 10% or more of any class of the Company's equity securities, or any of the Company's affiliates. ITEM 3: Defaults Upon Senior Securities None. ITEM 4: Submission of Matters to a Vote of Security Holders None. ITEM 5. Other Information On November 9, 2001, the Company issued a press release announcing that it had received a letter from EM Holdings, Inc. relating to a proposal to purchase the Company, and announcing the Company's retention of Credit Suisse First Boston Corporation, which press release is incorporated by reference and attached as Exhibit 99.1 ITEM 6: Exhibits and Reports on Form 8-K ----------------------------------------- Exhibits

Reports on Form 8-K Since the beginning of the third quarter of 2001, we filed the following reports on Form 8-K: . A report filed July 3, 2001, reporting under Item 5 our loans to certain of our officers, our entry into an escrow agreement with one of our officers and various indemnification agreements with several of our officers, and the resignation of John Muskovich, our Executive Vice President and Chief Financial Officer. . A report filed July 26, 2001, reporting under Item 5 the results of our second quarter ended June 30, 2001. . A report filed October 10, 2001, reporting under Item 5 the amendment of our Amended and Restated 2000 Stock Plan and form of related agreements, the amendment of our Marketing Agreement with America Online, Inc., the termination of our relationship with Credit Suisse First Boston Corporation in its role as financial advisor in evaluating strategic alternatives, and the termination of our Marketing Agreement as amended with America Online, Inc. and related termination of our Marketing Agreement with AOL (UK) Ltd., AOL Bertelsmann Online GmbH & Co. K.G., AOL Bertelsmann Online France SNC, and Compuserve Interactive Services Ltd. . A report filed October 29, 2001, reporting under Item 5 the results of the our third quarter ended September 29, 2001, and the announcement of our customer care initiative. 25 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. eMachines, Inc. Dated: November 13, 2001 By: /s/ Adam A. Andersen Adam A. Andersen Senior Vice President and Chief Operating Officer (on the Registrant's behalf and as Principal Financial Officer and Principal Accounting Officer) INDEX TO EXHIBITS Exhibit Number Description of Document ------- ----------------------------------------------------------------------- 10.1 eMachines Second Amended and Restated 1998 Stock Plan and form of agreements thereunder (incorporated by reference to Exhibit 99.1 to our current report on Form 8-K filed on October 10, 2001 (the "October 8-K")). 10.2 Fifth Amendment to Marketing Agreement between America Online, Inc. and eMachines dated as of August 29, 2001 (incorporated by reference to Exhibit 99.2 to the October 8-K). 99.1 eMachines, Inc. press release dated November 9, 2001. 26

EMACHINES INC /DE/ 10-Q