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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2004

OR

For the transition period from                      to                     

Commission file number 0-22784

GATEWAY, INC.

(Exact name of registrant as specified in its charter)

7565 Irvine Center Drive

Irvine, California 92618

(Address of principal executive offices, zip code)

Registrant’s telephone number, including area code: (949) 471-7000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x    No  ¨

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

As of November 5, 2004 there were 373,734,230 shares of the Common Stock of Gateway, $.01 par value per share, outstanding. As of November 5, 2004 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 September 30, 2004

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I.    FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

GATEWAY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

For the three and nine months ended September 30, 2004 and 2003

(in thousands, except per share amounts)

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

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CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

September 30, 2004 and December 31, 2003

(in thousands, except per share amounts)

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

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

For the nine months ended September 30, 2004 and 2003

(in thousands)

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    General:

The accompanying unaudited condensed consolidated financial statements of Gateway, Inc. (“Gateway” or “Company”) as of September 30, 2004 and for the three and nine months ended September 30, 2004 and 2003 have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2003 and, in the opinion of management, reflect all adjustments necessary to fairly state the condensed consolidated financial position, results of operations and cash flows for the interim periods. All adjustments are of a normal, recurring nature except for certain asset impairments as discussed in (h) below and restructuring, transformation and integration charges as discussed in Note 7. 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 unaudited condensed consolidated financial statements should be read in conjunction with Gateway’s audited consolidated financial statements and notes thereto for the year ended December 31, 2003, which are included in Gateway’s 2003 Annual Report on Form 10-K, filed with the Securities and Exchange Commission (“SEC”).

Gateway sells its desktop and notebook computers and servers (“PCs”), PC-related products and services and consumer electronics products and services that converge or connect with PCs through its direct sales force, website, phone centers, value added resellers and third-party retail partners. Convergence and PC related products and services (“Convergence/non-PC”) consist of all products and services other than the PC, such as peripherals, software, accessories, extended warranty services, training, internet services, digital TVs, digital music players and enterprise system and networking products and services.

On March 11, 2004, Gateway completed its acquisition of eMachines, Inc., a privately-held computer company. These unaudited condensed consolidated financial statements include eMachines’ condensed consolidated balance sheet and results of operations subsequent to March 11, 2004. On April 9, 2004, Gateway closed its 188 retail stores to pursue wider distribution of its products through third-party retail partners (domestic and international) in addition to continued direct-sales of products to consumers and businesses via Gateway’s sales force, website and phone centers.

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

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

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 revenue and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include the Company’s provisions for sales returns, bad debts in accounts receivable, inventory obsolescence, product warranties and rebates, restructuring activities, tax assets and litigation matters.

Gateway considers all highly liquid investments with original maturities of three months or less to be cash equivalents. The carrying amount of these investments approximates fair value because of their short maturities.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

(d)    Marketable Securities and Long-Term Investments:

Marketable securities are classified as available-for-sale and consist of mutual funds, equity securities, commercial paper and debt securities. Marketable securities are adjusted to their fair market values each reporting date based on quoted market prices. Unrealized gains and losses are recorded as a component of accumulated other comprehensive income. Upon disposition of marketable securities, the specific identification method is used to determine the cost basis in computing realized gains or losses.

Long-term investments, including publicly traded equity securities, represent minority investments in other companies and are carried at cost. Certain of these long-term investments carry restrictions on immediate disposition and are included within long-term other assets, net.

Gateway regularly monitors and evaluates the realizable value of its investments. When assessing 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 its 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. 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 an other-than-temporary decline in the value of these assets has occurred, Gateway records an impairment charge to income in that period.

Included in marketable securities as of September 30, 2004 are unrealized losses of $1.2 million. The underlying securities are primarily federal, state and municipal, mortgage-backed, and corporate debt securities not typically subject to a high degree of volatility. The securities have been in an unrealized loss position for less than 12 months. No impairment charge was necessary or recorded during the first nine months of 2004 or 2003.

(e)    Inventory:

Inventory, which is comprised of component parts, both owned and consigned, subassemblies and finished goods, including refurbished PCs, is valued at the lower of first-in, first-out (FIFO) cost or market. Component parts and subassemblies consist of raw materials and products other than the PC such as peripherals, software not included with the PC, accessories, and convergence consumer electronics products. On a quarterly basis, Gateway performs an assessment of its inventories, reviewing the amount of the inventory on hand and under commitment with its latest forecasted requirements to determine whether excess or obsolescence write-downs are required.

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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.

As part of Gateway’s restructuring and transformation efforts primarily resulting from the acquisition of eMachines and closure of our retail stores during the first and second quarters of 2004, the estimated useful lives of certain assets were shortened. The estimated useful lives of certain store assets had previously been shortened effective January 1, 2003 in connection with the closing of 76 stores in the first quarter of 2003. Additionally, effective July 1, 2003, Gateway reduced the estimated service lives for certain information technology assets to twelve months in connection with certain outsourcing initiatives.

These revisions to estimated useful lives resulted in additional depreciation expense of $9.7 million and $28.7 million for the third quarter and first nine months of 2004, respectively, and $8.9 million and $15.9 million in additional depreciation expense for the same periods in 2003, respectively. The effects of these changes in estimated useful lives will be present in future quarters until such time as the assets are fully depreciated. See Note 7.

Intangible assets with finite lives are amortized on a straight-line basis over their estimated useful lives, generally four to ten years. Intangible assets with indefinite lives such as tradenames and goodwill are not amortized. Intangible assets, including goodwill, are reviewed for impairment annually during the fourth quarter and whenever events or circumstances indicate an event of impairment may exist, such as the closure of our retail stores in the second quarter of 2004. Management concluded in the second quarter that no condition of intangible asset impairment existed as a result of the closure of the retail stores.

Intangible assets with finite lives acquired through the acquisition of eMachines including customer-related assets were assigned useful lives of ten years. Amortization expense related to these assets will approximate $4.8 million annually. Total intangible asset amortization expense for the third quarter and first nine months of 2004 was $3.6 million and $9.8 million, respectively as compared with $1.9 million and $5.7 million for the same periods in 2003, respectively.

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. Impairment charges of $27 million and $157 million were recorded in the third quarter and first nine months of 2004, respectively, as a result of Gateway’s decision to close the retail stores effective April 9, 2004, certain other facility closures and certain transformation and integration efforts (see Note 7).

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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 or in providing customer support. 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):

Gateway has experienced a significant decline in its warranty provision in recent quarters due to the shortening of Gateway’s PC standard warranty periods and an increase in the amount of warranty costs being reimbursed by its suppliers.

During the third quarter of 2004, Gateway established an accelerated supplier payment program through which certain suppliers may elect to receive advance payment from a designated finance company on invoices due to them by Gateway. Any difference between the original amount due to the supplier for the goods and/or services received and the amount ultimately required to be repaid by Gateway to the finance company, including fees and interest, is recorded as interest expense for the period. Included in accounts payable is approximately $1 million that was advanced and outstanding to the finance company as of September 30, 2004.

Gateway recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed and determinable, and collectibility is reasonably assured. Revenue from training services, previously offered through our store network was recognized as the services were rendered. Revenue from internet services provided by third parties is recognized as the services are provided based on subscriber counts as reported to Gateway by the service providers. Revenue from the sale of other services rendered by third parties, such as installation services, is generally recognized when such services are performed.

Gateway records reductions in revenue in the current period for estimated future product returns and estimated rebate redemption rates related to current period sales. Management analyzes historical returns, current trends, changes in customer demand and acceptance of Gateway products when evaluating the adequacy of the sales returns allowances in any accounting period. Management also analyzes historical rebate redemption rates, current trends and the interrelationship of these rates with the current rebate dollar amounts in evaluating rebate allowances. Gateway records reductions to revenue for estimated commitments related to customer incentive programs and other sales incentives. This includes, among other things, trade-ins and referral credits.

Gateway offers its customers an option to purchase extended warranties. Revenue related to sales of extended warranties sold on behalf of third-parties is recognized at the time of sale. Revenue from sales of

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

extended warranties where Gateway is the legal obligor is deferred and recognized on a straight-line basis over the warranty service period. 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 for the periods presented is as follows (in thousands):

Shipping and handling costs are included in costs of sales for all periods presented. Shipping and handling costs charged to customers is recorded as revenue in the period the related product sales revenue is recognized.

The provision or 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 include tax liabilities related to current or future federal, state or foreign tax audits. See Note 5.

Basic loss 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 loss per common share is computed using net loss attributable to common stockholders and the combination of potentially dilutive common stock (unless anti-dilutive) and the weighted average number of common shares outstanding during the period. Diluted shares for the three months ended September 30, 2004 and 2003 excludes 24,279 and 26,269 weighted average incremental shares, respectively, and diluted shares for the nine months ended September 30, 2004 and 2003 excludes 25,163 and 23,668 weighted average incremental shares, respectively, related to employee and director 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 on earnings per share is anti-dilutive.

The Series C Redeemable Convertible Preferred Stock is contingently convertible to 5,939 shares and is not included in calculating loss per share as the contingency was not met (and their effect is anti-dilutive) as of September 30, 2004.

For the three months ended September 30, 2004 and 2003 Gateway has excluded 56,937 and 36,086 shares, respectively, and for the nine months ended September 30, 2004 and 2003 excluded 52,694 and 44,355 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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

(p)    Derivative Instruments, Hedging Activities and Foreign Currency:

Gateway considers the U.S. dollar to be its functional currency for certain of Gateway’s 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 US 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.

(q)    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 Statement of Financial Accounting Standards No. 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 2004 and 2003: dividend yield of zero percent; risk-free interest rates ranging from 1.5 to 3.6 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 for options granted during the first nine months of 2004 and 2003 was 71 percent.

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 been (in thousands, except per share amounts):

(r)    Segment Data:

Gateway reports segment data based on the internal reporting that is used by senior management for making operating decisions and assessing performance. During the second quarter of 2004 and in connection with the acquisition of eMachines, Gateway reorganized its internal reporting structure and created two new segments, Retail and International. Gateway’s operating segments are Direct Sales (previously Consumer), Professional,

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Retail and International. The International segment currently meets the aggregation criteria of Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information” and is included in the Retail segment for external reporting purposes due to its largely retail nature at the current time. See Note 8.

(s)    New Accounting Pronouncements:

In December 2003, the Financial Accounting Standards Board issued a revised interpretation of FIN 46, “Consolidation of Variable Interest Entities” (“FIN 46-R”). FIN 46 requires certain variable interest entities (“VIEs”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk in the entity to finance its activities without additional subordinated financial support from the other parties and was effective for the Company for all VIE arrangements entered into after January 31, 2003. FIN 46-R was effective for the Company in the first quarter 2004 and neither the adoption of FIN 46 nor FIN 46-R had a material impact on its results of operations, financial position or cash flow.

In December 2003, the SEC issued Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition”, which supersedes SAB 101, “Revenue Recognition in Financial Statements”. SAB 104 rescinds the accounting guidance contained in SAB 101 specifically related to multiple element revenue arrangements, but leaves the remaining SAB 101 principles largely unchanged. The adoption of SAB 104 did not have a material impact on Gateway’s consolidated results of operations or financial position.

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidelines for the evaluation and determination of whether a loss on certain investments is other-than-temporary and requires certain additional quantitative and qualitative disclosures pertaining to unrealized investment losses in a company’s annual financial statements. The provisions of EITF 03-1 became effective for Gateway in the third quarter 2004 and did not have a material impact on Gateway’s results of operations or financial position.

In July 2004, the EITF reached a tentative conclusion on Issue No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share” that contingently convertible debt instruments, commonly referred to as Co-Cos, should be included in diluted earnings per share computations, if dilutive, regardless of whether the contingent feature has been met. If ratified, the consensus is expected to be effective for reporting periods ending after December 15, 2004. On November 1, 2004, Gateway agreed to repurchase from America Online, Inc. its outstanding Series C redeemable, convertible preferred stock, which contained a contingent conversion feature. See Note 11. Due to the anticipated retirement of the Series C shares, management does not expect adoption of this Issue, if ratified, to have an impact on Gateway’s consolidated results of operations or financial position.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

2.    Comprehensive Loss:

Comprehensive loss for Gateway includes net loss, foreign currency translation adjustments and net unrealized gains or losses on available-for-sale securities. Comprehensive loss for the three and nine months ended September 30, 2004 and 2003 is as follows (in thousands):

3.    Selected Balance Sheet Information (in thousands unless otherwise noted):

The increase in accounts receivable is driven by the acquisition of eMachines.

The increase in inventory is primarily driven by the addition of eMachines’ inventory, seasonal build-up of retail goods and a slow-down in the Los Angeles and Long Beach ports near the end of the third quarter of 2004. The Company expects that its future inventory levels will be higher than levels historically maintained by Gateway alone due to its new operational fulfillment model in support of distribution to third-party retailers. Approximately $90 million of inventory was in-transit at September 30, 2004 compared with $1 million at December 31, 2003. This primarily represents inventory in-transit from overseas manufacturers, including amounts in port awaiting delivery.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The decrease in property, plant and equipment is primarily the result of the impairment of long-lived assets associated with the closure of the Company’s retail stores on April 9, 2004 and facilities in Sioux Falls and manufacturing operations in North Sioux City, as well as sales and disposal of equipment no longer required due to the Company’s rightsizing efforts following the acquisition of eMachines. See Note 7 for additional information.

The increase in intangible assets results from the acquisition of eMachines. See Note 9 for additional information.

The increase in accounts payable is driven primarily by the acquisition of eMachines and improved payment terms with many of our suppliers, reflecting a greater proportion of payables with 60-day terms in 2004 as compared to 2003.

The increase in accrued liabilities is due primarily to the first quarter 2004 restructuring plan, including accruals for lease liabilities incurred with the closure of the Gateway retail stores on April 9, 2004. See Note 7 for additional information.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The decrease in other current liabilities results primarily from the reversal of previously accrued tax liabilities resulting from tax authority settlements during the first and third quarters of 2004.

The increase in other long-term liabilities is due to a deferred income tax liability associated with the acquisition of eMachines. See Note 9.

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 is being 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 on December 22, 2004, 2009 and 2014 at face value plus accrued and unpaid dividends and Gateway can satisfy this put option in cash out of funds legally available or registered common stock (at its then-current fair market value as defined) or some combination thereof at its option. The holder can convert the Series C Preferred Stock to 5,938,948 shares of common stock at any time prior to December 2020, provided Gateway’s common stock trades over $33.68 for 5 consecutive days or certain other conditions exist. In addition, Gateway can redeem the Series C Preferred Stock in cash at any time on or after December 22, 2004 for the face value plus accrued and unpaid dividends.

Gateway issued 50,000 shares of non-voting 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. The Series A Preferred Stock will automatically convert into common stock of Gateway on December 24, 2004 at a conversion rate between $8.9935 and $10.07 per share based on the fair value of Gateway’s common stock at the date of conversion. If the Company’s common stock price on that date is comparable to its common stock price as of September 30, 2004, the Series A would convert into a total of 22,238,283 shares of common stock. The Series A Preferred Stock is convertible earlier than December 24, 2004 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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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, the Company may not buy back its common stock while any 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 $8.9935 per share (based on the current market value of the common stock), 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 loss per share.

On November 1, 2004, we entered into agreements with AOL, pursuant to which we expect to repurchase the Series A and Series C preferred stock and 2.7 million shares of common stock from AOL for an aggregate purchase price of approximately $315.6 million. The transaction is expected to close on December 22, 2004 and is subject to customary conditions. See Note 11.

5.    Income Taxes:

Gateway records a tax provision or benefit for the anticipated tax consequences of its reported results of operations. The 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. Gateway recorded tax benefits of approximately $2 million and $15 million for the reversal of previously accrued tax liabilities resulting from tax authority settlements during the third quarter and first nine months of 2004, respectively. Gateway recorded no tax benefit during the first nine months of 2003. Gateway also recorded a $19.8 million deferred tax liability related to the eMachines’ purchase accounting. eMachines will be included in Gateway’s federal consolidated income tax return effective March 12, 2004, with any taxable income being offset by anticipated losses incurred by Gateway for 2004. Gateway expects to maintain a full valuation allowance on potential future tax benefits and generally to record no tax benefit until an appropriate level of profitability is sustained.

6.    Commitments and Contingencies:

Gateway had Standby Letters of Credit and Guarantees outstanding at September 30, 2004, amounting to $28.4 million.

Gateway is a party to various lawsuits, claims, including assertions of patent infringements, investigations and administrative proceedings that arise in connection with its business, including those identified below. Gateway evaluates such matters on a case by case basis, and its policy is to vigorously contest any such claims it believes are without merit.

Hewlett-Packard Development Company, L.P. v. Gateway, Inc. is a suit filed in the United States District Court in the Southern District of California on March 24, 2004. The complaint alleges that Gateway infringed six patents owned by Hewlett-Packard Development Company, L.P. (“HPDC”). On or about April 5, 2004, HPDC amended its complaint to allege the infringement of four additional patents. HPDC seeks damages, including

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(Unaudited)

treble damages, an injunction, prejudgment interest, costs and attorneys’ fees. Gateway has answered the complaint denying the allegations and alleging numerous affirmative defenses. In addition, Gateway has also asserted counterclaims against HPDC and Hewlett-Packard Company (“HP”) for patent infringement of five patents owned by Gateway and seeking damages, including treble damages, an injunction, prejudgment interest, costs and attorneys’ fees. On June 16, 2004, Gateway amended its counterclaims to add three additional patents to its infringement claims and to delete three other patents from its infringement claims. No trial date has been set.

HPDC and HP also filed a complaint with the United States International Trade Commission (“ITC”) in Washington, DC, entitled In re Certain Personal Computers, Server Computers, and Components Thereof against Gateway, Inc. in the United States International Trade Commission in Washington, D.C. on May 6, 2004. The ITC instituted the proceeding on June 7, 2004. The complaint alleges that Gateway products infringe on seven patents obtained by HP from Compaq Computer. The complaint seeks an order excluding any infringing products from being imported and a cease and desist order enjoining sales of those products. Gateway has answered the complaint denying the allegations and alleging numerous affirmative defenses, and the parties are in the discovery process. While the administrative law judge originally set a one week trial to commence on March 21, 2005, that judge now has resigned his position and the trial schedule is uncertain.

On July 2, 2004, Gateway, Inc. filed a complaint with the ITC entitled Certain Personal Computers, Monitors, and Components Thereof. On August 3, 2004, the ITC initiated proceedings in response to Gateway’s complaint. The complaint alleges that products imported into the United States by or for HP, including Compaq products, infringe one or more of three patents owned by Gateway. The complaint seeks a determination that HP has violated Section 337 of the Trade Act due to the infringement, and requests that the ITC issue an order excluding any infringing products from being imported, and enjoining sales of those products. HP has answered the complaint by denying the allegations and alleging numerous affirmative defenses, and the parties are in the discovery process. A one week trial is scheduled to commence on May 23, 2005, but that trial is set before the same administrative law judge presiding over the HPDC and HP ITC action. Therefore, the trial schedule is uncertain.

Amiga Development LLC v. Hewlett-Packard Co. was filed in the United States District Court in the Eastern District of Texas on July 2, 2004. Gateway has a less than controlling interest in Amiga, a holding company for intellectual property, controlled by Gateway’s Chairman of the Board. The complaint filed by Amiga alleges that HP is infringing three patents owned by Amiga. No trial date has been set.

On August 18, 2004, Gateway filed a complaint entitled Gateway, Inc. v. Hewlett-Packard Development Company, L.P. in the United States District Court for the Southern District of California seeking a declaratory judgment that Gateway has not infringed four HPDC patents and that those four HPDC patents are invalid. HPDC filed counterclaims against Gateway alleging that Gateway has infringed these four patents. HPDC seeks damages, including treble damages, an injunction, prejudgment interest, costs and attorneys’ fees. Gateway has not yet responded to these counterclaims. No trial date has been set.

HPDC also filed a complaint entitled Hewlett-Packard Development Company, L.P. v. eMachines, Inc. in the United States District Court for the Western District of Wisconsin on October 21, 2004. The complaint alleges that eMachines has infringed three patents previously asserted by HPDC against Gateway in the ITC. HPDC seeks damages, including treble damages, an injunction, prejudgment interest, costs and attorneys’ fees. Gateway has not yet answered the complaint. No trial date has been set.

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, and which was subsequently transferred to the United States District Court

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in the Southern District of California, asserting that Gateway infringes seven patents owned by Lucent Technologies, Inc. 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. On February 20, 2003, Lucent also sued Dell Computer in the United States District Court for the District of Delaware on six patents, all of which are included in Microsoft’s declaratory judgment action, and several of which are asserted by Lucent against Gateway. The suit against Dell was subsequently transferred to the United States District Court for the Southern District of California, where all three actions have been consolidated for discovery purposes. Lucent subsequently filed amended complaints against Dell and Gateway, respectively, to assert now the same patents against each. Through its amendments, Lucent asserted one additional patent against Dell and four additional patents against Gateway. All of the patents added through amendment are at issue in the Microsoft declaratory judgment action. The three actions, which have been consolidated for all purposes but trial, are currently set for trial in October 2005.

Dvorchak v. eMachines, Inc., et al. is a shareholder class action against eMachines, Inc. and others filed in November 2001, in California State Superior Court, County of Orange, relating to a 2001 transaction in which eMachines, which was then a public company, was taken private. The action originally sought to enjoin eMachines’ merger with Empire Acquisition Corp. (the Merger) to effectuate taking eMachines private. The court denied the requested injunction on December 27, 2001, allowing the consummation of the Merger. After the Merger, plaintiffs filed amended complaints seeking unspecified monetary and/or recession damages relating to the negotiations for and terms of the Merger through allegations of breaches of fiduciary duties by eMachines, its board members prior to the Merger, and certain of its officers. After initially denying class certification, on August 25, 2003, the court granted class certification. The court has yet to set a trial date.

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, the results of legal proceedings cannot be predicted with certainty. Should Gateway fail to prevail in any of these legal matters or should one or more of these legal matters be resolved against Gateway in the same reporting period, its operating results could be materially adversely affected.

First Quarter 2004 Plan (“Q1 2004 Plan”):

During the first quarter of 2004, Gateway approved a restructuring plan to, among other things, close its 188 retail stores, reduce its workforce and consolidate facilities. Charges of $73 million ($3 million in cost of goods sold and $70 million in selling, general and administrative expenses), $253 million ($56 million in cost of goods sold and $197 million in selling, general and administration expenses) and $52 million ($11 million in cost of goods sold and $41 million in selling, general and administrative expenses) were recorded in the first quarter, second and third quarters of 2004, respectively, relating to these actions. Additional related restructuring charges of approximately $20 million are expected to be recorded during the remainder of 2004 and beyond under this plan.

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The following table summarizes the restructuring charges recorded in the first, second and third quarters of 2004 for the Q1 2004 Plan (in millions):

The nature of the charges related to the Q1 2004 Plan summarized above is as follows:

In addition to the restructuring charges, Gateway recorded transformation and integration charges of $23 million ($6 million in cost of goods sold and $17 million in selling, general and administrative expenses), $28 million ($3 million in cost of goods sold and $25 million in selling, general and administrative expenses) and $12 million ($1 million in cost of goods sold and $11 million in selling, general and administrative expenses) in the first, second and third quarters of 2004, respectively, in other expenses related to the transformation and integration with eMachines, including redundant costs associated with the reintegration of previously outsourced activities.

Third Quarter 2003 Plan (“Q3 2003 Plan”):

During the third quarter of 2003, Gateway approved a restructuring plan to, among other things, reduce its workforce and close certain facilities. Charges of $10 million and $3 million, respectively, were recorded in the first and second quarters of 2004 related to these actions. In the third quarter of 2004, the Company recorded a reduction of approximately $3 million based on lower than expected severance costs and $1 million related to a higher than expected recovery on assets. The significant restructuring activities related to this charge were initiated in the third quarter of 2003 and related actions continued through the second quarter of 2004.

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The following table summarizes charges recorded in the first, second and third quarters of 2004 for the Q3 2003 Plan (in millions):

First Quarter 2003 Plan (“Q1 2003 Plan”):

During the first quarter of 2003, Gateway approved a restructuring plan to close 76 retail stores. The Company also continued its focus on other cost reductions, resulting in a workforce reduction of approximately 1,900 employees. A reduction of $4 million was recorded in selling, general and administrative expenses in the first and second quarters of 2004 related to these actions based on lower than estimated severance related costs, including health related benefits. The significant restructuring activities were completed during the first quarter of 2003; however, payments are expected to continue through 2005.

The following table summarizes adjustments recorded during the first, second and third quarters of 2004 for the Q1 2003 Plan (in millions):

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

During the first quarter of 2002, Gateway approved a restructuring plan to, among other things, reduce its workforce and close certain retail stores and other company sites. In the third quarter of 2004, the Company recorded a reduction of $1 million associated with this plan. The significant restructuring activities were completed during 2002; however, payments are expected to continue through 2005.

The following table summarizes payments recorded during the first, second and third quarters of 2004 for the Q1 2002 Plan (in millions):

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

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certain other activities, including its then company-owned international operations. A $7 million charge was recorded in the second quarter of 2004 for a further reduction in assets held for sale related to facilities closed in the third quarter of 2001 in connection with this plan. In the third quarter of 2004, the Company recorded a $1 million reduction associated with this plan.

The amounts charged against the provision during the first, second and third quarters of 2004 were as follows (in millions):

First Quarter 2001 Plan (“Q1 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 third quarter of 2004, the Company recorded an additional $5 million in selling, general and administrative expenses related to lease liability on vacated facilities. No charges were made against the provision during the first and second quarters of 2004. The accrual is as follows (in millions):

8.    Segment and Concentration Data:

For 2003 and the first quarter of 2004, Gateway managed its business by customer class, Consumer and Professional. With the acquisition of eMachines, the Company formed two new operating segments, Retail and International, and realigned the Company’s historical operating segments, Direct Sales (previously Consumer) and Professional. Revenues and operations are distinguished by segment as follows: