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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2003

OR

o

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 0-22784

GATEWAY, INC.

(Exact name of registrant as specified in its charter)

14303 Gateway Place
Poway, California 92064
(Address of principal executive offices, zip code)

Registrant’s telephone number, including area code: (858) 848-3401

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 o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)
Yes x No o

As of May 12, 2003 there were 324,072,364 shares of the Common Stock of Gateway, $.01 par value per share, outstanding. As of May 12, 2003 there were no shares of Gateway’s Class A Common Stock, $.01 par value per share, outstanding.

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Gateway, Inc
Form 10-Q
For the period ended March 31, 2003

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I. FINANCIAL INFORMATION

Item 1.

Financial Statements

Gateway, Inc.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For the three months ended March 31, 2003 and 2002
(in thousands, except per share amounts)
(unaudited )

The accompanying notes are an integral part of the consolidated condensed financial statements.

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Gateway, Inc.
CONSOLIDATED CONDENSED BALANCE SHEETS
March 31, 2003 and December 31, 2002
(in thousands, except per share amounts)
(unaudited)

The accompanying notes are an integral part of the consolidated condensed financial statements.

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Gateway, Inc.
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For the three months ended March 31, 2003 and 2002
(in thousands)
(unaudited)

The accompanying notes are an integral part of the consolidated condensed financial statements.

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Gateway, Inc.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Unaudited)

1.

General:

The accompanying unaudited consolidated condensed financial statements of Gateway, Inc. (“Gateway”) as of March 31, 2003 and for the three months ended March 31, 2003 and 2002 have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2002 and, in the opinion of management, reflect all adjustments necessary to fairly state the consolidated financial position, results of operations and cash flows for the interim periods. All adjustments noted above are of a normal, recurring nature. The results for the interim periods are not necessarily indicative of results to be expected for any other interim period or the entire year. These financial statements should be read in conjunction with Gateway’s audited consolidated financial statements and notes thereto for the year ended December 31, 2002, which are included in Gateway’s 2002 Annual Report on Form 10-K, filed with the Securities and Exchange Commission.

The significant accounting policies used in the preparation of the consolidated condensed financial statements of Gateway are as follows:

(a)

Basis of Presentation:

The consolidated condensed financial statements include the accounts of Gateway and its majority owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Certain reclassifications have been made to prior years’ financial statements to conform to current year presentation. These reclassifications had no impact on previously reported net loss or stockholders’ equity.

(b)

Use of Estimates:

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the 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 under different assumptions or conditions.

(c)

Cash and Cash Equivalents:

Gateway considers all highly liquid debt instruments and money market funds with an original maturity of three months or less to be cash equivalents. The carrying amount approximates fair value because of the short maturities of these instruments.

(d)

Marketable Securities and Long-Term Investments:

Marketable securities consist of mutual funds, equity securities which are in the process of being liquidated, commercial paper and debt securities, with market values that approximate their amortized cost. Long-term investments, including publicly traded equity securities, represent minority investments in companies having operations or technology in areas within or adjacent to Gateway’s strategic focus. Certain of the investments carry restrictions on immediate disposition. Marketable securities are classified as available-for-sale and are adjusted to their fair market value using quoted market prices. An investment in a public company, which carried Rule 144 restrictions on disposition within one year, was classified as available-for-sale as Gateway expected to fully dispose of the investment within one year. This investment was adjusted to our fair value each period through charges/credits to comprehensive income. Fair value was determined based on quoted market prices. Unrealized gains and losses are recorded as a component of accumulated other comprehensive income. Upon disposition of these investments, the specific identification method is used to determine the cost basis in computing realized gains or losses. Declines in value that are considered to be other than temporary are reported in other income, net.

Gateway regularly monitors and evaluates the realizable value of our investments. When assessing the investments for other-than-temporary declines in value, Gateway considers such factors as, among other things, how significant the decline in value is as a percentage of the original cost, how long the market value of the investment has been less than our original cost, the performance of the investee’s stock price in relation to the stock price of its competitors within the industry and the market in general, analyst recommendations, any news that has been released specific to the investee and the outlook for the overall industry in which the investee operates.

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Gateway also reviews the financial statements of the investee to determine if the investee is experiencing financial difficulties and considers new products/services that the investee may have forthcoming that will improve its operating results. If events and circumstances indicate that a decline in the value of these assets has occurred and is other than temporary, Gateway records a charge to other income, net.

(e)

Inventory:

Inventory, which is comprised of component parts, subassemblies and finished goods, is valued at the lower of first-in, first-out (FIFO) cost or market. On a quarterly basis, Gateway compares on a part by part basis, the amount of the inventory on hand and under commitment with its latest forecasted requirements to determine whether write-downs for excess or obsolete inventory are required. Although the writedowns for excess or obsolete inventory reflected in Gateway’s consolidated condensed balance sheet at March 31, 2003 and December 31, 2002 are considered adequate by Gateway’s management, there can be no assurance that these write-downs will prove to be adequate over time to cover ultimate losses in connection with Gateway’s inventory.

(f)

Property, Plant and Equipment:

Property, plant and equipment are stated at cost. Depreciation is provided using the straight-line method over the assets’ estimated useful lives, as follows:

Effective January 1, 2003, Gateway changed the accounting estimates related to depreciation for the estimated service lives for furniture and fixtures and leasehold improvements in our stores which were reduced to seven years. The change was based on an analysis of the expected lease life of our existing stores. This change in estimate resulted in approximately $3.5 million in additional depreciation expense for the first quarter of 2003. The effects of this change will be present in future quarters until such time as the assets are fully depreciated.

Upon sale or retirement of property, plant and equipment, the related costs and accumulated depreciation or amortization are removed from the accounts and any gain or loss is included in the determination of net loss.

(g)

Intangible Assets:

Intangible assets are amortized on a straight-line basis over four to ten years.

(h)

Long-lived Assets:

Gateway reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An asset is considered to be impaired when the sum of the undiscounted future net cash flows expected to result from the use of the asset and its eventual disposition does not exceed its carrying amount. The amount of impairment loss, if any, is measured as the difference between the net book value of the asset and its estimated fair value.

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(i)

Royalties:

Gateway has royalty-bearing license agreements that allow Gateway to sell certain hardware and software which is protected by patent, copyright or license. Royalty costs are accrued and included in cost of goods sold at the time revenue is recognized or amortized over the period of benefit when the license terms are not specifically related to the units shipped.

(j)

Warranty:

Gateway provides standard warranties with the sale of products. The estimated cost of providing the product warranty is recorded at the time revenue is recognized. Gateway maintains product quality programs and processes, including actively monitoring and evaluating the quality of suppliers. Estimated warranty costs are affected by ongoing product failure rates, specific product class failures outside of experience and material usage and service delivery costs incurred in correcting a product failure. A reconciliation of changes in Gateway’s accrued warranty liability, which is included in accrued liabilities and long-term liabilities, is as follows (in thousands):

(k)

Revenue Recognition:

Gateway recognizes revenue pursuant to applicable accounting standards, including Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”). SAB 101, as amended, summarizes certain of the SEC staff’s views in applying generally accepted accounting principles to revenue recognition in financial statements and provides guidance on revenue recognition issues in the absence of authoritative literature addressing a specific arrangement or a specific industry.

Gateway recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Revenue from the sale of products is recognized upon delivery of the products to customers. Revenue from services that are rendered by Gateway, such as extended warranties, is recognized straight-line over the service period, while training revenue is recognized as the services are provided. Other than internet services, revenue from the sale of services that are rendered by third parties, such as installation, is generally recognized when the associated product is delivered and installed, if applicable. We offer our customers Internet services which are provided by a third party. The revenue associated with these services is based on the monthly active subscriber counts, which are reported to Gateway by the service provider and recognized as the services are provided.

Gateway records reductions in revenue in the current period for future product returns related to current period revenue. Management analyzes historical returns, current economic trends, changes in customer demand and acceptance of Gateway products when evaluating the adequacy of the sales returns allowances in any accounting period. Gateway records reductions to revenue for estimated commitments related to customer incentive programs, including customer rebates and other sales incentives, including, among other things, trade-ins and referral credits.

A schedule of additions to extended warranty deferred revenue, which is included in other current liabilities and long-term liabilities, and recognition of extended warranty revenue is as follows (in thousands):

Gateway incurred approximately $10 million of expense in servicing the extended warranties noted above.

(l)

Advertising Costs:

Advertising costs are charged to expense as incurred.

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(m)

Income Taxes:

The provision/benefit for income taxes is computed using the liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Other current liabilities includes potential tax liabilities related to current or future federal, state or foreign tax audits.

(n)

Net Loss Per Share (in thousands):

Basic earnings per common share is computed using net loss attributable to common stockholders and the weighted average number of common shares outstanding during the period. Diluted earnings per common share is computed using net loss attributable to common stockholders and the combination of dilutive common stock equivalents and the weighted average number of common shares outstanding during the period. Diluted shares for the three months ended March 31, 2003 and 2002 exclude 22,353 and 22,378 weighted average incremental shares, respectively, related to employee and director common stock options and Series A Convertible Preferred Stock. These shares are excluded despite their exercise prices being below the average market price or assuming the “if converted” method for the Series A Convertible Preferred Stock as their effect is anti-dilutive. The Series C Redeemable Convertible Preferred Stock is contingently convertible to 5,939 shares and is not included in calculating earnings per share as the contingency was not met as of March 31, 2003. In addition, for the three months ended March 31, 2003 and 2002 Gateway has excluded 54,040 and 52,498 shares, respectively, related to non-employee warrants and employee and director stock options which have exercise prices greater than the average market price of the common shares.

(o)

Derivative Instruments, Hedging Activities and Foreign Currency:

Gateway considers the U.S. dollar to be its functional currency for certain of its international operations and the local currency for all others. For subsidiaries where the local currency is the functional currency, the assets and liabilities are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the period. Gains and losses from translation are included in accumulated other comprehensive income. Gains and losses resulting from remeasuring monetary asset and liability accounts that are denominated in currencies other than a subsidiary’s functional currency are included in other income, net.

(p)

Stock-Based Compensation:

Gateway measures compensation expense for its employee and non-employee director stock-based compensation using the intrinsic value method. Compensation charges related to other non-employee stock-based compensation are measured using fair value methods.

Gateway uses the disclosure-only provisions of SFAS 123, “Accounting for Stock-Based Compensation.” The fair value of options was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for all grants in 2003 and 2002: dividend yield of zero percent; risk-free interest rates ranging from 1.5 to 6.6 percent; and expected lives of the options of three and one-half years. The expected volatility used in estimating the fair market value on the date of grant was 71 percent in the first quarters of 2003 and 2002.

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No stock-based employee compensation cost is reflected in net loss, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Had compensation expense for employee and director stock options been determined based on the fair value of the options on the date of the grant, net loss and net loss per share would have resulted in the pro forma amounts indicated below (in thousands, except per share amounts):

(q)

Segment Data:

Gateway reports segment data based on the internal reporting that is used by management for making operating decisions and assessing performance which is designated as the source of Gateway’s reportable operating segments.

(r)

New Accounting Pronouncements:

In July 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 146, “Accounting for Exit or Disposal Activities” (“SFAS 146”). SFAS 146 requires the recognition of a liability for costs associated with an exit plan or disposal activity when incurred and nullifies Emerging Issues Task Force (“EITF”) Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring”), which allowed recognition at the date of an entity’s commitment to an exit plan. Costs covered by SFAS 146 include lease termination costs and certain employee severance costs that are associated with restructuring, discontinued operations, plant closings or other exit or disposal activity. The provisions of this statement are effective for exit or disposal activities initiated after December 31, 2002 and were applied in connection with restructuring activities during the three months ended March 31, 2003

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 elaborates on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees and clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken and issuing the guarantee. The disclosure requirements are effective for fiscal years ending after December 15, 2002. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The adoption of this statement during the three months ended March 31, 2003 did not have a material impact on our results of operations, financial position, or cash flows.

In November 2002, the EITF reached consensus on No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” This consensus requires that revenue arrangements with multiple deliverables be divided into separate units of accounting if the deliverables in the arrangement meet specific criteria. In addition, arrangement consideration must be allocated among the separate units of accounting based on their relative fair values, with certain limitations. We will be required to adopt the provisions of this consensus for revenue arrangements entered into after June 15, 2003. The adoption of this accounting pronouncement is not expected to have a material impact on our results of operations, financial position or cash flows.

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In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of SFAS 123” (“SFAS 148”). This statement amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, this statement amends the disclosure requirements of SFAS 123 to require prominent disclosures both in annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. As provided for in SFAS 148, we have elected to continue to apply the intrinsic value method of accounting, and have adopted the disclosure requirements of SFAS 148.

2.

Comprehensive Loss:

Comprehensive loss for Gateway includes net loss, foreign currency translation effects and unrealized gains or losses on available-for-sale securities which are charged or credited to the accumulated other comprehensive loss account within stockholders’ equity.

Comprehensive loss for the three months ended March 31, 2003 and 2002 was as follows (in thousands):

3.

Selected Balance Sheet Information (in thousands):

Included in cash and cash equivalents is approximately $41 million and $45 million in restricted amounts at March 31, 2003 and December 31, 2002, respectively.

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The decrease in accounts receivable reflects a decrease in days sales outstanding as well as decreased sales in the first quarter of 2003 versus the fourth quarter of 2002.

The decrease in inventory on hand reflects inventory reduction efforts throughout the supply chain and lower inventory needs to accommodate sales trends.

The decrease in other current assets primarily reflects the net income tax refunds of $287 million received by Gateway in the first quarter of 2003. The decline in prepaid expenses is primarily related to a decrease in prepaid marketing expenses.

The decrease in property, plant and equipment results from depreciation expense and the net impact of asset write-downs taken in the restructuring charge.

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The decrease in accrued liabilities reflects a decline in the warranty accrual attributable to the reduction in unit sales relative to previous levels. The restructuring accrual increased due to the first quarter of 2003 restructuring actions, partially offset by restructuring related payments made during 2003. See Note 7 for further information. The decrease in other accrued liabilities was driven primarily by decreases in rebates payable and accrued marketing expenses.

The decrease in other current liabilities reflects a decline in customer prepayments driven in part by a higher backlog in delivery of plasma TV’s at December 31, 2002.

The increase in deferred revenue is primarily due to sales of extended warranty service plans serviced by Gateway.

4.

Preferred Stock:

On February 2, 2001, Gateway received $200 million in exchange for a convertible note due December 22, 2020 in connection with the second closing of the investment agreement with America Online, Inc. (“AOL”). In December 2001, this convertible note was extinguished through the issuance of 50,000 shares of non-voting Series C Redeemable Convertible Preferred Stock (“Series C Preferred Stock”). The Series C Preferred Stock had a fair value on the date of issuance of approximately $193 million. The fair value of $193 million will be accreted to the face value of $200 million through 2004 using the interest method. The Series C Preferred Stock bears dividends at an annual rate of 1.5% paid semi-annually. The holder can put the Series C Preferred Stock to Gateway in December 2004, 2009 and 2014 at face value and Gateway can satisfy this put option in cash or registered common stock at our option. The holder can convert the Series C Preferred Stock to 5,938,948 shares of common stock at anytime prior to December 2014, provided Gateway’s common stock trades over $33.68 for 5 consecutive days. In addition, Gateway can redeem the Series C Preferred Stock at any time after December 2004 for the face value plus accrued and unpaid dividends.

Gateway issued 50,000 shares of nonvoting Series A Convertible Preferred Stock (“Series A Preferred Stock”) to AOL in exchange for $200 million in December 2001. This issuance was the third and final funding under the investment agreement which, among other things, reduced the total investment amount to $600 million for AOL. The Series A Preferred Stock will automatically convert into common stock of Gateway on the third anniversary of its issuance at a conversion rate between $8.99 and $10.07 per share based on the fair value of Gateway’s common

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stock at the date of conversion. If our common stock price on that date is comparable to our common stock price as of March 31, 2003, the Series A would convert into a total of 22,238,283 shares of our common stock. The Series A Preferred Stock is convertible earlier than the third anniversary of issuance at the option of AOL in the event of certain circumstances. The Series A Preferred Stock bears dividends at an annual rate of 2.92% paid quarterly.

Holders of Preferred Stock are entitled to receive dividends when and as declared by the Board of Directors. If dividends on the Preferred Stock are not paid, they continue to accrue and, in general, we may not buy back our common stock while such dividends remain unpaid. In addition, if dividends remain unpaid for (i) any two consecutive quarters or (ii) three quarterly payment periods in any six consecutive quarterly payment periods, then (1) if such dividends are unpaid on the Series A Preferred Stock, the holder has the option to convert the Series A Preferred Stock into 22,238,283 shares of Gateway common stock based on a conversion price of $8.99 per share, and (2) certain restrictions on the transfer of the Preferred Stock and the Gateway common stock held by the holder of the Preferred Stock are lifted.

The accretion and dividends on preferred stock are subtracted from net loss in calculating net loss attributable to common stockholders for the purposes of computing earnings per share.

5.

Income Taxes:

Gateway records a tax provision/benefit for the anticipated tax consequences of our reported results of operations. The provision for (benefit from) income taxes is computed using the liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. In the first quarter of 2003, Gateway recorded a deferred tax asset in the amount of $73 million equal to 37% of the loss before income taxes. Gateway also recorded a corresponding valuation allowance in the amount of $73 million. This resulted in no change in net deferred tax assets during the first quarter of 2003. In the first quarter of 2002, Gateway recorded a tax benefit of $72 million or 37% of the loss before income taxes. Gateway expects to maintain a full valuation allowance on future tax benefits until an appropriate level of profitability is sustained. Until an appropriate level of profitability is reached, we do not expect to recognize any significant tax benefits from results of operations.

6.

Contingencies:

Gateway is a party to various lawsuits, claims, investigations and administrative proceedings that arise in connection with our business, including those identified below. Gateway evaluates such matters on a case by case basis, and our policy is to vigorously contest any such claims which we believe are without merit.

Intergraph Hardware Technologies Company v. Dell Computer Corporation, Hewlett-Packard, Inc. & Gateway, Inc. is a suit filed in the United States District Court in the Eastern District of Texas on December 16, 2002. The suit alleges Gateway infringed three patents related to cache memory. Intergraph seeks damages (including enhanced damages), an injunction, prejudgment interest, costs and attorneys fees.

UNOVA, Inc. v. Apple Computer, Inc., et al. is a suit filed against Gateway and six other defendants in the Central District of California on May 8, 2002. The suit alleges that portable computers manufactured by the named defendants infringe eight patents. Plaintiff seeks unspecified past damages and other relief. Gateway has answered the complaint denying all allegations and asserting numerous affirmative defenses.

Lucent Technologies, Inc. v. Gateway, Inc. is a suit filed on June 6, 2002 in the United States District Court in the Eastern District of Virginia which was subsequently transferred to the United States District Court in the Southern District of California. The suit alleges that Gateway infringed seven patents related to PC systems and software. Plaintiff seeks unspecified damages and injunctive relief. Gateway has answered the complaint denying all allegations and asserting numerous affirmative defenses, and discovery has commenced. On or about February 26, 2003, Microsoft intervened in the action, seeking to challenge Lucent’s allegations with respect to five of the seven patents. In addition, on April 8, 2003, Microsoft filed an action against Lucent in the United States District Court for the Southern District of California. The suit seeks declaratory judgment that Microsoft products do not infringe patents held by Lucent, including the five patents upon which Microsoft based its intervention in the action Lucent brought against Gateway.

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Gateway has been responding to an investigation by the Securities and Exchange Commission (“SEC”) which commenced in December 2000. In connection with this investigation, we have furnished the SEC information primarily related to our fiscal year 2000. As previously disclosed, Gateway has received a “Wells Notice” from the SEC and has responded in writing to this notice. Gateway is cooperating fully with the SEC to resolve this matter as promptly as practicable. The U.S. Attorney’s office has also recently commenced a preliminary inquiry relating to the same time period and subject matter. Gateway is cooperating fully with this inquiry and does not believe that any current officer is a target of either investigation.

We voluntarily restated our results of operations for the first, second and third quarters of 2000 in February 2001. In April 2003, Gateway voluntarily restated certain results of operations included in our Annual Report on Form 10-K for 2001. The impact of this latter restatement was a decrease of $2.9 million or $0.01 per share, in net income for 2000 and a $2.9 million, or $0.01 per share, reduction of the 2001 net loss.

Gateway’s management believes that the ultimate resolution of pending matters will not have a material adverse impact on Gateway’s consolidated financial position, operating results or cash flows. However, such matters are inherently unpredictable and it is possible that our results of operations or cash flows could be affected in any particular period by the resolution of one or more of these contingencies.

7.

Restructuring and Other Special Charges:

First Quarter 2003 Plan:

During the first quarter of 2003, Gateway approved a restructuring plan to close 76 retail stores (in addition to the four stores previously announced) and continued our focus on cost reductions, resulting in a workforce reduction of approximately 1,900 employees. A charge of $69 million ($8 million in cost of goods sold and $61 million in selling, general and administrative expenses) was recorded in the first quarter of 2003 to provide for these actions. Included in the $69 million charge is $35 million primarily associated with retail stores that were closed during the quarter. The significant restructuring activities were completed during the first quarter of 2003, however, payments are expected to continue through 2005. The $69 million charge is in addition to $9 million of additional charges related to previous restructuring activities. The total restructuring charges for the first quarter of 2003 are $78 million.

The following table summarizes charges recorded for these actions (in millions):

The nature of the charges summarized above is as follows:

•

Productivity Initiatives – Gateway recorded an $18 million charge primarily related to severance benefits to terminated employees in the United States. We terminated approximately 1,900 employees during the quarter ended March 31, 2003, including approximately 900 retail store employees, 500 manufacturing employees and 500 administrative personnel.

•

Operating Assets – Gateway recorded a charge of $51 million related to the closure of 76 retail stores, including an accrual of approximately $13 million related to the present value of future lease commitments, net of expected recoveries, $4 million in other related expenses ($2 million of which was paid in the first quarter of 2003) and the write-off of $34 million of abandoned fixed assets related to retail stores that were closed.

First Quarter 2002 Plan (“Q1 2002 Plan”):

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During the first quarter of 2002, Gateway approved a restructuring plan to, among other things, reduce our workforce and close certain retail stores and other company sites. A pre-tax charge of $109 million ($16 million in cost of goods sold and $93 million in selling, general and administrative expenses) was recorded in the first quarter of 2002 to provide for these actions. Included in the pretax charge of $109 million is $55 million for asset write-downs related to the impairment of certain long-lived assets that were abandoned during the quarter. The significant restructuring activities were completed during 2002, however, payments are expected to continue through 2004. During the first quarter of 2003, we recorded an additional $3 million charge, included in cost of goods sold, for further asset write-downs.

The following table summarizes charges recorded during 2002 for the Q1 2002 Plan (in millions):

The amounts charged against the provision during the first quarter of 2003 were as follows (in millions):

The nature of the charges related to the Q1 2002 Plan summarized above is as follows:

•

Productivity Initiatives – Gateway recorded a $30 million charge related to severance benefits to terminated employees in the United States. We terminated approximately 2,400 employees during the quarter ended March 31, 2002, including approximately 1,400 employees primarily related to sales and customer service, 600 manufacturing employees and 400 other administrative personnel.

•

Facilities/Capital Assets – Gateway recorded a $59 million charge related to the abandonment of certain capital assets during the first quarter of 2002, including $27 million related to the closure of certain facilities and $16 million primarily related to the abandonment of certain information technology projects in the United States. We recorded charges of approximately $16 million, principally related to future lease commitments, net of expected recoveries, as a result of closing certain facilities. During the first quarter of 2003, we recorded an additional $3 million charge for further asset write downs.

•

Operating Assets – Gateway recorded a charge of $20 million related to the closing of 19 retail stores in the United States. In connection with these store closings, we recorded approximately $10 million in exit costs related to future lease commitments, net of expected recoveries, and $10 million for impairment of store assets that were abandoned during the quarter ended March 31, 2002.

In addition, we recorded an adjustment to reduce previously recorded charges pursuant to the Q3 2001 Plan by $10 million during the quarter ended March 31, 2002, primarily due to a higher than expected recovery on assets.

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Third Quarter 2001 Plan ("Q3 2001 Plan”):

During the third quarter of 2001, Gateway approved a restructuring plan to, among other things, reduce its workforce, close certain retail stores, consolidate facilities, redefine its information technology strategy, and exit certain other activities, including its company-owned international operations. In the first quarter of 2002, an adjustment to reduce these charges by $10 million (included in selling, general and administrative expenses) was made due to higher than expected recovery on assets. In the first quarter of 2003, we recorded an additional charge of $2 million, included in cost of goods sold, for further asset write-downs.

The amounts charged against the provision during the first quarter of 2003 were as follows (in millions):

First Quarter 2001 Plan:

During the first quarter of 2001, Gateway approved a restructuring plan to, among other things, reduce its workforce, close certain retail stores, consolidate facilities, redefine its information technology strategy, and exit certain other activities. In the first quarter of 2003, we recorded an additional charge of $4 million, included in selling, general and administrative expenses, for additional lease commitments, net of expected recoveries.

The amounts charged against the provision during the first quarter of 2003 were as follows (in millions):

8.

Segment Data:

Gateway’s segments are based on customer class. Customer class segments are consumer and business. Gateway evaluates the performance of its consumer and business segments based on sales and operating income, and does not include segment assets or other income and expense items for management reporting purposes. Management evaluates net sales by customer class based on units shipped in the period. Segment operating income includes selling, general and administrative expenses and other overhead charges directly attributable to the segment and excludes certain expenses managed outside the reporting segment. Costs excluded from the segments primarily consist of general and administrative expenses that are managed on a corporate-wide basis and the restructuring charges discussed in Note 7.

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The following table sets forth summary information by segment (in thousands):

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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following should be read in conjunction with the consolidated condensed financial statements and the related notes that appear elsewhere in this document. This Quarterly Report includes forward-looking statements made based on management’s current expectations pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future performance and actual outcomes may differ materially from what is expressed or forecasted. There are many factors that affect Gateway’s business, consolidated financial position, results of operations, cash flows and such forward-looking statements, including the factors discussed or referenced below.

Outlook

The demand environment continues to be difficult and we cannot count on significant demand uplift in 2003. We are comfortable with the average analyst consensus estimates that indicate net sales of $3.5 billion in 2003. We expect selling, general and administrative (“SG&A”) expenses in subsequent quarters of 2003 to be down significantly through further process re-engineering, non-labor reductions and increased marketing communication efficiencies. Our plan contemplates that fourth quarter SG&A expenses will be below $200 million. In addition, we expect to reduce cost of goods sold significantly in 2003 through component cost reductions, supply chain efficiencies, end-to-end warranty costs reductions and manufacturing productivity. We expect to be cash-flow positive in the fourth quarter and that we will exit 2003 with more than $1 billion in cash and marketable securities. We also anticipate an effective tax rate of 0%, which will result in pre-tax losses being equal to net losses in 2003. Actual results may vary depending on our results of operations and other factors, including the risk factors identified elsewhere in this Quarterly Report.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses Gateway’s consolidated condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements and related disclosures in conformity with generally accepted accounting principles and Gateway’s discussion and analysis of our financial condition and results of operations requires Gateway’s management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated condensed financial statements and accompanying notes. Note 1 to the consolidated condensed financial statements in Item 1 of this Form 10-Q summarizes the significant accounting policies and methods used in the preparation of Gateway’s consolidated condensed financial statements.

Management believes the following to be critical accounting policies whose application has a material impact on Gateway’s financial presentation. That is, they are both important to the portrayal of Gateway’s financial condition and results, and they require management to make judgments and estimates about matters that are inherently uncertain.

Revenue Recognition

Gateway recognizes revenue pursuant to applicable accounting standards, including SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements”, (“SAB 101”). SAB 101, as amended, summarizes certain of the SEC staff’s views in applying generally accepted accounting principles to revenue recognition in financial statements and provides guidance on revenue recognition issues in the absence of authoritative literature addressing a specific arrangement or a specific industry.

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Gateway recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Revenue from the sale of products is recognized upon delivery of the products to customers. Revenue from services that are rendered by Gateway, such as extended warranties, is recognized straight-line over the service period, while training revenue is recognized as the services are provided. Other than internet services, revenue from the sale of services that are rendered by third parties, such as installation is generally recognized when the associated product is delivered and installed, if applicable. We offer our customers internet services which are provided by a third party. The revenue associated with these services is based on the monthly active subscriber counts, which are reported to us by the service provider and is recognized as the services are provided. If the actual subscriber counts or the economics associated with these subscriber counts prove to be less than originally reported by the service provider, we may be required to adjust revenue associated therewith downward, as occurred in the fourth quarter of 2002. In the fourth quarter of 2002, America Online, Inc. (“AOL”) unilaterally recomputed payments it had made in 2001 and the first half of 2002 and withheld the claimed overpayments from amounts currently owed to us. We have disputed AOL’s retroactive adjustment to the mutually agreed and previously paid amounts and have commenced formal dispute proceedings as required by our agreement.

Gateway records reductions in revenue in the current period for estimated future product returns related to current period revenue. Management analyzes historical returns, current economic trends, changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns allowances in any accounting period. If actual returns exceed estimated returns, we would be required to record additional reductions to revenue.

Gateway records reductions to revenue for estimated commitments related to customer incentive programs, including customer rebates and other sales incentives, such as trade-ins and referral credits. Future market conditions and product transitions may require us to increase customer incentive programs that could result in incremental reductions of revenue at the time such programs are offered. Additionally, certain incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and the specific terms and conditions of the particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, we would be required to record additional reductions to revenue.

Allowance for Doubtful Accounts

Gateway maintains an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The estimate is based on management’s assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition of those specific customers. We record an allowance to reduce the specific receivables to the amount that is reasonably believed to be collectible. We also record an allowance for all other trade receivables based on multiple factors including historical experience with bad debts, the general economic environment, the financial condition of our customers, and the aging of such receivables. We do not expect default rates to be greater than 1% of business segment net sales. If there is a deterioration of a major customer’s financial condition or we become aware of additional information related to the credit worthiness of a major customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, we may have to adjust our allowance for doubtful accounts, which would affect earnings in the period the adjustments are made. Gateway does not have a single customer that accounts for 10% or more of our revenue.

Inventory Valuation

The business environment in which Gateway operates is subject to rapid changes in technology and customer demand. We record write-downs for components and products which have become obsolete or are in excess of anticipated demand or whose costs are in excess of net realizable value. We perform a detailed assessment of inventory by part each quarter, which includes a review of, among other factors, inventory on hand and forecast requirements, product life cycle (including end of life product) and development plans, component cost trends, product pricing and quality issues. Based on this analysis, if necessary, we record an adjustment for excess and obsolete inventory. Gateway may be required to record additional write-downs if actual demand, component costs or product life cycles differ from estimates which would affect earnings in the period the write-downs are made.

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Warranty Provision

Gateway provides standard warranties with the sale of products. The estimated cost of providing the product warranty is recorded at the time revenue is recognized. We maintain product quality programs and processes, including actively monitoring and evaluating the quality of suppliers. Estimated warranty costs are affected by ongoing product failure rates, specific product class failures outside of experience and material usage and service delivery costs incurred in correcting a product failure. If actual product failure rates or material usage or service delivery costs differ from the estimates, revisions to the estimated warranty liability would be required and would affect earnings in the period the adjustments are made.

Taxes on Earnings

Gateway records a tax provision/benefit for the anticipated tax consequences of our reported results of operations. The provision for (benefit from) income taxes is computed using the liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. In the first quarter of 2003, Gateway recorded a deferred tax asset in the amount of $73 million equal to 37% of the loss before income taxes. Gateway also recorded a corresponding valuation allowance in the amount of $73 million. This resulted in no change in net deferred tax assets during the first quarter of 2003. In the first quarter of 2002, Gateway recorded a tax benefit of $72 million, or 37% of the loss before income taxes. Gateway expects to maintain a full valuation allowance on future tax benefits until an appropriate level of profitability is sustained. Until an appropriate level of profitability is reached, we do not expect to recognize any significant tax benefits from results of operations.

As of March 31, 2003 and December 31, 2002, our net deferred tax asset is approximately $6 million. Gateway records a valuation allowance to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. As of March 31, 2003 and December 31, 2002, our valuation allowance was approximately $200 million and $127 million, respectively. Gateway has considered our ability to carryback losses and future taxable income and feasible tax planning strategies in determining the need for a valuation allowance. In the event that we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if we were to later determine that it is more likely than not that the net deferred tax assets would be realized, the previously provided valuation allowance would be reversed, resulting in a positive adjustment to earnings in the period such determination is made.

Litigation

Gateway is currently involved in certain legal proceedings where the amount or range of loss can be estimated. A liability is recorded in these instances when the loss is considered probable. Where a liability is probable to occur in connection with litigation or governmental proceedings and there is a range of estimated loss, we record the minimum estimated liability related to the claim. As additional information becomes available, we assess the potential liability related to the legal proceedings and revise those estimates. Revisions in estimates of the potential liability could materially impact our results of operations in the period of adjustment.

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Results of Operations

The following table sets forth, for the periods indicated, certain data derived from Gateway’s consolidated condensed statements of operations and certain of such data expressed as a percentage of net sales (dollars in thousands):