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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2005

OR

For the transition period from                  to                 

Commission file number 000-22784

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 May 6, 2005 there were 371,248,592 shares of the Common Stock of Gateway, $.01 par value per share, outstanding. As of May 6, 2005 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 quarter ended March 31, 2005

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I.    FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

GATEWAY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

For the three months ended March 31, 2005 and 2004

(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)

March 31, 2005 and December 31, 2004

(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 three months ended March 31, 2005 and 2004

(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.    Nature of Operations and Summary of Significant Accounting Policies:

The accompanying unaudited condensed consolidated financial statements of Gateway, Inc. (“Gateway” or “Company”) as of and for the three months ended March 31, 2005 and 2004 have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2004 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, 2004, which are included in Gateway’s 2004 Annual Report on Form 10-K, filed with the Securities and Exchange Commission (“SEC”).

Gateway directly and indirectly sells its desktop and notebook computers and servers (“PCs”) and PC-related products and services that are enabled by or connect with PCs to third-party retailers, consumers, businesses, government agencies and educational institutions. Convergence and PC related products and services (“Non-PC/convergence”) consist of all products and services other than the PC, such as plasma and LCD TVs, digital music players, peripherals, software, accessories, extended warranty services, training, internet access, 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’ 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 unaudited condensed consolidated financial statements of Gateway are as follows:

(a)    Basis of Presentation:

The condensed consolidated financial statements include the accounts of Gateway and its subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

(b)    Use of Estimates:

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 provisions for sales returns, bad debts in accounts receivable, inventory obsolescence, product warranties and rebates, restructuring activities, deferred tax assets and litigation matters.

(c)    Cash and Cash Equivalents:

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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(d)    Marketable Securities and Long-Term Investments:

Marketable securities consist of investments in mutual funds and equity securities with readily determinable fair values, commercial paper and debt securities and are classified as available for sale and carried at fair market value based on quoted market prices. Unrealized gains and losses are recorded as a component of accumulated other comprehensive loss. The specific identification method is used to determine the cost basis in computing realized gains or losses on dispositions of marketable securities.

Long-term investments represent minority investments in other companies and are carried at cost and included in 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 below original cost, Gateway’s ability and intent to continue holding the investment, the regulatory, economic or technological environment of the investee, performance of the investee’s stock price in relation to the stock price of its competitors and the market in general, analyst recommendations and forecasts and the outlook for the overall industry in which the investee operates. If events and circumstances indicate that an other-than-temporary decline in the value of an investment has occurred, Gateway records an impairment charge to income in that period.

Included in marketable securities as of March 31, 2005 are unrealized losses of $2.7 million. The underlying securities are primarily federal, state and municipal, mortgage-backed, and corporate debt securities and the unrealized losses are largely due to recent interest rate increases. Approximately $0.4 million of unrealized losses relates to securities that have been in an unrealized loss position greater than 12 months. No other-than-temporary impairment charge was necessary or recorded during the first quarter of 2005 or 2004.

(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. Gateway performs an assessment of its inventories quarterly, reviewing the amounts of inventory on hand and under commitment against its latest forecasted demand requirements to determine whether excess or obsolescence write-downs are required.

(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:

The company capitalizes only those direct costs associated with the actual development of internal use software including design, coding, installation and testing. Costs associated with preliminary development such as the evaluation and selection of alternatives as well as training and maintenance are expensed as incurred.

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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 income (loss).

As part of Gateway’s restructuring efforts primarily resulting from the acquisition of eMachines and closure of its remaining 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 $3.0 million ($0.01 per share) and $7.5 million ($0.02 per share) for the first three months of 2005 and 2004, 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.

Total depreciation expense was $11.0 million (including $3.0 million due to the changes in estimated useful lives) and $30.5 million (including $7.5 million due to changes in estimated useful lives) for the first three months of 2005 and 2004, respectively.

(g)    Intangible Assets and Goodwill:

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. Amortizable intangible assets are reviewed for impairment whenever events or circumstances indicate an event of impairment may exist. Non-amortizable intangible assets, including goodwill, are reviewed for impairment annually during the fourth quarter (based on the discounted cash flow model under the income approach) or whenever events or circumstances indicate an event of impairment may exist.

During the fourth quarter of 2004, Gateway revised the estimated useful lives of certain intangible assets based on planned changes in the assets’ use, resulting in additional amortization expense of $1.1 million for the first three months of 2005. Total intangible asset amortization expense was $2.6 million (including the $1.1 million in accelerated amortization) and $2.8 million for the first quarter of 2005 and 2004, respectively.

(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 net future 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 based on appraised or other estimated values. Impairment charges of $8.8 million related to one of our facilities that has been classified as held for sale were recorded in the first quarter of 2005. This compares with impairment charges of $70 million in the first quarter of 2004, primarily due to 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).

(i)    Royalties:

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.

(j)    Warranty:

Gateway provides standard warranties with the sale of its products. The estimated cost of providing the product warranty is recorded at the time revenue is recognized. Gateway maintains product quality programs and

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processes including actively monitoring and evaluating the quality of its 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. Gateway has experienced a decline in its required levels of accrued warranties in recent years due to the shortening of warranty periods coupled with the increasing assumption of warranty repair costs by the original design manufacturers who produce the Company’s products. A summary of changes in Gateway’s accrued warranty liability, which is included in accrued liabilities and other long-term liabilities, for the first three months of 2005 and 2004 is as follows (in thousands):

(k)    Trade Payables Program:

Gateway has an accelerated supplier payment program through which certain suppliers may elect to receive advance payment, up to an aggregate maximum of $38 million, 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 (or income, if applicable) for the period. Included in accounts payable is approximately $18 million that was advanced to suppliers and outstanding to the finance company as of March 31, 2005.

(l)    Deferred Stock-Based Compensation:

Gateway issued 5.3 million shares of restricted stock valued at approximately $27 million to certain executives in connection with its acquisition of eMachines. Approximately 2.5 million and 300,000 shares vest on January 1, 2006 and 2007, respectively. Deferred stock-based compensation was $11.2 million as of March 31, 2005 and will continue to be amortized to compensation expense in future periods in accordance with the vesting schedule.

(m)    Revenue Recognition:

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 Gateway’s 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. These include, 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 on a net basis (only that portion owed to Gateway for its efforts in the sale) at the time of sale. Revenue from sales of extended warranties where Gateway

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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 first three months of 2005 and 2004 is as follows (in thousands):

During the fourth quarter of 2004, Gateway entered into an agreement with a third-party service provider to sell extended service plans on Gateway’s products to Gateway customers on behalf of that provider and its affiliates. Revenue sold on behalf of this administrator is recognized on a net basis at the time of sale except in States where law requires Gateway to be the legal obligor on extended service plans. In those instances, revenue is deferred and recognized over the service period; this revenue is included in the table above.

(n)    Shipping and Handling:

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.

(o)    Income Taxes:

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. Gateway expects to maintain a full valuation allowance on potential future tax benefits until an appropriate level of profitability is sustained. Other current liabilities include tax liabilities related to current or future federal, state or foreign tax audits. See Note 5.

(p)    Net Loss Per Share:

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 (if applicable) is computed using net loss attributable to common stockholders, as adjusted, and the combination of the weighted average number of shares outstanding and all potentially dilutive common shares outstanding during the period unless the inclusion of such shares is anti-dilutive. Diluted shares outstanding for the first quarter of 2005 and 2004 excludes the following weighted average incremental shares as their effect is anti-dilutive given Gateway’s net losses for the periods (in thousands):

The Series A and Series C preferred stock was repurchased from America Online, Inc. in the fourth quarter of 2004. Gateway has also excluded from diluted loss per share 47,665 shares and 42,598 shares for the first quarter of 2005 and 2004, respectively, related to employee and director stock options and non-employee warrants which have exercise prices greater than the average market price of the common shares for those periods.

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(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. 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 the first quarter of 2005 and 2004:

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 based on the assumptions above and applying graded vesting, net loss and net loss per share for the first three months of 2005 and 2004 would have resulted in the following pro forma amounts (in thousands, except per share amounts):

(r)    Treasury Stock:

Gateway has repurchased shares of its common stock which are held in treasury. This includes 2.7 million shares repurchased during the fourth quarter of 2004 in connection with the repurchase of the Series A and Series C preferred stock from America Online, Inc. In March 2004, Gateway issued 5.3 million shares of restricted stock to certain executives in connection with its acquisition of eMachines. In January 2005, approximately 2.5 million of these shares vested and the executives surrendered their restricted stock certificates for fully vested, unrestricted shares and cash. Gateway issued 1.4 million shares of unrestricted stock (subject to certain limitations on disposition) and provided cash for the remaining 1.1 million shares to assist the executives in meeting certain tax liabilities associated with such vesting. The 1.1 million shares were valued at their fair market value on the vesting date and are included in treasury stock for the first quarter of 2005. Treasury stock is accounted for under the cost method and is available for issuance.

(s)    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

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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 and are not significant.

(t)    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, 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. See Note 8.

(u)    Recent Accounting Pronouncements:

In March 2004, the Financial Accounting Standards Board (“FASB”) issued EITF No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidelines for the evaluation and determination of whether a loss on certain investments is other-than-temporary and requires certain additional disclosures pertaining to unrealized investment losses in a company’s financial statements. The effective date of the evaluation and measurement criteria of EITF No. 03-1 have been delayed pending issuance of additional implementation guidance. Management continues to monitor the FASB’s progress on this issue and does not expect adoption of the evaluation and measurement criteria, once finalized, will have a material impact on Gateway’s consolidated results of operations or financial position.

In November 2004, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 151, “Inventory Costs – An Amendment of ARB No. 43, Chapter 4, Inventory Pricing” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material or spoilage that may be incurred. Among other things, SFAS 151 requires that these items be recognized as charges to expense in the periods incurred and clarifies that fixed production overhead costs be allocated to inventory based on “normal” production capacity. SFAS 151 is effective for Gateway on January 1, 2006 and management does not believe adoption of this statement will have a material impact on Gateway’s consolidated results of operations or financial position.

In December 2004, the FASB issued SFAS No. 123-R, “Share-Based Payment” which requires, among other things, that stock options be measured at fair value and recognized as expense in the financial statements. SFAS 123-R requires management to select an appropriate option-pricing model and make certain assumptions about employee exercise habits and forfeiture rates in determining fair value and to select an appropriate amortization methodology for recognizing that value in the financial statements. The effective date of this Statement has been delayed until January 1, 2006. Management believes the adoption of SFAS 123-R will have a material impact on Gateway’s consolidated results of operations and earnings per share but has not yet determined the method of adoption that will be applied or whether adoption will result in expense amounts materially different from the pro forma stock option expense disclosures currently provided in Note 1.

In March 2005, the FASB issued Interpretation (“FIN”) No. 47, “Accounting for Conditional Asset Retirement Obligations – an interpretation of FASB Statement No. 143.” FIN 47 clarifies that liabilities associated with asset-retirement obligations whose timing or method of settlement is conditional upon future events should be recorded at fair value as soon as fair value can be reasonably estimated and provides guidance on whether fair value is considered reasonably estimable. Gateway adopted FIN 47 during the first quarter of 2005 and such adoption did not materially impact Gateway’s consolidated results of operations or financial position.

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(v)    Reclassification:

During the first quarter of 2005, the Company reclassified restricted cash that had previously been included in cash and cash equivalents. Prior period information has been restated for consistency with current presentation.

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 first quarters of March 31, 2005 and 2004 is as follows (in thousands):

Approximately $73 million and $61 million of inventory was in-transit as of March 31, 2005 and December 31, 2004, respectively, primarily representing inventory in-transit from overseas manufacturers, including amounts in port awaiting delivery.

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The increase in supplier receivables stems from increased purchases of certain inventory components on behalf of our suppliers during the first quarter in anticipation of higher second quarter sales. The increase in assets held for sale is due to the company’s first quarter 2005 decision to actively market one of our facilities, which resulted in the reclassification of such facility out of property, plant and equipment and into assets held for sale.

The decrease in property, plant and equipment primarily results from the impairment of certain facilities and assets in connection with the company’s restructuring and transformation efforts (see Note 7 for additional information) coupled with the reclassification of a facility to assets held for sale.

The decrease in accrued expenses is primarily due to the first quarter 2005 payout of approximately $13 million in employee bonuses and a $4 million incremental payment toward independent labor accruals. The decrease in restructuring-related accruals is due to first quarter 2005 payouts under the company’s restructuring plans (see Note 7).

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The decrease in both current and long term deferred revenue is due to changes in Gateway’s extended warranty service offerings. Gateway previously sold its own extended service plan and recognized related revenues ratably over the contract service period. Beginning in the fourth quarter of 2004, Gateway began selling extended service plans on behalf of an independent third-party service plan administrator and its affiliates. Revenue on sales of third party extended warranties is recognized (net of amounts due the service provider) at the time of sale, except in those States where law requires Gateway to be the legal obligor on extended service plans. In those instances, revenue continues to be deferred and recognized over the service period.

4.    Financing Arrangements

On October 30, 2004, Gateway entered into a credit agreement with a major financial institution to provide for a revolving credit facility of up to an aggregate of $200 million. Borrowings under this agreement bear interest, at Gateway’s election, based on LIBOR or the prime rate and are secured by substantially all of Gateway’s accounts receivable, inventory and certain deposit accounts into which accounts receivable payments are initially deposited. The agreement contains usual and customary covenants for an arrangement of its type, including an obligation of Gateway to maintain at all times $150 million of unrestricted cash and marketable securities. The agreement expires on October 31, 2009, at which time all amounts then outstanding will be due and payable. Gateway had borrowings outstanding under this credit agreement of $25 million, bearing interest at 3.71% as of March 31, 2005.

In December 2004, Gateway completed the sale of $150 million of 1.50% senior convertible notes due December 31, 2009 and $150 million of 2.00% senior convertible notes due December 31, 2011 through a private placement to institutional investors. The notes are direct, unsecured and unsubordinated obligations of the Company and rank equal in priority to Gateway’s existing and future unsecured indebtedness and senior in right of payment to any future subordinated indebtedness. Each $1,000 note is initially convertible into 115.8749 shares of Gateway common stock based on an initial conversion price of $8.63 or approximately 34.8 million shares in aggregate, at any time prior to the close of business on the business day immediately prior to scheduled maturity. Gateway may settle a conversion election in cash, common shares or a combination of both. Note holders who elect to convert upon the occurrence of any transaction or event in connection with which 90% or more of Gateway’s common stock is exchanged for, converted into, acquired for (or constitutes solely the right to receive), consideration which is not at least 90% common stock that is listed on a United States national securities exchange or approved for trading on the NASDAQ National Market may be entitled to receive additional shares of Gateway common stock based on established formulas. Gateway may not redeem the notes prior to maturity, but note holders may require Gateway to repurchase all or a portion of the notes at 100% of principal plus accrued and unpaid interest upon occurrence of certain defined designated events. Interest is payable semi-annually each June 30 and December 31, beginning June 30, 2005.

Interest expense was $2.2 million and $0.2 million for the first quarter of 2005 and 2004, respectively.

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 $1 million in the first quarter of 2005 and $13 million for the reversal of previously accrued tax liabilities resulting

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from tax authority settlements during the first quarter of 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 March 31, 2005, amounting to $36.9 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 April 2, 2004, HPDC amended its complaint to allege the infringement of four additional patents. HPDC seeks damages, including 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 and to delete three other patents from its infringement claims. As a result of the actions described below in the Amiga Development LLC matter and the August 18th Gateway Declaratory Judgment matter, HP ultimately added four additional patents in the present case, seeking the same relief as outlined above. In January 2005, the Court began the Markman hearing to interpret the claims of the patents-in-suit. The Court interpreted the claims of three of the 19 patents-in-suit. The Markman hearing is scheduled to resume in July 2005. No discovery has yet been taken in the case and 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 now completing the discovery process. HP has withdrawn three patents from the case, and withdrawn the assertion of a number of claims of the remaining patents. The trial was held at the end of March 2005 and post-trial briefing was completed on April 21, 2005. An Initial Determination by the Administrative Law Judge is scheduled to be issued on or before June 7, 2005.

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, and amended its complaint on or about November 11, 2004. The original complaint alleges that eMachines has infringed three patents previously asserted by HPDC against Gateway in the ITC. The amended complaint asserts infringement of two additional patents. HPDC seeks damages, including treble damages, an injunction, prejudgment interest, costs and attorneys’ fees, and moved for a preliminary injunction barring eMachines’ sales based on assertions of infringement of one of the patents in suit, U.S. Patent No. 5, 737,604. On December 1, 2004, the Court denied HPDC’s motion for a preliminary injunction. In January 2005, HPDC withdrew two of the original asserted patents from the case. On February 17, 2005, the Court granted eMachines’ motion to transfer the action to the United States District Court, Southern District of Texas. No schedule for the trial has been set.

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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. In February 2005, a Markman hearing was held and in March 2005 the Court issued an order interpreting the claims of the three asserted patents. Gateway has since withdrawn the assertion of two of the patents and is proceeding to trial on the remaining patent, which relates to multimedia PCs. A one week trial is scheduled to commence on May 23, 2005 before the same Administrative Law Judge presiding over the HPDC and HP ITC action.

On July 2, 2004, Amiga Development LLC v. Hewlett-Packard Co. was filed in the United States District Court in the Eastern District of Texas, by Amiga Development LLC, a holding company for intellectual property, in which Gateway has a majority equity interest but which is controlled by Gateway’s Chairman of the Board. The complaint filed by Amiga alleges that HP is infringing three patents owned by Amiga. A Markman hearing to interpret the claims of the asserted patent is set for December 2005 and trial is scheduled to commence in April 2006. Discovery has commenced and is ongoing.

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. As noted above, the dispute over these four patents has been consolidated with the HPDC v. Gateway matter pending in the United States District Court, Southern District of California.

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 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 Inc. 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 Court began conducting a Markman hearing on the asserted patents in August 2003 and has conducted 25 days of hearings to date. The hearing is expected to resume in June 2005. The three actions, which have been consolidated for all purposes but trial, do not have a current trial date.

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

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the Merger, plaintiffs filed amended complaints seeking unspecified monetary damages and/or rescission 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. The court granted class certification on August 25, 2003. A dispositive motion filed by the defendants was heard and denied by the Court in August 2004. It is anticipated that further dispositive motions on behalf of the defendants will be heard and ruled upon by the Court prior to trial. The Court has set a trial date for September 19, 2005.

In accordance with SFAS No. 5, “Accounting for Contingencies,” Gateway reserves for a legal liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. At least quarterly Gateway reviews and adjusts these reserves to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular case. The ultimate outcome of some of these matters cannot presently be determined or estimated. Gateway’s management believes the Company has sufficiently reserved for legal matters and 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 current legal matters or should one or more of these legal matters be resolved against Gateway, Gateway could be required to pay substantial monetary damages or, if injunctive relief is granted, may be prohibited from selling one or more of its products and, in either case, its operating results and cash flows could be materially adversely affected.

7.    Restructuring, Transformation and Other Charges:

Gateway recorded a net $8 million in restructuring, transformation and other charges during the first quarter of 2004. A summary of such charges and the status of all restructuring plans with remaining accrued and unpaid balances follows.

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 $14 million in selling, general and administrative expenses were recorded in the first quarter of 2005 relating to this plan. Adjustments of $5 million were recorded in the first quarter of 2005 primarily related to this plan due to better than expected recovery on Gateway retail store lease buyouts.

The following table summarizes the status of the Q1 2004 Plan as of March 31, 2005 (in millions):

Additional related restructuring charges of approximately $3 million are expected to be recorded during the remainder of 2005, most likely in the second quarter under this plan.

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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. 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. The following table summarizes the status of the Q3 2003 Plan as of March 31, 2005 (in millions):

An adjustment of $1 million was recorded in the first quarter of 2005, which relates to better than expected recovery on Gateway retail store lease buyouts.

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. The significant restructuring activities were completed during the first quarter of 2003. Approximately $1 million related to lease liabilities was paid during the first quarter of 2005 and no liabilities remain under this plan as of March 31, 2005.

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. The significant restructuring activities were completed during 2002; however, payments are expected to continue through 2005. Approximately $2 million related to lease liabilities remained accrued and unpaid under this plan as of March 31, 2005.

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. Approximately $9 million related to lease liabilities remained accrued and unpaid under this plan as of March 31, 2005.

Approximate future cash outlays for all restructuring plans, representing primarily lease liabilities on closed facilities, are $55 million (approximately $20 million on a net basis after including anticipated proceeds from the sale of assets) and are projected to be paid as follows: $30 million for the remainder of 2005, $11 million in fiscal 2006, $6 million in fiscal 2007 and $8 million thereafter.

8.    Segment and Concentration Data:

During the first quarter of 2004, Gateway managed its business by customer class, Consumer and Professional. With the acquisition of eMachines, Gateway formed two new operating segments, Retail and International, and realigned the historical operating segments, Direct Sales (previously Consumer) and Professional during the second quarter of 2004. Management also realigned the allocation of certain corporate overhead expenses to the operating segments. Gateway’s revenues and operations are delineated by operating segment as follows:

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Revenues from these segments are derived from sales of PC and Non-PC/convergence products and services. Gateway evaluates the performance of its segments based on sales and operating income, and does not include segment assets or other income and expense items for management reporting purposes. Segment operating income (loss) includes selling, general and administrative expenses and other overhead charges directly attributable to the segment and excludes certain expenses managed outside the reporting segment, such as depreciation and amortization. Other costs excluded from segment operating income (loss) primarily consist of general and administrative expenses that are managed on a corporate-wide basis and the restructuring, transformation and integration charges discussed in Note 7.

Prior to the second quarter of 2004, Gateway’s reportable segments were Consumer and Professional. The following table, with prior year amounts reclassified for consistency with current presentation, sets forth summary information by segment (in thousands):

The following table summarizes Gateway’s net sales by major product group (dollars in thousands):

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Best Buy accounted for approximately 29% of total net sales for the first quarter of 2005 and approximately 30% of accounts receivable, net at both March 31, 2005 and December 31, 2004. No single customer accounted for more than 10% of net sales for the first quarter of 2004.

9.    Related Party Transactions:

Through its acquisition of eMachines, Gateway acquired preferred stock in Alorica, Inc. that is convertible into approximately 17% of the common stock of Alorica. This related party provides reverse logistics, product registration, technical support, parts sales, PC refurbishing and other related services to Gateway and its customers and is currently developing a customized customer service technology solution for Gateway. Gateway paid approximately $15.8 million and $3.1 million to Alorica for services during the first quarter of 2005 and 2004, respectively. We expect to continue to utilize the services of Alorica in 2005 at an increased level.

The sole common stock shareholder of Alorica, Andy Lee, was appointed to Gateway’s executive team in April 2004 as Senior Vice President of Information Technology/Web. Mr. Lee continues to hold the common stock of Alorica and Mr. Lee’s spouse is the current Vice President of Legal and Business Affairs at Alorica. Effective May 9, 2005, Mr. Lee resigned from his position at Gateway and agreed to provide consulting services to the company as an independent contractor.

Mr. Lee had general oversight for the implementation of technology provided by Alorica in his former position at Gateway. He also had provided limited input regarding Gateway’s use of other third party technical support service providers. Gateway has implemented procedures to provide for prior Audit Committee approval of all commercial relationships between Gateway and Alorica that exceed $500,000 per quarter in the aggregate. All other services provided by Alorica below this threshold are reviewed quarterly by independent senior management and the Audit Committee.

10.    Subsequent Event

On April 7, 2005, Gateway entered into a Marketing, Development and Settlement Agreement (the “Agreement”) with Microsoft Corporation that provides for an aggregate of $150 million in payments to Gateway (including $6 million to outside legal counsel) to be made in quarterly installments through the end of 2008. As part of the agreement, Gateway agreed to use a substantial majority of the proceeds to fund various marketing initiatives, including advertising, sales training and consulting, as well as the research, development, and testing of new Gateway products that run Microsoft products. Gateway also released Microsoft from all antitrust claims. The Agreement does not limit Gateway’s ability to promote, distribute or otherwise support non-Microsoft products.

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The following discussion should be read in conjunction with the Unaudited Condensed Consolidated Financial Statements and the related notes that appear elsewhere in this document as well as our 2004 Annual Report on Form 10-K filed with the SEC in March 2005.

This Quarterly Report includes forward-looking statements made based on current management expectations. These statements are not guarantees of future performance and actual outcomes may differ materially from what is expressed or forecasted. Factors that could cause future results to differ from Gateway’s expectations include the factors described under “Factors that May Affect Gateway’s Business and Future Results” beginning on page 35 of this Quarterly Report or that are otherwise described from time to time in our reports filed with the Securities and Exchange Commission after this Quarterly Report. We assume no obligation to update any forward-looking statements to reflect events that occur or circumstances that arise after the date as of which they are made.

This Quarterly Report contains certain non-GAAP financial information, including disclosure of the portion of the company’s SG&A, gross margins and net loss relating to, or affected by, certain restructuring charges, transformation expenses and integration expenses. This non-GAAP financial information is provided as supplementary information and is not an alternative to GAAP. This non-GAAP financial information is used by management to analyze Gateway’s baseline performance before charges and expenses that are considered by management to be outside of Gateway’s core operating results, notwithstanding the fact that such restructuring charges and transformation expenses may be recurring. This non-GAAP information is among the primary indicators management uses as a basis for evaluating Gateway’s financial performance as well as for forecasting of future periods. The presentation of this additional information is not meant to be considered in isolation or as a substitute for reported results determined in accordance with GAAP.

The management’s discussion and analysis that follows is designed to provide information that will assist readers in understanding our unaudited condensed consolidated financial statements, changes in certain items in those statements during the quarter and from year to year and the primary factors that caused those changes and how certain accounting principles, policies and estimates affect our financial statements.

Overview

Since its founding in 1985, Gateway has focused on marketing award-winning, quality personal computers and related products and providing personalized service at a price that represents value to consumers, businesses, government offices and educational institutions. We manage our business through our four operating segments: Direct Sales, Professional, Retail and International. Our strengths include our strong brand name recognition, our technologically advanced product lines, and our ability to maneuver quickly and react to product development trends in the rapidly changing PC industry.

With the acquisition of eMachines in March 2004, we significantly enhanced our overall efficiency and ability to compete, and gained greater access to third-party retail distribution networks. In the year since the eMachines acquisition, we have completely overhauled the distribution of our products to consumers, including the closure of our 188 Gateway-owned retail stores, the introduction of our products into more than 3,000 retail locations domestically including Best Buy, Circuit City, Comp USA, and Costco (among others) and expansion internationally. We have significantly reduced our SG&A cost structure, transitioned to a more efficient manufacturing model and consolidated our supply bases and service and support relationships to further drive efficiencies. Despite these accomplishments, we are still in the early days of the turnaround and there is much hard work remaining.

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Some of the key developments and achievements since the beginning of 2005 include:

A key to our long-term success is that Gateway has been, and will remain, a product-focused company. For the remainder of 2005, we plan to leverage our low-cost business model, drive growth in Professional, notebooks and TFT monitors, and further extend our success in Retail. We continue to face a variety of challenges and opportunities inherent within the PC industry which is characterized by rapid change, evolving customer

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demands and intense competition. Key challenges include our ability to increase demand for our products, anticipate changing customer demands, continue to simplify our business, lower costs, manage our manufacturing suppliers, customer service and administrative relationships, and maintain gross margin dollar and percentage levels that provide sufficient fixed cost coverage to generate sustained profitability.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses Gateway’s unaudited condensed consolidated 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 financial statements and accompanying notes. Note 1 to the unaudited condensed consolidated 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 financial statements.

Management believes the following are 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 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 provided. Revenue from Internet services provided by third parties is recognized as the services are provided based on subscriber counts reported to us by the service providers. If the actual subscriber counts or the economics associated with these subscriber counts prove to be more or less than originally reported by the service providers, we may be required to adjust revenue. Revenue from the sale of other services rendered by third parties, such as installation services, is generally recognized when such services are performed.

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, net of amounts due to the third-party. Revenue from sales of extended warranties where Gateway is the legal obligor is deferred and recognized on a straight-line basis over the warranty service period.

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 our 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. If actual returns exceed estimated returns or if actual rebate redemptions exceed estimates, we would be required to record additional reductions to revenue which would affect earnings in the period the adjustments are made. Gateway also records reductions to revenue for estimated commitments related to other customer and sales incentive programs. This includes, among other things, 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, which would affect earnings in the period the adjustments are made.

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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. 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. One customer accounted for approximately 30% of accounts receivable, net, as of March 31, 2005.

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 net realizable value. We perform an assessment of inventory 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, 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.

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 or in providing customer support. If actual product failure rates, 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.

Restructuring

Gateway has engaged and may continue to engage in restructuring actions which require our management to make significant estimates related to realizable values of assets made redundant or obsolete, expenses for severance and other employee separation costs, lease cancellation / lease buyout and other exit costs, and estimates of future rental income that may be generated through the subleasing of excess facilities. Should the actual amounts differ from our estimates, the amount of the restructuring charges could be materially impacted. For a full description of our restructuring actions, refer to our discussion of restructuring charges in the Results of Operations section.

Long-lived Asset Impairments

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. This process requires management to make assumptions and estimates related to estimated future cash flows to be generated and used by an asset or asset group as well as the expected or future use of such assets and/or their estimated future useful lives. Actual results could differ from the assumptions and estimates used and a significant change to the planned use of an asset or asset group could result in a material impairment charge in a given reporting period.

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Taxes on Earnings

Gateway records a tax provision or 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. We record a valuation allowance to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. We consider our ability to carryback historical losses, cumulative losses in recent years, forecasted earnings and future taxable income and feasible tax planning strategies in determining the need for and amount of a valuation allowance. If we determine that it is more likely than not that our net deferred tax assets will be realized, our valuation allowance would be reversed, resulting in a positive adjustment to earnings in the period such determination is made. 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.

Litigation

Gateway is currently involved in certain legal proceedings (see Note 6). When a loss is considered probable in connection with litigation or governmental proceedings and the loss amount can be reasonably estimated within a range, we record the minimum estimated liability related to the claim if there is no best estimate in the range. 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 or resolution of pending matters could materially impact our results of operations in the period of adjustment.

Non-Amortized Intangible Assets Including Goodwill

Gateway capitalized $50 million related to the eMachines’ tradename and $156 million in goodwill in connection with its acquisition of eMachines in March 2004. These intangible assets are not amortized but are reviewed for impairment annually during the fourth quarter or whenever events or circumstances indicated an event of impairment may have occurred or exist. Our fourth quarter review process utilizes the income method to estimate fair value based on a discounted future cash flow approach which relies on estimates about Gateway’s future revenues (based on assumed market segment growth rates) and costs, discounted at appropriate rates based on Gateway’s weighted average cost of capital. Future revenue and cost estimates are based on historical data, various internal estimates and a variety of external sources, and are developed as part of our long-range planning process. A significant change in our Retail business could result in a material impairment of these assets.

Results of Operations

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

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Net Sales

Net sales were $838 million on shipments of 941,000 units in the first quarter of 2005 as compared with $868 million on shipments of 604,000 units for the same period last year. This 4% decline in net sales is primarily due to the closure of our Gateway retail stores in April 2004 ($266 million) and declines in Direct Sales and Professional segment sales ($73 million), partially offset by gains in the Retail segment ($308 million). Retail gains reflect the inclusion of eMachines’ net sales for the full first quarter in 2005 as compared with only 20 days in the first quarter of 2004, as well as significant growth in sales of Gateway-branded products which were introduced to third-party retail in the summer of 2004.

On a pro forma basis – which adds eMachines’ sales and units and subtracts Gateway retail store sales and units from the first quarter of 2004 for comparative purposes – net sales declined 8% and PC unit sales declined 12% year-over-year primarily due to the timing of a significant order from a major retail customer in the first quarter of 2004 ($71 million impact) and a first quarter 2005 market share loss in the Direct Sales segment.

The 56% increase in year-over-year unit shipments is primarily due to the full quarter inclusion of eMachines’ sales in the first quarter 2005 as compared with only 20 days in the prior year period.

According to preliminary International Data Corporation (“IDC”) market rankings, Gateway domestic market share was 5.7% for the first quarter of 2005 compared with 4.2% in the first quarter of 2004 on a Gateway stand-alone basis and 7.9% in the first quarter of 2004 on a pro forma combined company basis. The decline in market share on a pro forma basis is due to the timing of a significant order from a retail customer in the first quarter of 2004. See further discussion and analysis of first quarter net sales activity in the ‘Segment Performance’ and ‘Major Product Groups’ sections below.

Average PC unit prices fell to $720 in the first quarter of 2005 compared with $987 for the same period last year, due to a greater mix of Retail sales and lower-priced eMachines’ PC unit sales in 2005 as compared with last year, which included 20 days of eMachines net sales, and the elimination of the Gateway retail store sales, which had higher unit prices.

Gross profit

Gross profit was $80 million in the first quarter of 2005 as compared with $108 million (including $11 million in restructuring, transformation and integration charges) for the same period last year. Gross profit for the first quarter of 2005 includes a $4 million legal settlement benefit and a $4 million benefit from the reduction of certain retail rebate liabilities.

Excluding the $11 million in restructuring-related charges in the first quarter of 2004, gross profit declined $39 million year-over-year primarily due to a significant shift in sales from the Direct Sales segment to third-party retail, lower Non-PC/convergence product sales associated with the closure of the Gateway retail stores in April 2004 and increased price competition in our Direct Sales segment, partially offset by improvements in Retail segment gross profit. The shift in sales from our Direct Sales segment to third-party retail adversely affects gross profit due to lower Retail gross margins reflecting the fact that products sold to third party retailers are at wholesale prices as compared to retail pricing obtained through sales to customers directly at the former Gateway stores. The first quarter of 2005 improvements in Retail segment gross profit are primarily due to the acceptance of higher-margin Gateway products in third-party retail, increased sales of higher-margin portable products, and the fact that eMachines’ sales for the first quarter of 2004 did not significantly contribute to gross profit due to the write-up of eMachines’ finished goods inventory to fair value in connection with the eMachines’ purchase accounting last year.

Gross profit as a percentage of net sales for the first quarter of 2005 was 9.6% (with no impact from restructuring, transformation and integration charges) as compared to 12.5% (which includes 1.2 percentage points impact from restructuring and transformation charges) for the same period last year due to the factors described above.

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Gross profit contribution from Non-PC/convergence products and services represented 74% of the gross profit dollars in the first quarter of 2005 as compared with 72% in the prior year. Gross profit contribution from Non-PC products, on a percentage basis, more than offset the reduced contribution from convergence products. See further discussion and analysis in the ‘Major Product Groups’ section below.

Selling, General and Administrative Expense

Selling, general and administrative (“SG&A”) expense totaled $88 million (including $8 million of restructuring, transformation and integration costs) in the first quarter of 2005, compared with $296 million (including $93 million of restructuring and transformation costs) for the same period last year. In addition to the decrease of restructuring, transformation and integration costs, the first quarter 2005 reductions in SG&A expense resulted from the closure of our retail stores in April 2004 ($75 million), reduced direct marketing costs partially related to the shift to third-party retail ($13 million), rationalization of IT expenses ($15 million), and reductions in corporate overhead and headcount costs and continued focus on other SG&A cost savings ($20 million) during the first quarter of 2005. We employed approximately 1,850 people during the first quarter of 2005 as compared with 7,400 for the same period last year.

As a percentage of net sales, SG&A was 10.5% (including 1.0% in restructuring, transformation and integration charges) in the first quarter of 2005 as compared with 34.1% (including 10.7% in restructuring, transformation and integration charges) for the same period last year.

Restructuring Activities

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. This is in addition to previous restructuring plans that were adopted in 2003 and 2002, including the first quarter 2003 plan to close 76 retail stores (in addition to four stores previously announced).

Restructuring, transformation and integration expenses totaled $8 million (all in SG&A) for the first quarter of 2005, primarily representing asset write-downs of $14 million, including $9 million related to a facility reclassified as an asset held for sale, offset by better than expected recovery on retail store lease buyouts of $6 million. This compares with $104 million ($11 million in cost of goods sold and $93 million in SG&A expenses) for the first quarter of 2004.

An estimated $3 million of restructuring, transformation and integration charges associated with the First Quarter 2004 Restructuring Plan remain and will likely be incurred in the second quarter of 2005.

Other Income, Net

Other income, net was $2 million for the first quarter of 2005, including $3 million of interest income and a $1 million gain on the extinguishment of certain extended warranty liabilities, partially offset by interest expense of $2 million. Other income, net of $6 million for the same period last year represents interest income. The year over year decline in interest income is primarily due to an overall reduction in the company’s average cash and marketable securities balances for the first quarter of 2005 as compared with the first quarter of 2004. The year-over-year increase in interest expense is due to the $300 million in senior convertible notes and amounts outstanding under our revolving credit facility in the first quarter of 2005 as compared with no debt outstanding in the first quarter of 2004.

Income Taxes

We recorded tax benefits of $1 million in the first quarter of 2005 and $13 million associated with the reversal of previously accrued tax liabilities during the first quarter of 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.

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Dividends

We recorded preferred stock dividends of $3 million during the first quarter of 2004 related to our Series A and Series C preferred stock. These shares were retired through a repurchase from America Online, Inc, during the fourth quarter of 2004. Accordingly, no dividends were recorded during the first quarter of 2005.

Segment Performance

The following table presents Gateway’s net sales and operating results for the periods indicated by reportable segment (in thousands):