10-Q 1 d10q.htm FOR THE QUARTERLY PERIOD ENDED 09/30/2002 For the quarterly period ended 09/30/2002
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-Q

 
(Mark One)
x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2002
 
or
 
¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                              to                             .
 
Commission File No. 000-22513
 
AMAZON.COM, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
    
91-1646860
(State or other jurisdiction of
incorporation or organization)
    
(I.R.S. Employer
Identification No.)
 
1200 12th Avenue South, Suite 1200, Seattle, Washington 98144-2734
(Address of principal executive offices, zip code)
 
(206) 266-1000
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x  No  ¨
 
381,465,499 shares of $0.01 par value common stock outstanding as of October 14, 2002
 


Table of Contents
AMAZON.COM, INC.
 
FORM 10-Q
For the Three Months Ended September 30, 2002
 
INDEX
 
         
Page

    
PART I.    FINANCIAL INFORMATION
    
Item 1.
  
Consolidated Financial Statements (Unaudited)
    
       
1
       
2
       
3
       
4
Item 2.
     
18
Item 3.
     
48
Item 4.
     
49
    
PART II.    OTHER INFORMATION
    
Item 1.
     
50
Item 2.
     
50
Item 3.
     
50
Item 4.
     
50
Item 5.
     
50
Item 6.
     
51
  
52


Table of Contents
PART I.    FINANCIAL INFORMATION
 
Item 1.    Financial Statements
 
AMAZON.COM, INC.
 
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
(Unaudited)
 
    
September 30,
2002

    
December 31, 2001

 
ASSETS

             
Current assets:
                 
Cash and cash equivalents
  
$
327,564
 
  
$
540,282
 
Marketable securities
  
 
538,238
 
  
 
456,303
 
Inventories
  
 
151,514
 
  
 
143,722
 
Prepaid expenses and other current assets
  
 
102,291
 
  
 
67,613
 
    


  


Total current assets
  
 
1,119,607
 
  
 
1,207,920
 
Fixed assets, net
  
 
239,238
 
  
 
271,751
 
Goodwill, net
  
 
70,811
 
  
 
45,367
 
Other intangibles, net
  
 
4,373
 
  
 
34,382
 
Investments in equity-method investees
  
 
1,136
 
  
 
10,387
 
Other equity investments
  
 
15,362
 
  
 
17,972
 
Other assets
  
 
46,878
 
  
 
49,768
 
    


  


Total assets
  
$
1,497,405
 
  
$
1,637,547
 
    


  


LIABILITIES AND STOCKHOLDERS’ DEFICIT

             
Current liabilities:
                 
Accounts payable
  
$
347,519
 
  
$
444,748
 
Accrued expenses and other current liabilities
  
 
241,674
 
  
 
305,064
 
Unearned revenue
  
 
65,878
 
  
 
87,978
 
Interest payable
  
 
42,793
 
  
 
68,632
 
Current portion of long-term debt and other
  
 
13,134
 
  
 
14,992
 
    


  


Total current liabilities
  
 
710,998
 
  
 
921,414
 
Long-term debt and other
  
 
2,264,846
 
  
 
2,156,133
 
Commitments and contingencies
                 
Stockholders’ deficit:
                 
Preferred stock, $0.01 par value:
                 
Authorized shares—500,000
                 
Issued and outstanding shares—none
  
 
—  
 
  
 
—  
 
Common stock, $0.01 par value:
                 
Authorized shares—5,000,000
                 
Issued and outstanding shares—381,216 and 373,218 shares, respectively
  
 
3,812
 
  
 
3,732
 
Additional paid-in capital
  
 
1,550,118
 
  
 
1,462,769
 
Deferred stock-based compensation
  
 
(7,775
)
  
 
(9,853
)
Accumulated other comprehensive loss
  
 
(12,233
)
  
 
(36,070
)
Accumulated deficit
  
 
(3,012,361
)
  
 
(2,860,578
)
    


  


Total stockholders’ deficit
  
 
(1,478,439
)
  
 
(1,440,000
)
    


  


Total liabilities and stockholders’ deficit
  
$
1,497,405
 
  
$
1,637,547
 
    


  


 
See accompanying notes to consolidated financial statements.

1


Table of Contents
AMAZON.COM, INC.
 
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(Unaudited)
 
    
Three Months Ended
September 30,

    
Nine Months Ended
September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Net sales
  
$
851,299
 
  
$
639,281
 
  
$
2,504,326
 
  
$
2,007,262
 
Cost of sales
  
 
635,132
 
  
 
477,089
 
  
 
1,846,867
 
  
 
1,482,753
 
    


  


  


  


Gross profit
  
 
216,167
 
  
 
162,192
 
  
 
657,459
 
  
 
524,509
 
Operating expenses:
                                   
Fulfillment
  
 
90,342
 
  
 
81,400
 
  
 
265,908
 
  
 
265,231
 
Marketing
  
 
26,728
 
  
 
32,537
 
  
 
87,804
 
  
 
103,833
 
Technology and content
  
 
52,907
 
  
 
53,846
 
  
 
166,569
 
  
 
188,840
 
General and administrative
  
 
18,698
 
  
 
21,481
 
  
 
59,034
 
  
 
70,287
 
Stock-based compensation (1)
  
 
(832
)
  
 
(2,567
)
  
 
33,247
 
  
 
2,700
 
Amortization of goodwill and other intangibles
  
 
1,212
 
  
 
41,835
 
  
 
4,565
 
  
 
143,496
 
Restructuring-related and other
  
 
36,757
 
  
 
3,994
 
  
 
46,731
 
  
 
176,904
 
    


  


  


  


Total operating expenses
  
 
225,812
 
  
 
232,526
 
  
 
663,858
 
  
 
951,291
 
    


  


  


  


Loss from operations
  
 
(9,645
)
  
 
(70,334
)
  
 
(6,399
)
  
 
(426,782
)
Interest income
  
 
5,600
 
  
 
6,316
 
  
 
16,902
 
  
 
23,073
 
Interest expense
  
 
(35,922
)
  
 
(35,046
)
  
 
(106,817
)
  
 
(103,942
)
Other income (expense), net
  
 
3,183
 
  
 
(2,203
)
  
 
2,876
 
  
 
(7,265
)
Other gains (losses), net
  
 
2,261
 
  
 
(63,625
)
  
 
(55,677
)
  
 
(18,453
)
    


  


  


  


Total non-operating expenses, net
  
 
(24,878
)
  
 
(94,558
)
  
 
(142,716
)
  
 
(106,587
)
    


  


  


  


Loss before equity in losses of equity-method investees
  
 
(34,523
)
  
 
(164,892
)
  
 
(149,115
)
  
 
(533,369
)
Equity in losses of equity-method investees, net
  
 
(557
)
  
 
(4,982
)
  
 
(3,469
)
  
 
(28,472
)
    


  


  


  


Loss before change in accounting principle
  
 
(35,080
)
  
 
(169,874
)
  
 
(152,584
)
  
 
(561,841
)
Cumulative effect of change in accounting principle
  
 
—  
 
  
 
—  
 
  
 
801
 
  
 
(10,523
)
    


  


  


  


Net loss
  
$
(35,080
)
  
$
(169,874
)
  
$
(151,783
)
  
$
(572,364
)
    


  


  


  


Basic and diluted loss per share:
                                   
Prior to cumulative effect of change in accounting principle
  
$
(0.09
)
  
$
(0.46
)
  
$
(0.41
)
  
$
(1.55
)
Cumulative effect of change in accounting principle
  
 
—  
 
  
 
—  
 
  
 
0.01
 
  
 
(0.03
)
    


  


  


  


    
$
(0.09
)
  
$
(0.46
)
  
$
(0.40
)
  
$
(1.58
)
    


  


  


  


Shares used in computation of loss per share:
                                   
Basic and diluted
  
 
379,650
 
  
 
368,052
 
  
 
376,564
 
  
 
361,782
 
    


  


  


  


(1) Components of stock-based compensation:
                                   
Fulfillment
  
$
(98
)
  
$
(575
)
  
$
5,512
 
  
$
206
 
Marketing
  
 
115
 
  
 
(110
)
  
 
2,419
 
  
 
370
 
Technology and content
  
 
(765
)
  
 
(948
)
  
 
17,305
 
  
 
1,708
 
General and administrative
  
 
(84
)
  
 
(934
)
  
 
8,011
 
  
 
416
 
    


  


  


  


    
$
(832
)
  
$
(2,567
)
  
$
33,247
 
  
$
2,700
 
    


  


  


  


 
See accompanying notes to consolidated financial statements.
 

2


Table of Contents
 
AMAZON.COM, INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
    
Three Months Ended September 30,

    
Nine Months Ended September 30,

 
    
2002

    
2001

    
2002

    
2001

 
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
  
$
270,438
 
  
$
462,949
 
  
$
540,282
 
  
$
822,435
 
OPERATING ACTIVITIES:
                                   
Net loss
  
 
(35,080
)
  
 
(169,874
)
  
 
(151,783
)
  
 
(572,364
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
                                   
Depreciation of fixed assets and other amortization
  
 
20,501
 
  
 
19,795
 
  
 
62,411
 
  
 
63,662
 
Stock-based compensation
  
 
(832
)
  
 
(2,567
)
  
 
33,247
 
  
 
2,700
 
Equity in losses of equity-method investees, net
  
 
557
 
  
 
4,982
 
  
 
3,469
 
  
 
28,472
 
Amortization of goodwill and other intangibles
  
 
1,212
 
  
 
41,835
 
  
 
4,565
 
  
 
143,496
 
Non-cash restructuring-related and other
  
 
2,370
 
  
 
1,881
 
  
 
2,370
 
  
 
70,410
 
Gain on sale of marketable securities, net
  
 
(3,020
)
  
 
(1,351
)
  
 
(3,833
)
  
 
(1,137
)
Other losses (gains), net
  
 
(2,261
)
  
 
63,625
 
  
 
55,677
 
  
 
18,453
 
Non-cash interest expense and other
  
 
7,911
 
  
 
6,834
 
  
 
22,436
 
  
 
20,119
 
Cumulative effect of change in accounting principle
  
 
—  
 
  
 
—  
 
  
 
(801
)
  
 
10,523
 
Changes in operating assets and liabilities:
                                   
Inventories
  
 
(24,029
)
  
 
(659
)
  
 
(2,935
)
  
 
44,441
 
Prepaid expenses and other current assets
  
 
(14,670
)
  
 
2,960
 
  
 
(31,420
)
  
 
18,091
 
Accounts payable
  
 
49,408
 
  
 
(22,594
)
  
 
(106,296
)
  
 
(253,984
)
Accrued expenses and other current liabilities
  
 
40,895
 
  
 
(9,721
)
  
 
(37,455
)
  
 
(15,212
)
Unearned revenue
  
 
26,237
 
  
 
33,443
 
  
 
75,641
 
  
 
76,640
 
Amortization of previously unearned revenue
  
 
(29,487
)
  
 
(30,100
)
  
 
(97,741
)
  
 
(95,400
)
Interest payable
  
 
(1,604
)
  
 
(2,892
)
  
 
(25,840
)
  
 
(27,812
)
    


  


  


  


Net cash provided by (used in) operating activities
  
 
38,108
 
  
 
(64,403
)
  
 
(198,288
)
  
 
(468,902
)
INVESTING ACTIVITIES:
                                   
Sales and maturities of marketable securities and other investments
  
 
50,621
 
  
 
141,724
 
  
 
400,532
 
  
 
303,061
 
Purchases of marketable securities
  
 
(28,186
)
  
 
(223,817
)
  
 
(462,290
)
  
 
(280,938
)
Purchases of fixed assets, including internal-use software and Web site development
  
 
(11,353
)
  
 
(12,925
)
  
 
(23,647
)
  
 
(42,787
)
    


  


  


  


Net cash provided by (used in) investing activities
  
 
11,082
 
  
 
(95,018
)
  
 
(85,405
)
  
 
(20,664
)
FINANCING ACTIVITIES:
                                   
Proceeds from exercise of stock options and other
  
 
6,038
 
  
 
1,101
 
  
 
56,313
 
  
 
14,578
 
Proceeds from issuance of common stock, net of issuance costs
  
 
—  
 
  
 
99,831
 
  
 
—  
 
  
 
99,831
 
Proceeds from long-term debt and other
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
10,000
 
Repayment of capital lease obligations and other
  
 
(4,126
)
  
 
(6,466
)
  
 
(12,121
)
  
 
(15,135
)
    


  


  


  


Net cash provided by financing activities
  
 
1,912
 
  
 
94,466
 
  
 
44,192
 
  
 
109,274
 
Effect of exchange-rate changes on cash and cash equivalents
  
 
6,024
 
  
 
34,313
 
  
 
26,783
 
  
 
(9,836
)
    


  


  


  


Net increase (decrease) in cash and cash equivalents
  
 
57,126
 
  
 
(30,642
)
  
 
(212,718
)
  
 
(390,128
)
    


  


  


  


CASH AND CASH EQUIVALENTS, END OF PERIOD
  
$
327,564
 
  
$
432,307
 
  
$
327,564
 
  
$
432,307
 
    


  


  


  


SUPPLEMENTAL CASH FLOW INFORMATION:
                                   
Fixed assets acquired under capital leases
  
$
162
 
  
$
2,014
 
  
$
2,297
 
  
$
4,483
 
Equity securities received for commercial agreements
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
331
 
Cash paid for interest
  
 
29,898
 
  
 
30,275
 
  
 
110,947
 
  
 
110,990
 
 
See accompanying notes to consolidated financial statements.

3


Table of Contents
AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
September 30, 2002
 
Note 1.    ACCOUNTING POLICIES
 
Unaudited Interim Financial Information
 
The accompanying consolidated financial statements have been prepared by Amazon.com, Inc. (“Amazon.com” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. These consolidated financial statements are unaudited and, in the opinion of management, include all adjustments, consisting of normal recurring adjustments and accruals, as well as the accounting changes to adopt Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets,” necessary for a fair presentation of the consolidated balance sheets, operating results, and cash flows for the periods presented. Operating results for the three and nine months ended September 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002 due to seasonal and other factors. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been omitted in accordance with the rules and regulations of the SEC. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001. Certain prior period amounts have been reclassified to conform to the current period presentation.
 
Loss Per Share
 
The weighted average number of shares used in calculating loss per share for the three month and nine month periods ended September 30, 2002 and 2001 was reduced by 1 million for each period. These reductions reflect the weighted average number of outstanding shares subject to repurchase or forfeiture for the corresponding periods. The effects of outstanding stock options are antidilutive and, accordingly, are excluded from diluted loss per share.
 
Revenues
 
Product sales, net of promotional gift certificates and return allowances, are recorded when the products are shipped and title passes to customers. Retail items sold to customers are made pursuant to a sales contract that provides for transfer of both title and risk of loss upon the Company’s delivery to the carrier (commonly referred to as “F.O.B. Shipping Point”). Return allowances (which reduce product revenue by the Company’s best estimate of expected product returns) are estimated using historical experience.
 
Amounts billed to customers for outbound shipping charges are included in net sales and were $73 million and $74 million for the three months ended September 30, 2002 and 2001, respectively, and $244 million and $232 million for the nine months ended September 30, 2002 and 2001, respectively.
 
Technology and Content
 
Technology and content costs are expensed as incurred, except for certain costs relating to the development of internal-use software, including upgrades and enhancements to the Company’s Web sites, that are capitalized and depreciated over their useful lives, which are generally two years.

4


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
Accounting Changes
 
Change in Accounting for Inventory Costing
 
Effective January 1, 2002, the Company prospectively changed its inventory costing method to the first-in first-out (“FIFO”) method of accounting. This change resulted in a cumulative increase in inventory of $0.8 million, with a corresponding amount recorded to “Cumulative effect of change in accounting principle” on the consolidated statements of operations. The Company has evaluated the effect of the change on each quarter of 2001 and determined such effect to be less than $1.2 million individually and in the aggregate. The Company has determined this change to be preferable under accounting principles generally accepted in the United States since, among other reasons, it facilitates the Company’s record keeping process, significantly improves its ability to provide cost-efficient fulfillment services to third-party companies as part of its services offering, and results in increased consistency with others in the industry. The Company has received a letter of preferability for this change in inventory costing from its independent auditors.
 
In accordance with Accounting Principles Board Opinion No. 20, Accounting Changes, the effect of this accounting change is reflected prospectively. Supplemental comparative disclosure, as if the change had been retroactively applied to the prior year periods, is as follows (in thousands, except per share amounts):
 
    
Three Months Ended September 30,

    
Nine Months Ended September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Net loss:
                                   
Reported net loss
  
$
(35,080
)
  
$
(169,874
)
  
$
(151,783
)
  
$
(572,364
)
Inventory costing change
  
 
—  
 
  
 
1,162
 
  
 
(801
)
  
 
913
 
    


  


  


  


Adjusted net loss
  
$
(35,080
)
  
$
(168,712
)
  
$
(152,584
)
  
$
(571,451
)
    


  


  


  


Basic and diluted loss per share:
                                   
Reported loss per share
  
$
(0.09
)
  
$
(0.46
)
  
$
(0.40
)
  
$
(1.58
)
Inventory costing change
  
 
—  
 
  
 
—  
 
  
 
(0.01
)
  
 
—  
 
    


  


  


  


Adjusted basic and diluted loss per share
  
$
(0.09
)
  
$
(0.46
)
  
$
(0.41
)
  
$
(1.58
)
    


  


  


  


 
Change in Accounting for Goodwill and Certain Other Intangibles
 
Effective July 1, 2001, the Company adopted certain provisions of SFAS No. 141, and effective January 1, 2002, the Company adopted the full provisions of SFAS No. 141 and SFAS No. 142. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting, and broadens the criteria for recording intangible assets apart from goodwill. The Company evaluated its goodwill and intangibles acquired prior to June 30, 2001 using the criteria of SFAS No. 141, which resulted in $25 million of other intangibles (comprised entirely of assembled workforce intangibles) being subsumed into goodwill at January 1, 2002. SFAS No. 142 requires that purchased goodwill and certain indefinite-lived intangibles no longer be amortized, but instead be tested for impairment at least annually. The Company evaluated its intangible assets, as noted below, and determined that all such assets have determinable lives.
 
SFAS No. 142 prescribes a two-phase process for impairment testing of goodwill. The first phase screens for impairment; while the second phase (if necessary) measures the impairment. The Company completed its first

5


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

phase impairment analysis during the first quarter of 2002 and found no instances of impairment of its recorded goodwill; accordingly, the second testing phase was not necessary. No subsequent indicators of impairment have been noted by the Company.
 
In accordance with SFAS No. 142, the effect of this accounting change is reflected prospectively. Supplemental comparative disclosure, as if the change had been retroactively applied to the prior year periods, is as follows (in thousands, except per share amounts):
 
    
Three Months Ended
September 30,

    
Nine Months Ended
September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Net loss:
                                   
Reported net loss
  
$
(35,080
)
  
$
(169,874
)
  
$
(151,783
)
  
$
(572,364
)
Goodwill amortization (1)
  
 
—  
 
  
 
39,692
 
  
 
—  
 
  
 
136,932
 
    


  


  


  


Adjusted net loss
  
$
(35,080
)
  
$
(130,182
)
  
$
(151,783
)
  
$
(435,432
)
    


  


  


  


Basic and diluted loss per share:
                                   
Reported loss per share
  
$
(0.09
)
  
$
(0.46
)
  
$
(0.40
)
  
$
(1.58
)
Goodwill amortization (1)
  
 
—  
 
  
 
0.11
 
  
 
—  
 
  
 
0.38
 
    


  


  


  


Adjusted basic and diluted loss per share
  
$
(0.09
)
  
$
(0.35
)
  
$
(0.40
)
  
$
(1.20
)
    


  


  


  



(1)
 
Includes $13 million and $41 million, or $0.04 and $0.11 per share, for the three months and nine months ended September 30, 2001, respectively, related to amortization of other intangibles that are classified as goodwill effective January 1, 2002.
 
For the three months and nine months ended September 30, 2002, no goodwill or other intangibles were acquired, impaired, or disposed.
 
Other intangibles consisted of the following (in thousands):
 
    
September 30, 2002

  
December 31, 2001

    
Gross Carrying Amount

  
Accumulated Amortization

    
Other Intangibles, Net

  
Gross Carrying Amount

  
Accumulated Amortization

    
Other Intangibles, Net

Contract-based
  
$
16,584
  
$
(13,711
)
  
$
2,873
  
$
16,584
  
$
(11,170
)
  
$
5,414
Marketing-related
  
 
5,617
  
 
(4,930
)
  
 
687
  
 
5,617
  
 
(3,793
)
  
 
1,824
Technology-based
  
 
4,386
  
 
(4,324
)
  
 
62
  
 
4,386
  
 
(3,808
)
  
 
578
Customer-related
  
 
2,021
  
 
(1,270
)
  
 
751
  
 
2,021
  
 
(899
)
  
 
1,122
Assembled workforce (1)
  
 
—  
  
 
—  
 
  
 
—  
  
 
193,271
  
 
(167,827
)
  
 
25,444
    

  


  

  

  


  

Other intangibles
  
$
28,608
  
$
(24,235
)
  
$
4,373
  
$
221,879
  
$
(187,497
)
  
$
34,382
    

  


  

  

  


  


(1)
 
As of January 1, 2002, in accordance with SFAS No. 142, the Company reclassified its assembled workforce intangibles into goodwill.
 
The net carrying amount of intangible assets at September 30, 2002 is scheduled to be fully amortized by the end of fiscal 2004. Amortization expense for the net carrying amount of intangible assets at September 30, 2002

6


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

is estimated to be $1 million for the remainder of fiscal 2002, $3 million in fiscal 2003, and less than $1 million in fiscal 2004.
 
Change in Accounting for Derivative Instruments
 
Effective January 1, 2001, the Company adopted SFAS No. 133, which requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current results of operations or other comprehensive income (loss) depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction.
 
The adoption of SFAS No. 133 resulted in the reporting of cumulative transition losses of $11 million in the results of operations and $12 million as a stockholders’ deficit adjustment during the first quarter 2001.
 
Note 2.    MARKETABLE SECURITIES
 
Marketable securities, at fair value, consist of the following (in thousands):
 
    
September 30, 2002

  
December 31, 2001

Certificates of deposit
  
$
20,727
  
$
18,159
Commercial paper and short-term obligations
  
 
37,281
  
 
28,622
Corporate notes and bonds
  
 
16,963
  
 
37,602
Asset-backed and agency securities
  
 
327,561
  
 
232,821
Treasury notes and bonds
  
 
132,557
  
 
125,947
Equity securities
  
 
3,149
  
 
13,152
    

  

    
$
538,238
  
$
456,303
    

  

 
The Company has pledged a portion of its marketable securities as collateral for certain of its contractual obligations. See Note 8 of these “Notes to Consolidated Financial Statements.”
 
Note 3.    UNEARNED REVENUE
 
During the nine months ended September 30, 2002, activity in unearned revenue was as follows (in thousands):
 
Balance, December 31, 2001
  
$
87,978
 
Cash received or accounts receivable
  
 
75,641
 
Amortization to revenue
  
 
(97,741
)
    


Balance, September 30, 2002
  
$
65,878
 
    


 
All amounts recorded as accounts receivable, including amounts associated with unearned or deferred revenue, are legally due and contractually enforceable. At September 30, 2002 and December 31, 2001, accounts receivable (included in “Prepaid expenses and other current assets” on the consolidated balance sheets) associated with unearned revenue were $6 million and $1 million, respectively.

7


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
Note 4.    STOCK-BASED COMPENSATION
 
During the first quarter of 2001, the Company offered a limited non-compulsory exchange of employee stock options. The exchange resulted in the voluntary cancellation of employee stock options to purchase 31 million shares of common stock with varying exercise prices in exchange for 12 million employee stock options with an exercise price of $13.375. The option exchange offer resulted in variable accounting treatment for, at the time of the exchange, approximately 15 million stock options, which includes options granted under the exchange offer and 3 million options, with a weighted average exercise price of $52.41, that were subject to the exchange offer but were not exchanged. Variable accounting will continue until all options subject to variable accounting treatment are exercised, cancelled, or expired. At September 30, 2002, approximately 8 million shares remain under variable accounting treatment, which includes 7 million options granted under the exchange offer and 1 million options, with a weighted average exercise price of $42.68, that were subject to the exchange offer but were not exchanged. Variable accounting treatment will result in unpredictable charges or credits, recorded to “Stock-based compensation,” dependent on fluctuations in quoted prices for the Company’s common stock.
 
Stock-based compensation includes stock-based charges resulting from variable accounting treatment, option-related deferred compensation recorded at the Company’s initial public offering, as well as certain other compensation and severance arrangements. Stock-based compensation also includes the portion of acquisition-related consideration conditioned on the continued tenure of key employees of certain acquired businesses, which must be classified as compensation expense rather than as a component of purchase price under accounting principles generally accepted in the United States. Additionally, stock-based compensation will include amounts associated with the Company’s planned restricted stock unit program. Under this program, the Company will, commencing in the fourth quarter of 2002, award restricted stock units as its primary vehicle for employee equity compensation. Restricted stock units are measured at fair value on the date of grant based on the number of shares granted and the quoted price of the Company’s common stock. Such value is recognized as an expense ratably over the corresponding service period. To the extent restricted stock units are forfeited prior to vesting, the corresponding previously recognized expense is reversed as an offset to “Stock-based compensation.”
 
Stock-based compensation was a credit of $1 million and a credit of $3 million for the three months ended September 30, 2002 and 2001, respectively, and an expense of $33 million and an expense of $3 million for the nine months ended September 30, 2002 and 2001, respectively. As the quoted price of the Company’s common stock at September 30, 2002 was below the quoted price at June 30, 2002, previously recorded variable accounting charges were partially reversed. However, these reversed charges were partially offset by costs associated with exercises of vested options and costs associated with incremental vesting during the period. As of September 30, 2002, cumulative compensation expense associated with variable accounting treatment was $29 million, of which $12 million was associated with options exercised.
 
The number of shares of common stock subject to outstanding vested and unvested employee stock options was approximately 48 million and 66 million, or 13% and 18% of the Company’s outstanding common stock, at September 30, 2002 and December 31, 2001, respectively.
 
Note 5.    RESTRUCTURING-RELATED AND OTHER
 
Restructuring-related and other expenses were $37 million and $4 million for the three months ended September 30, 2002 and 2001, respectively, and $47 million and $177 million for the nine months ended September 30, 2002 and 2001, respectively. In the first quarter of 2001, the Company announced and began implementation of its operational restructuring plan to reduce operating costs, streamline its organizational

8


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

structure, consolidate certain of its fulfillment and customer service operations, and migrate a large portion of its technology infrastructure to a new operating platform. This initiative involved the reduction of employee staff by 1,327 positions throughout the Company in managerial, professional, clerical, technical, and fulfillment roles; consolidation of its Seattle, Washington corporate office locations; closure of its McDonough, Georgia fulfillment center; seasonal operation of its Seattle, Washington fulfillment center; closure of its customer service centers in Seattle, Washington and The Hague, Netherlands; and migration of a large portion of the Company’s technology infrastructure to a new operating platform, which entails ongoing lease obligations for technology infrastructure no longer being utilized. Actual employee termination benefits paid were $12 million. Each component of the restructuring plan is complete, however, as discussed below, the Company may adjust its restructuring-related estimates, if necessary (See Note 8—”Commitments and Contingencies”).
 
In the third quarter of 2002, related to its January 2001 operational restructuring, the Company recorded an additional restructuring-related expense of $37 million associated with ongoing lease obligations relating to vacated office and fulfillment center space and other costs, including revised sublease income estimates to reflect current information and higher-than-expected tenant improvement costs necessary to sublease vacated space. The Company revised its restructuring-related expense estimate due to a number of factors, primarily related to weakness in the real estate markets in Seattle, Washington and Atlanta, Georgia. In addition, during the first quarter 2002, the Company permanently closed its fulfillment center in Seattle, Washington and revised its sublease income estimates for office space vacated as part of the restructuring, resulting in additional restructuring-related expenses of $10 million primarily associated with ongoing lease obligations.
 
Restructuring-related charges were as follows (in thousands):
 
    
Three Months Ended September 30,

  
Nine Months Ended September 30,

    
2002

  
2001

  
2002

  
2001

Asset impairments
  
$
—  
  
$
1,852
  
$
—  
  
$
67,825
Continuing lease obligations
  
 
36,757
  
 
1,275
  
 
45,835
  
 
85,280
Termination benefits
  
 
—  
  
 
694
  
 
—  
  
 
15,455
Broker commissions, professional fees, and other miscellaneous restructuring costs
  
 
—  
  
 
173
  
 
896
  
 
8,344
    

  

  

  

    
$
36,757
  
$
3,994
  
$
46,731
  
$
176,904
    

  

  

  

 
At September 30, 2002, the accrued liability associated with restructuring-related and other charges was $74 million and consisted of the following (in thousands):
 
    
Balance at December 31, 2001

  
Subsequent Accruals, Net

  
Payments

    
Balance at September 30, 2002

  
Due Within 12 Months

  
Due After 12 Months

Lease obligations, net of estimated sublease income (See Note 8)
  
$
53,187
  
$
45,835
  
$
(30,935
)
  
$
68,087
  
$
19,005
  
$
49,082
Termination benefits
  
 
61
  
 
—  
  
 
(61
)
  
 
—  
  
 
—  
  
 
—  
Broker commissions, professional fees, and other miscellaneous restructuring costs
  
 
8,190
  
 
896
  
 
(3,393
)
  
 
5,693
  
 
—  
  
 
5,693
    

  

  


  

  

  

    
$
61,438
  
$
46,731
  
$
(34,389
)
  
$
73,780
  
$
19,005
  
$
54,775
    

  

  


  

  

  

9


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
Note 6.    OTHER INCOME (EXPENSE), NET
 
Other income (expense), net consisted of the following (in thousands):
 
    
Three Months Ended September 30,

    
Nine Months Ended September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Gains (losses) on sale of marketable securities, net
  
$
3,020
 
  
$
1,351
 
  
$
3,833
 
  
$
1,137
 
Foreign-currency transaction gains (losses), net
  
 
(360
)
  
 
(1,150
)
  
 
(411
)
  
 
(2,532
)
Gains (losses) on disposal of fixed assets, net
  
 
47
 
  
 
4
 
  
 
(567
)
  
 
(83
)
Miscellaneous state, foreign, and other taxes
  
 
(274
)
  
 
(1,338
)
  
 
(617
)
  
 
(5,834
)
Other miscellaneous gains (losses), net
  
 
750
 
  
 
(1,070
)
  
 
638
 
  
 
47
 
    


  


  


  


    
$
3,183
 
  
$
(2,203
)
  
$
2,876
 
  
$
(7,265
)
    


  


  


  


 
Note 7.    OTHER GAINS (LOSSES), NET
 
Other gains (losses), net consisted of the following (in thousands):
 
    
Three Months Ended September 30,

    
Nine Months Ended September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Foreign-currency gains (losses) on 6.875% PEACS
  
$
123
 
  
$
(39,572
)
  
$
(64,637
)
  
$
29,118
 
Gains (losses) on sale of Euro-denominated investments, net
  
 
—  
 
  
 
(16,332
)
  
 
2,227
 
  
 
(22,548
)
Other-than-temporary impairment losses on equity investments
  
 
—  
 
  
 
(2,382
)
  
 
(5,362
)
  
 
(43,408
)
Gains (losses) on sale of equity investments, net
  
 
2,236
 
  
 
—  
 
  
 
12,339
 
  
 
—  
 
Contract termination, Kozmo.com
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
22,400
 
Warrant remeasurements and other
  
 
(98
)
  
 
(5,339
)
  
 
(244
)
  
 
(4,015
)
    


  


  


  


    
$
2,261
 
  
$
(63,625
)
  
$
(55,677
)
  
$
(18,453
)
    


  


  


  


 
Currency gains and losses arising from the remeasurement of the 6.875% Convertible Subordinated Notes due 2010 (“6.875% PEACS”) principal from Euros to U.S. dollars each period are recorded to “Other gains (losses), net.”
 
The Company holds warrants to purchase equity securities of other companies. Warrants that can be exercised and settled by delivery of net shares such that the Company pays no cash upon exercise are deemed derivative financial instruments under the provisions of SFAS No. 133. Such warrants are not designated as hedging instruments; accordingly, gains or losses resulting from changes in fair value are recognized on the consolidated statements of operations in the period of change.

10


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
Note 8.    COMMITMENTS AND CONTINGENCIES
 
Commitments
 
The Company currently leases office and fulfillment center facilities and fixed assets under non-cancelable operating and capital leases. Rental expense under operating lease agreements was $13 million and $16 million for the three months ended September 30, 2002 and 2001, respectively, and $43 million and $66 million for the nine months ended September 30, 2002 and 2001, respectively.
 
Contractual commitments associated with the Company’s operational restructuring, indebtedness, lease obligations, and marketing agreements are as follows (in thousands):
 
      
Three Months Ending December 31, 2002

  
Year Ending December 31,

  
Thereafter

  
Total

         
2003

  
2004

  
2005

  
2006

     
Restructuring-related commitments:
                                                  
Operating leases, net of estimated sublease income
    
$
6,235
  
$
16,170
  
$
14,581
  
$
7,903
  
$
5,326
  
$
17,872
  
$
68,087
Other
    
 
—  
  
 
1,580
  
 
1,000
  
 
3,113
  
 
—  
  
 
—  
  
 
5,693
      

  

  

  

  

  

  

Restructuring-related commitments
    
 
6,235
  
 
17,750
  
 
15,581
  
 
11,016
  
 
5,326
  
 
17,872
  
 
73,780
      

  

  

  

  

  

  

Other commitments:
                                                  
Debt principal and other (1)
    
 
1,196
  
 
4,962
  
 
2,004
  
 
74
  
 
—  
  
 
2,188,229
  
 
2,196,465
Debt interest (1)
    
 
—  
  
 
124,871
  
 
138,074
  
 
138,074
  
 
138,074
  
 
397,234
  
 
936,327
Capital leases
    
 
2,559
  
 
7,555
  
 
624
  
 
—  
  
 
—  
  
 
—  
  
 
10,738
Operating leases
    
 
17,767
  
 
54,640
  
 
44,765
  
 
38,188
  
 
38,457
  
 
177,050
  
 
370,867
Marketing agreements
    
 
5,311
  
 
4,942
  
 
45
  
 
—  
  
 
—  
  
 
—  
  
 
10,298
      

  

  

  

  

  

  

Other commitments
    
 
26,833
  
 
196,970
  
 
185,512
  
 
176,336
  
 
176,531
  
 
2,762,513
  
 
3,524,695
      

  

  

  

  

  

  

Total commitments
    
$
33,068
  
$
214,720
  
$
201,093
  
$
187,352
  
$
181,857
  
$
2,780,385
  
$
3,598,475
      

  

  

  

  

  

  


(1)
 
Principal and interest payments due under the Company’s 6.875% PEACS, excluding those payments with a fixed exchange ratio under the currency swap hedge arrangement, will fluctuate based on the Euro/U.S. dollar exchange ratio.
 
Long-term capital lease obligations are as follows (in thousands):
 
      
September 30, 2002

 
Gross capital lease obligations
    
$
10,738
 
Less imputed interest
    
 
(814
)
      


Present value of net minimum lease payments
    
 
9,924
 
Less current portion
    
 
(8,613
)
      


Long-term capital lease obligations
    
$
1,311
 
      


11


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
Restructuring-related lease obligations are as follows (in thousands):
 
    
Three Months Ending December 31, 2002

   
Years Ending December 31,

   
Thereafter

   
Total

 
      
2003

   
2004

   
2005

   
2006

     
Gross lease obligations
  
$
6,614
 
 
$
17,868
 
 
$
18,050
 
 
$
14,781
 
 
$
13,677
 
 
$
50,382
 
 
$
121,372
 
Estimated sublease income (1)
  
 
(379
)
 
 
(1,698
)
 
 
(3,469
)
 
 
(6,878
)
 
 
(8,351
)
 
 
(32,510
)
 
 
(53,285
)
    


 


 


 


 


 


 


Lease obligations, net
  
$
6,235
 
 
$
16,170
 
 
$
14,581
 
 
$
7,903
 
 
$
5,326
 
 
$
17,872
 
 
$
68,087
 
    


 


 


 


 


 


 



(1)
 
At September 30, 2002, the Company had signed contractual sublease agreements covering $11 million in future payments.
 
Pledged Securities
 
The Company has pledged a portion of its marketable securities as collateral for standby letters of credit that guarantee certain of its contractual obligations, a majority of which relates to property leases; the swap agreement that hedges the foreign-exchange rate risk on a portion of its 6.875% PEACS; and some of its real estate lease agreements. The amount of marketable securities the Company is required to pledge pursuant to the swap agreement fluctuates with the fair market value of the swap obligation. The change in the amount of collateral pledged under these agreements was as follows (in thousands):
 
    
Standby Letters of Credit

    
Swap Agreement

    
Real Estate Leases

    
Total

 
Balance at December 31, 2001
  
$
77,635
 
  
$
48,498
 
  
$
40,657
 
  
$
166,790
 
Net change in collateral pledged
  
 
(19,402
)
  
 
(12,153
)
  
 
(578
)
  
 
(32,133
)
    


  


  


  


Balance at September 30, 2002
  
$
58,233
 
  
$
36,345
 
  
$
40,079
 
  
$
134,657
 
    


  


  


  


 
Legal Proceedings
 
On April 12, 2001, the Company received a request from the SEC staff for the voluntary production of documents and information concerning, among other things, previously reported sales of the Company’s common stock by its Chairman and Chief Executive Officer, Jeffrey Bezos, on February 2 and 5, 2001. The Company is cooperating with the SEC staff’s continuing inquiry.
 
A number of purported class action complaints were filed by holders of Amazon.com equity and debt securities against the Company, its directors and certain of its senior officers during 2001, in the United States District Court for the Western District of Washington, alleging violations of the Securities Act of 1933 (the “1933 Act”) and/or the Securities Exchange Act of 1934 (the “1934 Act”). On October 5, 2001, plaintiffs in the 1934 Act cases filed a consolidated amended complaint alleging that the Company, together with certain of its officers and directors and certain third-parties, made false or misleading statements during the period from October 29, 1998 through July 23, 2001 concerning the Company’s business, financial condition and results, inventories, future prospects, and strategic alliance transactions. The 1933 Act complaint alleges that the defendants made false or misleading statements in connection with the Company’s February 2000 offering of the 6.875% PEACS. The complaints seek recissionary and/or compensatory damages and injunctive relief against all defendants. The Company disputes the allegations of wrongdoing in these complaints and intends to vigorously defend itself in these matters.

12


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
On August 28, 2002, the Trustee for the Creditors’ Trust for Living.com instituted an adversary proceeding against a subsidiary of the Company in the United States Bankruptcy Court for the Western District of Texas. The plaintiff alleges that Living.com’s creditors are entitled to a contractual recovery of approximately $58 million in fees that Living.com had previously paid in 2000 primarily by issuing Living.com stock to the Company. The Company disputes the plaintiff’s allegations and intends to vigorously defend itself in this matter.
 
Depending on the amount and the timing, an unfavorable resolution of some or all of these matters could materially affect the Company’s business, future results of operations, financial position, or cash flows in a particular period.
 
From time to time, the Company is subject to other legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks, copyrights, patents, and other intellectual property rights. The Company currently is not aware of any such legal proceedings or claims that management believes will have, individually or in the aggregate, a material adverse effect on the Company’s business, financial condition or operating results.
 
Inventory Suppliers
 
During the nine months ended September 30, 2002, approximately 20% of all inventory purchases were made from two major vendors, of which Ingram Book Group accounted for over 10% of all inventory purchases. No other vendor exceeded 10% of all inventory purchases during this period. The Company does not have long-term contracts or arrangements with most of its vendors to guarantee the availability of merchandise, particular payment terms, or the extension of credit limits.
 
Note 9.    COMPREHENSIVE LOSS
 
The components of comprehensive loss were as follows (in thousands):
 
    
Three Months Ended
September 30,

    
Nine Months Ended
September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Net loss
  
$
(35,080
)
  
$
(169,874
)
  
$
(151,783
)
  
$
(572,364
)
Other comprehensive income (loss):
                                   
Foreign currency translation gains (losses), net
  
 
1,408
 
  
 
1,292
 
  
 
9,831
 
  
 
(89
)
Net unrealized gains on available-for-sale securities
  
 
1,613
 
  
 
56,740
 
  
 
12,462
 
  
 
7,780
 
Net unrealized gains (losses) on Euro-based currency swap
  
 
(7,658
)
  
 
(10,620
)
  
 
1,544
 
  
 
(19,644
)
Reclassification of currency gains on 6.875% PEACS
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
(9,811
)
Cumulative effect of accounting change to adopt SFAS No. 133
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
(12,294
)
    


  


  


  


Other comprehensive income (loss)
  
 
(4,637
)
  
 
47,412
 
  
 
23,837
 
  
 
(34,058
)
    


  


  


  


Comprehensive loss
  
$
(39,717
)
  
$
(122,462
)
  
$
(127,946
)
  
$
(606,422
)
    


  


  


  


13


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
Activity in other comprehensive income (loss) relating to the Euro-based currency swap was as follows (in thousands):
 
    
Three Months Ended September 30,

    
Nine Months Ended
September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Remeasurement of swap to fair value
  
$
(7,673
)
  
$
(5,794
)
  
$
9,426
 
  
$
(22,040
)
Reclassification of losses (gains) to offset currency gains and losses on hedged portion of 6.875% PEACS included in net loss
  
 
15
 
  
 
(4,826
)
  
 
(7,882
)
  
 
2,396
 
    


  


  


  


    
$
(7,658
)
  
$
(10,620
)
  
$
1,544
 
  
$
(19,644
)
    


  


  


  


 
The Company is not able to predict future gains or losses due to the remeasurement of the hedged portion of the 6.875% PEACS and equivalent reclassifications of losses or gains on the swap contract from accumulated other comprehensive loss to earnings.
 
Note 10.    SEGMENT INFORMATION
 
The Company presents information to its chief operating decision maker in four segments: North America Books, Music, and DVD/Video (“BMVD”); North America Electronics, Tools, and Kitchen (“ETK”); International; and Services. Accordingly, the Company discloses its segment financial information along these lines.
 
BMVD Segment
 
The BMVD segment includes revenues, direct costs, and cost allocations associated with retail sales from www.amazon.com and www.amazon.ca for books, music, and DVD/video products and for magazine subscription commissions. This segment also includes commissions from sales of these products through Amazon Marketplace, and revenues from stores offering these products through the Company’s Syndicated Stores Program (where the Company operates a co-branded e-commerce Web site under a third-party seller’s name and URL, which utilizes the Company’s e-commerce features and technology and sells the Company’s products), such as www.borders.com. This segment also includes amounts earned from offerings of these products by third-party sellers (such as magazine subscriptions) through the Company’s Merchant@amazon.com Program (where a third-party seller offers its products for sale on the Company’s Web site in the Company’s retail stores or in a co-branded store, or both).
 
ETK Segment
 
The ETK segment includes revenues, direct costs, and cost allocations associated with www.amazon.com retail sales of electronics, home improvement, and home and garden products, as well as the Company’s catalog sales of tools and toys. This segment also includes commissions earned from sales of these products through Amazon Marketplace on www.amazon.com and amounts earned from offerings of these products by third-party sellers under our Merchant@amazon.com Program, including J&R Electronics, and will include revenues from stores offering these products, if any, through the Syndicated Stores Program.

14


Table of Contents

AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
International Segment
 
The International segment includes all revenues, direct costs, and cost allocations associated with the retail sales of the following internationally-focused Web sites of the Company: www.amazon.co.uk, www.amazon.de, www.amazon.fr and www.amazon.co.jp. These international sites share a common Amazon experience, but are localized in terms of language, products, customer service, and fulfillment. To the extent available on these sites, this segment includes commissions and other amounts earned from sales of products through Amazon Marketplace and revenues from stores offering products through the Company’s internationally-focused Syndicated Stores Program, such as www.waterstones.co.uk, and will include other amounts earned from sales of products by third-party sellers through the Company’s Merchant@amazon.com Program. Export sales from www.amazon.com, and www.amazon.ca are not included in the International segment. Operating results for the International segment are affected by movements in currency exchange rates. During the three months and nine months ended September 30, 2002, International segment revenues improved $22 million and $12 million, respectively, and operating results improved $1 million for each respective period in comparison to the prior year due to changes in currency exchange rates. If currency rates had remained constant with the same period in the prior year, the International segment’s very slight operating profit would have been a very slight operating loss for the three months ended September 30, 2002.
 
Services Segment
 
The Services segment includes revenues, direct costs, and cost allocations associated with the Company’s business-to-business commercial agreements, including the Merchant Program (where the Company operates a third-party seller’s e-commerce Web site under the third-party seller’s name and URL, which utilizes the Company’s e-commerce services, features and technology, and sells the third-party seller’s products), such as www.target.com, and to the extent full product categories are not also offered by the Company through its online retail stores, the Merchant@amazon.com Program, as well as miscellaneous marketing, promotional, and other agreements.
 
Included in Services segment revenues are equity-based service revenues of $2 million and $5 million for the three months ended September 30, 2002 and 2001, respectively, and $12 million and $22 million for the nine months ended September 30, 2002 and 2001, respectively.
 
Stock-based compensation, amortization of goodwill and other intangibles, and restructuring-related and other costs are not allocated to segment results. All other centrally-incurred operating costs are fully allocated to segment results. There are no internal transactions between the Company’s reporting segments.
 
The Company measures the results of operations of its reportable segments using a pro forma measure. Pro forma results from operations, which exclude stock-based compensation, amortization of goodwill and other intangibles, and restructuring-related and other charges, are not in conformity with accounting principles generally accepted in the United States.

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AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
Information on reportable segments and reconciliation to consolidated net loss is as follows:
 
Three Months Ended September 30, 2002:
 
    
North America

  
International

  
Services

  
Consolidated

 
    
Books, Music, and DVD/Video

  
Electronics, Tools, and Kitchen

    
Total

        
Net sales
  
$
412,428
  
$
128,516
 
  
$
540,944
  
$
263,540
  
$
46,815
  
$
851,299
 
Gross profit
  
 
116,458
  
 
13,027
 
  
 
129,485
  
 
60,728
  
 
25,954
  
 
216,167
 
Pro forma income (loss) from operations
  
 
43,102
  
 
(24,071
)
  
 
19,031
  
 
819
  
 
7,642
  
 
27,492
 
Stock-based compensation
                                       
 
832
 
Amortization of other intangibles
                                       
 
(1,212
)
Restructuring-related and other
                                       
 
(36,757
)
Total non-operating expenses, net
                                       
 
(24,878
)
Equity in losses of equity-method investees, net
                                       
 
(557
)
                                         


Net loss
                                       
$
(35,080
)
                                         


 
Three Months Ended September 30, 2001:
 
    
North America

    
International

    
Services

  
Consolidated

 
    
Books, Music, and DVD/Video

  
Electronics, Tools, and Kitchen

    
Total

          
Net sales
  
$
351,431
  
$
103,112
 
  
$
454,543
 
  
$
138,491
 
  
$
46,247
  
$
639,281
 
Gross profit
  
 
93,354
  
 
13,327
 
  
 
106,681
 
  
 
28,163
 
  
 
27,348
  
 
162,192
 
Pro forma income (loss) from operations
  
 
26,223
  
 
(33,107
)
  
 
(6,884
)
  
 
(28,000
)
  
 
7,812
  
 
(27,072
)
Stock-based compensation
                                           
 
2,567
 
Amortization of goodwill and other intangibles
                                           
 
(41,835
)
Restructuring-related and other
                                           
 
(3,994
)
Total non-operating expenses, net
                                           
 
(94,558
)
Equity in losses of equity-method investees, net
                                           
 
(4,982
)
                                             


Net loss
                                           
$
(169,874
)
                                             


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AMAZON.COM, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(Unaudited)
September 30, 2002

 
Nine Months Ended September 30, 2002:
 
    
North America

  
International

    
Services

  
Consolidated

 
    
Books, Music, and DVD/Video

  
Electronics, Tools, and Kitchen

    
Total

        
Net sales
  
$
1,267,193
  
$
383,150
 
  
$
1,650,343
  
$
707,517
 
  
$
146,466
  
$
2,504,326
 
Gross profit
  
 
363,266
  
 
50,968
 
  
 
414,234
  
 
157,101
 
  
 
86,124
  
 
657,459
 
Pro forma income (loss) from operations
  
 
138,558
  
 
(63,325
)
  
 
75,233
  
 
(20,632
)
  
 
23,543
  
 
78,144
 
Stock-based compensation
                                         
 
(33,247
)
Amortization of other intangibles
                                         
 
(4,565
)
Restructuring-related and other
                                         
 
(46,731
)
Total non-operating expenses, net
                                         
 
(142,716
)
Equity in losses of equity-method investees, net
                                         
 
(3,469
)
Cumulative effect of change in accounting principle
                                         
 
801
 
                                           


Net loss
                                         
$
(151,783
)
                                           


 
Nine Months Ended September 30, 2001:
 
    
North America

    
International

    
Services

  
Consolidated

 
    
Books, Music, and DVD/Video

  
Electronics, Tools, and Kitchen

    
Total

          
Net sales
  
$
1,150,740
  
$
330,576
 
  
$
1,481,316
 
  
$
398,942
 
  
$
127,004
  
$
2,007,262
 
Gross profit
  
 
313,317
  
 
43,706
 
  
 
357,023
 
  
 
85,578
 
  
 
81,908
  
 
524,509
 
Pro forma income (loss) from operations
  
 
92,815
  
 
(120,262
)
  
 
(27,447
)
  
 
(92,562
)
  
 
16,327
  
 
(103,682
)
Stock-based compensation
                                           
 
(2,700
)
Amortization of goodwill and other intangibles
                                           
 
(143,496
)
Restructuring-related and other
                                           
 
(176,904
)
Total non-operating expenses, net
                                           
 
(106,587
)
Equity in losses of equity-method investees, net
                                           
 
(28,472
)
Cumulative effect of change in accounting principle
                                           
 
(10,523
)
                                             


Net loss
                                           
$
(572,364
)
                                             


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Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Statements
 
This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. We use words such as anticipates, believes, expects, future, intends, and similar expressions to help identify forward-looking statements. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Our actual results may differ significantly from management’s expectations. The following discussion includes forward-looking statements regarding expectations of future pro forma operating and net income, net sales and free cash flow, each of which are inherently difficult to predict. Actual results could differ materially for a variety of reasons, including, among others, the rate of growth of the economy in general, the Internet and online commerce, customer spending patterns, the amount that we invest in new business opportunities and the timing of those investments, the mix of products sold to customers, the mix of net sales derived from products as compared with services, competition, risks of inventory management, the degree to which we enter into, maintain, and develop relationships with third party sellers and other strategic transactions, fluctuations in the value of securities and non-cash payments we receive in connection with such transactions, foreign currency risks, seasonality, international growth and expansion, and risks of fulfillment throughput and productivity. These risks and uncertainties, as well as other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations, are described in greater detail in the section entitled “Additional Factors That May Affect Future Results,” which, along with the following discussion, describes some, but not all, of the factors that could cause actual results to differ significantly from management’s expectations.
 
Critical Accounting Judgments
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The U.S. Securities and Exchange Commission (“SEC”) has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments and assumptions that are significant to understanding our results. For additional information see Note 1 “Accounting Policies” in Item 1 of Part I, “Financial Statements” of this Form 10-Q, and Note 1 “Description of Business and Accounting Policies” in Item 8 of Part II, “Financial Statements and Supplementary Data,” of our Annual Report on Form 10-K for the year ended December 31, 2001. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.
 
Significant Accounting Policies
 
Inventories
 
Inventories, consisting of products available for sale, are valued at the lower of cost or market value, which requires us to make judgments, based on currently-available information, about the likely method of disposition (whether through sales to individual customers, returns to product vendors, or liquidations), and expected recoverable values of each disposition category. Based on this evaluation, which is applied consistently from period to period, we record a valuation allowance to adjust the carrying amount of our inventories to lower of cost or market value.

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Revenue Recognition
 
We generally recognize revenue from product sales or services rendered when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectibility is reasonably assured.
 
We evaluate the criteria outlined in Emerging Issues Task Force (“EITF”) Issue No. 99-19, “Reporting Revenue Gross as a Principal Versus Net as an Agent,” in determining whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. Generally, when we are the primary obligor in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross as a principal. If we are not the primary obligor and amounts earned are determined using a fixed percentage, a fixed-payment schedule, or a combination of the two, we generally record the net amounts as commissions earned.
 
Product sales, net of promotional gift certificates and return allowances, are recorded when the products are shipped and title passes to customers. Retail items sold to customers are made pursuant to a sales contract that provides for transfer of both title and risk of loss upon our delivery to the carrier (commonly referred to as “F.O.B. Shipping Point”). Return allowances (which reduce product revenue by our best estimate of expected product returns) are estimated using historical experience.
 
Commissions received on sales of products through Amazon Marketplace, as well as commissions earned through our Merchant@amazon.com Program (as defined below), are recorded as a net amount since we are acting as an agent in such transactions. In addition, we recognize amounts earned through our Merchant Program (as defined below) as a net amount. Amounts earned are recognized as net sales when the item is sold by the third-party seller and our collectibility is reasonably assured. We record an allowance for refunds on such commissions using historical experience.
 
We earn revenues from services primarily by entering into business-to-business commercial agreements, including providing our technology services such as search, browse, and personalization; permitting third parties to offer products or services through our Web sites; and powering third-party Web sites, providing fulfillment services, or both. These commercial agreements also include miscellaneous marketing and promotional agreements. As compensation for the services we provide under these agreements, we receive cash, equity securities, or a combination thereof. Generally, the fair value of the equity consideration received is measured when the agreement is executed, but to the extent that the equity consideration is subject to forfeiture or vesting provisions and no significant performance commitment exists upon execution of the agreement, the fair value of the equity consideration and corresponding revenue is determined as of the date that the forfeiture provision lapses or as the vesting provision lapses. Subsequent to initial measurement of fair value, appreciation or decline in the fair value of such securities will affect our ultimate realization of equity securities received as compensation; however, any such change does not affect the amount of revenue to be recognized over the term of the agreement. We generally recognize revenue from these marketing and promotional services on a straight-line basis over the period during which we perform services under these agreements, commencing at the launch date of the service. If we receive non-refundable advance payments, such amounts are deferred for revenue recognition purposes until service commences.
 
Included in Services segment revenues are equity-based service revenues of $2 million and $5 million for the three months ended September 30, 2002 and 2001, respectively, and $12 million and $22 million for the nine months ended September 30, 2002 and 2001, respectively.
 
We have in the past, and may in the future, amend our agreements with certain of the companies with which we have commercial agreements to modify future cash proceeds to be received by us, modify the service term of our commercial agreements, or both. Although these amendments do not affect the amount of unearned revenue previously recorded by us (if any), the timing of future revenue recognition changes to correspond with the terms

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of amended agreements. These amendments or future amendments will affect the timing and amount of revenues recognized in connection with these commercial agreements. To the extent we believe any such amendments cause or may cause the compensation to be received under an agreement to no longer be fixed or determinable, we limit our revenue recognition to amounts received, excluding any future amounts not deemed fixed or determinable. As future amounts are subsequently received, such amounts are incorporated into our revenue recognition over the remaining term of the agreement.
 
Fair Value of Equity Securities Received as Compensation Under Commercial Agreements
 
For equity securities of public companies received as compensation under commercial agreements, we generally determine fair value based on the quoted market price at the time we enter into the underlying commercial agreement, and adjust such market price appropriately if significant restrictions on marketability exist. Because an observable market price does not exist for equity securities of private companies, our estimates of fair value of such securities are more subjective than for the securities of public companies. For significant transactions involving equity securities in private companies, we obtain and consider independent, third-party valuations where appropriate. Such valuations use a variety of methodologies to estimate fair value, including comparing the security with securities of publicly traded companies in similar lines of business, applying price multiples to estimated future operating results for the private company, and utilizing estimated discounted cash flows for that company. These valuations also reduce the otherwise fair value by a factor that is intended to account for restrictions on control and marketability where appropriate. Using these valuations and other information available to us, such as our knowledge of the industry and the company itself, we determine the estimated fair value of the securities received.
 
Accounting for Goodwill and Certain Other Intangibles
 
Effective July 1, 2001, we adopted certain provisions of SFAS No. 141, and effective January 1, 2002, we adopted the full provisions of SFAS No. 141 and SFAS No. 142. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting, and broadens the criteria for recording intangible assets apart from goodwill. We evaluated our goodwill and intangibles acquired prior to June 30, 2001 using the criteria of SFAS No. 141, which resulted in $25 million of other intangibles (comprised entirely of assembled workforce intangibles) being subsumed into goodwill at January 1, 2002. SFAS No. 142 requires that purchased goodwill and certain indefinite-lived intangibles no longer be amortized, but instead be tested for impairment at least annually. We evaluated our intangible assets and determined that all such assets have determinable lives.
 
SFAS No. 142 prescribes a two-phase process for impairment testing of goodwill. The first phase screens for impairment, while the second phase (if necessary) measures the impairment. We completed our first phase impairment analysis and found no instances of impairment of our recorded goodwill; accordingly, the second testing phase was not necessary during 2002. No subsequent indicators of impairment have been noted.
 
Restructuring Estimates
 
Restructuring-related liabilities include estimates for, among other things, anticipated disposition of lease obligations. Key variables in determining such estimates include anticipated commencement timing of sublease rentals, estimates of sublease rental payment amounts and tenant improvement costs, and estimates for brokerage and other related costs. We periodically evaluate and, if necessary, adjust our estimates based on currently-available information.

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Results of Operations
 
Net Sales
 
Net sales include the selling price of consumer products sold by us, less promotional gift certificates and sales returns; outbound shipping charges billed to our customers; commissions and other amounts earned from sales of new and used products on Amazon Marketplace; amounts earned (fixed fees, sales commissions, per-unit activity fees, or some combination thereof) for sales of retail products through our Merchant@amazon.com Program (where a third party seller offers its products for sale on our Web site in our retail stores or in a co-branded store, or both), including our strategic alliances with Toysrus.com, Inc. and J&R Electronics; the selling price of consumer products sold by us through our Syndicated Stores Program (where we operate a co-branded e-commerce Web site under a third party seller’s name and URL, which utilizes our e-commerce features and technology and sells our products), such as www.borders.com; amounts earned (fixed fees, sales commissions, per-unit activity fees, or some combination thereof) in connection with our Merchant Program (where we operate a third-party seller’s e-commerce Web site under the third-party seller’s name and URL, which utilizes our e-commerce services, features and technology, and sells the third-party seller’s products), such as Target.com, which launched in the third quarter of 2002; amounts earned from third parties who utilize our technology services such as search, browse, and personalization; and amounts earned for miscellaneous marketing and promotional agreements.
 
Net sales were $851 million and $639 million for the three months ended September 30, 2002 and 2001, respectively, and $2.5 billion and $2.0 billion for the nine months ended September 30, 2002 and 2001, respectively, representing increases of 33% and 25%, respectively. The increases in net sales dollars were primarily attributable to our International segment and our North America Books, Music, and DVD/Video (“BMVD”) segment, which increased $125 million and $61 million for the three months ended September 30, 2002, respectively, and $309 million and $116 million for the nine months ended September 30, 2002, respectively. During the three months and nine months ended September 30, 2002, revenues from our International segment improved $22 million and $12 million, respectively, in comparison to the prior year periods due to changes in currency exchange rates. In addition, as previously disclosed, we estimated that net sales for the prior year comparative periods were negatively impacted by between $25 million and $35 million due to the events of September 11, 2001. Year over year comparisons for the three months and nine months ended September 30, 2002 should be viewed in this context.
 
Net sales for our BMVD segment were $412 million and $351 million for the three months ended September 30, 2002 and 2001, respectively, and $1.3 billion and $1.2 billion for the nine months ended September 30, 2002 and 2001, respectively, representing increases of 17% and 10%, respectively. This segment includes retail sales from www.amazon.com and www.amazon.ca of books, music, and DVD/video products and for magazine subscription commissions. This segment also includes commissions from sales of these products through Amazon Marketplace and revenues from stores offering these products through our Syndicated Stores Program, such as www.borders.com. This segment also includes amounts earned from offerings of these products by third-party sellers (such as magazine subscriptions) under our Merchant@amazon.com Program. The increase in net sales for our BMVD segment reflects the increase in units sold (including the increase in sales through our Amazon Marketplace), offset by increases in customer discounts on books and the introduction of our new shipping offer at www.amazon.com that offers free shipping for certain orders.
 
Net sales for our North America Electronics, Tools, and Kitchen (“ETK”) segment were $129 million and $103 million for the three months ended September 30, 2002 and 2001, respectively, and $383 million and $331 million for the nine months ended September 30, 2002 and 2001, respectively, representing increases of 25% and 16%, respectively. This segment includes www.amazon.com retail sales of electronics, home improvement, and home and garden products, as well as our catalog sales of tools and toys. This segment also includes commissions earned from sales of these products through Amazon Marketplace on www.amazon.com and amounts earned from offerings of these products by third-party sellers under our Merchant@amazon.com Program, including J&R Electronics, and will include revenues from stores offering these products, if any,

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through our Syndicated Stores Program. The growth in our ETK segment is attributable to an increase in units sold, offset by increases in customer discounts and the introduction of our new shipping offer at www.amazon.com that offers free shipping for certain orders.
 
Net sales for our International segment were $264 million and $138 million for the three months ended September 30, 2002 and 2001, respectively, and $708 million and $399 million for the nine months ended September 30, 2002 and 2001, respectively, representing increases of 90% and 77%, respectively. We anticipate that as the revenue base of our International segment increases, the percentage growth rates will likely decline over time. During the three months and nine months ended September 30, 2002, revenues improved $22 million and $12 million, respectively, in comparison to the prior year periods due to changes in currency exchange rates (if currency rates had remained constant with the same period in the prior year, the International segment’s very slight operating profit would have been a very slight operating loss for the three months ended September 30, 2002). This segment includes all retail sales of the following internationally-focused Web sites: www.amazon.co.uk, www.amazon.de, www.amazon.fr, and www.amazon.co.jp. These international sites share a common Amazon experience, but are localized in terms of language, products, customer service, and fulfillment. To the extent available on these sites, this segment includes commissions and other amounts from sales of products through Amazon Marketplace and revenues from stores offering products through our internationally-focused Syndicated Stores Program, such as www.waterstones.co.uk, and will include other amounts earned from sales of products by third-party sellers through our Merchant@amazon.com Program. Export sales from www.amazon.com and www.amazon.ca are not included in the International segment. The increase in net sales from our International segment results from increased unit sales in each of the four internationally-focused Web sites (including from the introduction of Amazon Marketplace on www.amazon.co.uk and www.amazon.de in March 2002), offset by increases in customer discounts and free and reduced-rate shipping offers. The future growth for our International segment may fluctuate significantly with changes in foreign exchange rates. See “Additional Factors That May Affect Future Results—We Have Foreign Currency Risk.”
 
Net sales for our Services segment were $47 million and $46 million for the three months ended September 30, 2002 and 2001, respectively, and $146 million and $127 million for the nine months ended September 30, 2002 and 2001, respectively, representing increases of 1% and 15%, respectively. This segment consists of commissions, fees and other amounts earned from our business-to-business commercial agreements, including our Merchant Program and, to the extent full product categories are not also offered by us through our online retail stores, our Merchant@amazon.com Program, such as www.target.com, as well as miscellaneous marketing, promotional, and other agreements. The increase in net sales from our Services segment results from amounts earned through our Merchant@amazon.com Program, and to a lesser extent our Merchant Program, offset by the conclusion of certain of our marketing and promotional agreements. The amount of compensation we receive under certain of these services agreements is dependent on the volume of sales that the other company makes. See “Additional Factors That May Affect Future Results—Our Business Could Suffer If We Are Unsuccessful in Making and Integrating Strategic Alliances and Other Business Relationships.”
 
Shipping revenue, which consists of outbound shipping charges to our customers, across all segments was $73 million and $74 million for the three months ended September 30, 2002 and 2001, respectively, and $244 million and $232 million for the nine months ended September 30, 2002 and 2001, respectively. Shipping revenue does not include any commissions or other amounts earned from Amazon Marketplace. Shipping revenue generally corresponds with overall sales levels, offset by our free and reduced-fee shipping promotions. In January 2002, we introduced a new shipping option at www.amazon.com, offering free shipping for certain orders of $99 or more. In June 2002, we introduced a long-term test at www.amazon.com and reduced the purchase threshold to $49, which we further reduced in August 2002 to $25. We offer or may offer a similar shipping option for our internationally-focused Web sites, and may offer other free or reduced-fee shipping options over time. The effect of these shipping offers reduces shipping revenue as a percentage of sales, and causes our gross margins on retail sales to decline.

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Fourth quarter 2002 net sales are expected to be between $1.325 billion and $1.425 billion, or grow between 19% and 28%. Full year 2003 net sales are expected to grow over 10%. However, any such projections are subject to substantial uncertainty. See “Additional Factors that May Affect Future Results.”
 
Gross Profit
 
Gross profit is net sales less the cost of sales, which consists of the purchase price of consumer products sold by us, inbound and outbound shipping charges to us, packaging supplies, and certain costs associated with our service revenues. Costs associated with our Services segment revenues classified as cost of services generally include fulfillment-related costs to ship products on behalf of third-party sellers, costs to provide customer service, credit card fees, and other related costs.
 
Effective January 1, 2002, we prospectively changed our inventory costing method to the first-in first-out (“FIFO”) method of accounting. This change resulted in a cumulative effect increase in product inventory of $0.8 million, with a corresponding amount recorded to “Cumulative effect of change in accounting principle” on the statements of operations. We have evaluated the effect of the change on each quarter during 2001 and determined such effect to be less than $1.2 million individually and in the aggregate. We have determined this change to be preferable under accounting principles generally accepted in the United States since, among other reasons, it facilitates our record keeping process, significantly improves our ability to provide cost-efficient fulfillment services to third-party companies as part of our services offering, and results in increased consistency with others in our industry.
 
Gross profit was $216 million and $162 million for the three months ended September 30, 2002 and 2001, respectively and $657 million and $525 million for the nine months ended September 30, 2002 and 2001, respectively, representing increases of 33% and 25%, respectively. Gross margin was 25% for each of the three months ended September 30, 2002 and 2001, and 26% for each of the nine months ended September 30, 2002 and 2001, respectively. Increases in the absolute dollars of gross profit primarily correspond with increases in units sold (including increased product sales through Amazon Marketplace), improvements in transportation and inventory management, and improvements in product sourcing, offset by increases in customer discounts on books and electronics, a reduction in high-margin marketing and promotional agreements, and our free and reduced-rate shipping offers. We intend to continue to focus on lowering prices for customers over time.
 
Gross profit for our BMVD segment was $116 million and $93 million for the three months ended September 30, 2002 and 2001, respectively, and $363 million and $313 million for the nine months ended September 30, 2002 and 2001, respectively, representing increases of 25% and 16%, respectively. Gross margin was 28% and 27% for the three months ended September 30, 2002 and 2001, respectively, and 29% and 27% for the nine months ended September 30, 2002 and 2001, respectively. The slight improvement in gross margin in comparison with the prior year periods corresponds with the increase in higher margin sales through Amazon Marketplace, improvements in transportation and inventory management, and continued improvements in product sourcing, offset by higher customer discounts and our free shipping offer.
 
Gross profit for our ETK segment was $13 million for each of the three months ended September 30, 2002 and 2001, respectively, and $51 million and $44 million for the nine months ended September 30, 2002 and 2001, respectively, representing a slight decline and an increase of 17%, respectively. Gross margin was 10% and 13% for the three months ended September 30, 2002 and 2001, respectively, and 13% for each of the nine months ended September 30, 2002 and 2001, respectively. Gross margin for the three months ended September 30, 2002 declined in comparison to the prior year period due primarily to increases in customer discounts, rebates offered in our wireless store, and the effect of our free shipping offer, offset by improvements in product sourcing and vendor management, improvements in transportation and inventory management and increased product sales through Amazon Marketplace. Since we currently defer revenues on wireless service contracts until the cancellation period lapses, our recent rebate program on wireless phones reduced our ETK gross margins during the three months ended September 30, 2002 by approximately 140 basis points. This margin effect will be

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offset in future periods as the incremental service contract revenue is recognized, offsetting the effect of lower net revenues from product sales.
 
During 2002, sales of products through Amazon Marketplace increased significantly in comparison to the prior year periods. If product sales through Amazon Marketplace continue to increase, we anticipate improvement in gross margin, offset to the extent we offer additional or broader customer discounts, free shipping offers and other promotions.
 
Gross profit for our International segment was $61 million and $28 million for the three months ended September 30, 2002 and 2001, respectively, and $157 million and $86 million for the nine months ended September 30, 2002 and 2001, respectively, representing increases of 116% and 84%, respectively. Gross margin was 23% and 20% for the three months ended September 30, 2002 and 2001, respectively, and 22% and 21% for the nine months ended September 30, 2002 and 2001, respectively. The increase in our absolute gross profit dollars reflects increases in units sold by each of our internationally-focused Web sites (including from the introduction of Amazon Marketplace on www.amazon.co.uk and www.amazon.de in March 2002) in comparison with the same periods in the prior year.
 
Gross profit for our Services segment was $26 million and $27 million for the three months ended September 30, 2002 and 2001, respectively, and $86 million and $82 million for the nine months ended September 30, 2002 and 2001, respectively, representing a decrease of 5% and an increase of 5%, respectively. Costs associated with our service revenues generally include fulfillment-related costs to ship products on behalf of third-party sellers, costs to provide customer service, credit card fees and other related costs. Gross margin was 55% and 59% for the three months ended September 30, 2002 and 2001, respectively, and 59% and 64% for the nine months ended September 30, 2002 and 2001, respectively. Gross profit from our Services segment largely corresponds with revenues from our commercial agreements, which includes our Merchant Program and, to the extent product categories are not also offered by us through our online retail stores, the Merchant@amazon.com Program, as well as amounts earned through miscellaneous marketing and promotional agreements. The decline in gross margin from our Services segment relates to service costs classified in cost of sales resulting from the shift in the mix of our strategic relationships towards alliances that incorporate a broader range of services, including fulfillment. Also contributing to the decline in Services gross margin was a reduction in high-margin marketing and promotional agreements. We expect Services segment margins will continue to decline over the next year since high-margin marketing arrangements are expected to represent a lower percentage of our overall revenue mix for this segment. See “Additional Factors That May Affect Future Results—Our Business Could Suffer If We Are Unsuccessful in Making and Integrating Strategic Alliances and Other Business Relationships.”
 
Shipping loss across all segments was $10 million and $2 million for the three months ended September 30, 2002 and 2001, respectively, and $10 million and $8 million for the nine months ended September 30, 2002 and 2001, respectively. The loss from shipping primarily reflects the free and reduced-rate shipping offers, offset in part by increases in injection shipping (where we deliver to shipping hubs large quantities of items destined for similar geographic locations). We continue to measure our shipping results relative to their effect on our overall financial results, with the viewpoint that shipping promotions are an effective marketing tool. In January 2002, we introduced a new shipping option at www.amazon.com, offering free shipping for certain orders of $99 or more. In June 2002, we introduced a long-term test at www.amazon.com and reduced the purchase threshold to $49, which we further reduced in August 2002 to $25. Because the $25 threshold for our free shipping offer at www.amazon.com will be effective throughout the fourth quarter 2002 we expect our overall gross margins to decline. We offer or may offer a similar shipping option for our internationally-focused Web sites and may offer other free or reduced-fee shipping options over time. These shipping offers reduce shipping revenue as a percentage of sales and cause gross margins on retail sales to decline.

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Fulfillment
 
Fulfillment costs represent those costs incurred in operating and staffing our fulfillment and customer service centers, including costs attributable to receiving, inspecting, and warehousing inventories; picking, packaging, and preparing customers’ orders for shipment; credit card fees and bad debt costs; and responding to inquiries from customers. Fulfillment costs also include amounts paid to third-party co-sourcers who assist us in fulfillment and customer service operations. Certain Services segment fulfillment-related costs incurred on behalf of third-party sellers are classified as cost of sales rather than fulfillment. Fulfillment costs were $90 million and $81 million for the three months ended September 30, 2002 and 2001, respectively, representing 11% and 13% of net sales, respectively. Fulfillment costs were $266 million and $265 million for the nine months ended September 30, 2002 and 2001, respectively, representing 11% and 13% of net sales for the corresponding periods. Excluding net sales from our Services segment, fulfillment costs represent 11% and 14% of net sales for the three months ended September 30, 2002 and 2001, respectively, and 11% and 14% for the nine months ended September 30, 2002 and 2001, respectively. The improvement in fulfillment costs as a percentage of net sales results from improvements in productivity, the increase in units fulfilled helping to leverage our fixed-cost base, a decline in customer service contacts resulting from improvements in our operations and enhancements to our customer self-service features available on our Web sites, and the closure of our fulfillment centers in McDonough, Georgia and Seattle, Washington, and customer service centers in The Hague, Netherlands and Seattle, Washington. These improvements were offset, in part, by increases in employee wages and benefits, and credit card interchange fees associated with Amazon Marketplace, which represent a higher percent of sales relative to amounts earned.
 
Marketing
 
Marketing expenses consist of advertising, promotional, and public relations expenditures, and payroll and related expenses for personnel engaged in marketing and selling activities. Marketing expenses, net of co-operative marketing reimbursements, were $27 million and $33 million, representing 3% and 5% of net sales, for the three months ended September 30, 2002 and 2001, respectively, and $88 million and $104 million, representing 4% and 5% of net sales, for the nine months ended September 30, 2002 and 2001, respectively. To the extent co-operative marketing reimbursements decline in future periods, we may incur additional expenses to continue certain promotions, or elect to reduce or discontinue them. Declines in expense for marketing-related activities in comparison to the prior year period reflect management efforts to target advertising spending in channels considered most effective at driving incremental net sales (such as targeted online advertising through various Web portals and our Associates Program) as well as reduced rates charged to us for online marketing. We expect to incur increased marketing and promotion costs during the fourth quarter 2002. In January 2002, we introduced a new shipping option at www.amazon.com, offering free shipping for certain orders of $99 or more. In June 2002, we introduced a long-term test and reduced the purchase threshold to $49, which we further reduced in August 2002 to $25. We offer or may offer a similar shipping option for our internationally-focused Web sites. Although marketing expenses do not include our free and reduced shipping offers, we view such offers as an effective marketing tool.
 
Technology and Content
 
Technology and content expenses consist principally of payroll and related expenses for development, editorial, systems, and telecommunications operations personnel and consultants; systems and telecommunications infrastructure; and costs of acquired content, including freelance reviews. Technology and content expense was $53 million and $54 million for the three months ended September 30, 2002 and 2001, respectively, representing 6% and 8% of net sales for the corresponding periods, respectively, and $167 million and $189 million for the nine months ended September 30, 2002 and 2001, respectively, representing 7% and 9% of net sales for the corresponding periods, respectively. Included in technology and content expense for the three months and nine months ended September 30, 2002 were $2 million of costs associated with the impairment of purchased software and hardware removed from service during the third quarter of 2002. Additionally, included

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in technology and content expense for the nine months ended September 30, 2002 were $2 million of costs associated with ongoing lease payment obligations for certain networking equipment that was removed from service during the second quarter 2002. The decline in absolute dollars spent for each comparative period primarily reflects our migration to a technology platform that utilizes a less-costly technology infrastructure, as well as improved expense management and general price reductions in most expense categories. We expect to continue to invest in technology and improvements to our Web sites during the remainder of 2002, which may include, but is not limited to, hiring additional employees, offering additional Web site features and product categories to our customers and implementing additional strategic alliances, as well as potentially continuing our international expansion.
 
General and Administrative
 
General and administrative expenses consist of payroll and related expenses for executive, finance and administrative personnel, human resources, professional fees, and other general corporate expenses. General and administrative expenses were $19 million and $21 million for the three months ended September 30, 2002 and 2001, respectively, representing 2% and 3% of net sales for the corresponding periods, respectively, and $59 million and $70 million for the nine months ended September 30, 2002 and 2001, respectively, representing 2% and 4% of net sales for the corresponding periods, respectively. The decline in absolute dollars of general and administrative costs for each comparative period is attributable to a decline in facility and depreciation costs due to our operational restructuring plan that consolidated our corporate office locations, and continued efforts to improve efficiency.
 
Stock-Based Compensation
 
Stock-based compensation includes stock-based charges resulting from variable accounting treatment of certain stock options, option-related deferred compensation recorded at our initial public offering, as well as certain other compensation and severance arrangements. Stock-based compensation also includes the portion of acquisition-related consideration conditioned on the continued tenure of key employees of certain acquired businesses, which must be classified as compensation expense rather than as a component of purchase price under accounting principles generally accepted in the United States. Additionally, stock-based compensation will include amounts associated with our planned restricted stock unit program. Under this program, we will, commencing in the fourth quarter of 2002, award restricted stock units as our primary vehicle for employee equity compensation. Restricted stock units are measured at fair value on the date of grant based on the number of shares granted and the quoted price of the Company’s common stock. Such value is recognized as an expense ratably over the corresponding service period. To the extent restricted stock units are forfeited prior to vesting, the corresponding previously recognized expense is reversed as an offset to “Stock-based compensation.”
 
Stock-based compensation was a credit of $1 million and a credit of $3 million for the three months ended September 30, 2002 and 2001, respectively, and an expense of $33 million and an expense of $3 million for the nine months ended September 30, 2002 and 2001, respectively. As the quoted price of our common stock at September 30, 2002 was below the quoted price of our common stock at June 30, 2002, previously recorded variable accounting charges were partially reversed. However, these reversed charges were partially offset by costs associated with exercises of vested options and costs associated with incremental vesting during the period.
 
The number of shares of common stock subject to outstanding vested and unvested employee stock options was approximately 48 million and 66 million, or 13% and 18% of our outstanding common stock, at September 30, 2002 and December 31, 2001, respectively.
 
Variable accounting treatment will result in unpredictable and potentially significant charges or credits recorded to “Stock-based compensation,” dependent on fluctuations in quoted prices for our common stock. We have quantified the hypothetical effect on “Stock-based compensation” associated with increases in the quoted price of our common stock using a sensitivity analysis for our outstanding stock options subject to variable

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accounting at September 30, 2002. We have provided this information to provide additional insight into the potential volatility we may experience in the future in our results of operations to the extent that the quoted price for our common stock is above $13.375. This sensitivity analysis is not a prediction of future performance of the quoted prices of our common stock. Using the following hypothetical market prices of our common stock above $13.375 (including the actual expense associated with options exercised and no longer subject to future variability), our hypothetical cumulative compensation expense at September 30, 2002 resulting from variable accounting treatment would have been as follows (in thousands, except percentages and per share amounts):
 
Hypothetical Increase
Over $13.375

    
Hypothetical Market
Price per Share

    
Hypothetical Cumulative Compensation Expense

    
Hypothetical vs. Cumulative Compensation Expense
September 30, 2002

 
5%
    
$14.04
    
$17,051
    
($12,424
)
10%
    
$14.71
    
$21,618
    
($  7,857
)
15%
    
$15.38
    
$26,185
    
($  3,290
)
25%
    
$16.72
    
$35,319
    
$  5,844
 
50%
    
$20.06
    
$58,155
    
$28,680
 
 
As of September 30, 2002, cumulative compensation expense associated with variable accounting treatment was $29 million, of which $12 million is associated with options exercised.
 
Actual variable-accounting related compensation could differ significantly from the above illustration in instances where options are exercised during a period at prices that differ from the closing stock price for the reporting period.
 
If at the end of any fiscal quarter the quoted price of our common stock is lower than the quoted price at the end of the previous fiscal quarter, or to the extent previously-recorded amounts relate to unvested portions of options that were cancelled, compensation expense associated with variable accounting will be recalculated using the cumulative expense method and may result in a net benefit to our results of operations.
 
We expect that, by the beginning of 2003, we will expense our future stock-based awards, either due to a change in accounting policy, the issuance of alternative forms of equity compensation (such as our planned restricted stock unit program), or both.
 
Amortization of Goodwill and Other Intangibles
 
Amortization of goodwill and other intangibles was $1 million and $42 million for the three months ended September 30, 2002 and 2001, respectively, and $5 million and $143 million for the nine months ended September 30, 2002 and 2001, respectively. The decline in amortization of goodwill and intangibles primarily results from our adoption of SFAS No. 141, which resulted in $25 million of intangible assets, comprised of assembled workforce intangibles, being subsumed into goodwill, and our adoption of SFAS No. 142, which requires that goodwill no longer be amortized.
 
Restructuring-Related and Other
 
Restructuring-related and other expenses were $37 million and $4 million for the three months ended September 30, 2002 and 2001, respectively, and $47 million and $177 million for the nine months ended September 30, 2002 and 2001, respectively. In the first quarter of 2001, we announced and began implementation of our operational restructuring plan to reduce operating costs, streamline our organizational structure, consolidate certain of our fulfillment and customer service operations, and migrate a large portion of our technology infrastructure to a new operating platform. This initiative involved the reduction of employee staff by 1,327 positions throughout the Company in managerial, professional, clerical, technical, and fulfillment roles; consolidation of our Seattle, Washington corporate office locations; closure of our McDonough, Georgia

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fulfillment center; seasonal operation of our Seattle, Washington fulfillment center; closure of our customer service centers in Seattle, Washington and The Hague, Netherlands; and migration of a large portion of our technology infrastructure to a new operating platform, which entails ongoing lease obligations for technology infrastructure no longer being utilized. Actual employee termination benefits paid were $12 million. Each component of the restructuring plan is complete, however, as discussed below, we may adjust our restructuring-related estimates, if necessary.
 
In the third quarter of 2002, related to our January 2001 operational restructuring, we recorded an additional restructuring-related expense of $37 million associated with ongoing lease obligations relating to vacated office and fulfillment center space and other costs, including revised sublease income estimates to reflect current information and higher-than-expected tenant improvement costs necessary to sublease vacated space. We revised our restructuring-related expense estimate due to a number of factors, primarily related to weakness in the real estate markets in Seattle, Washington and Atlanta, Georgia. In addition, during the first quarter 2002, we permanently closed our fulfillment center in Seattle, Washington and revised our sublease income estimates for office space vacated as part of the restructuring, resulting in additional restructuring-related expenses of $10 million primarily associated with ongoing lease obligations.
 
Restructuring-related charges were as follows (in thousands):
 
    
Three Months Ended September 30,

  
Nine Months Ended September 30,

    
2002

  
2001

  
2002

  
2001

Asset impairments
  
$
—  
  
$
1,852
  
$
—  
  
$
67,825
Continuing lease obligations
  
 
36,757
  
 
1,275
  
 
45,835
  
 
85,280
Termination benefits
  
 
—  
  
 
694
  
 
—  
  
 
15,455
Broker commissions, professional fees, and other miscellaneous restructuring costs
  
 
—  
  
 
173
  
 
896
  
 
8,344
    

  

  

  

    
$
36,757
  
$
3,994
  
$
46,731
  
$
176,904
    

  

  

  

 
At September 30, 2002, the accrued liability associated with restructuring-related and other charges was $74 million and consisted of the following (in thousands):
 
    
Balance at December 31, 2001

  
Subsequent Accruals, Net

  
Payments

    
Balance at September 30, 2002

  
Due Within 12 Months

  
Due After 12 Months

Lease obligations, net of estimated sublease income
  
$
53,187
  
$
45,835
  
$
(30,935
)
  
$
68,087
  
$
19,005
  
$
49,082
Termination benefits
  
 
61
  
 
—  
  
 
(61
)
  
 
—  
  
 
—  
  
 
—  
Broker commissions, professional fees, and other miscellaneous restructuring costs
  
 
8,190
  
 
896
  
 
(3,393
)
  
 
5,693
  
 
—  
  
 
5,693
    

  

  


  

  

  

    
$
61,438
  
$
46,731
  
$
(34,389
)
  
$
73,780
  
$
19,005
  
$
54,775
    

  

  


  

  

  

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Cash payments resulting from our operational restructuring were $8 million and $15 million for the three months ended September 30, 2002 and 2001, respectively, and $34 million and $35 million for the nine months ended September 30, 2002 and 2001, respectively. As a result of the continued weakness in the real estate markets in Seattle, Washington and Atlanta, Georgia, we have reduced our estimates of future sublease cash flows and have increased our estimate of cash outflows for tenant improvements and other costs necessary to secure sublease tenants. We estimate, based on these adjustments and other currently available information, the remaining net cash outflows associated with our January 2001 operational restructuring will be as follows (in thousands):
 
    
Leases

  
Other

  
Total

Three Months Ending December 31, 2002
  
$
6,235
  
$
—  
  
$
6,235
Years Ending December 31, 2003
  
 
16,170
  
 
1,580
  
 
17,750
2004
  
 
14,581
  
 
1,000
  
 
15,581
2005
  
 
7,903
  
 
3,113
  
 
11,016
2006
  
 
5,326
  
 
—  
  
 
5,326
Thereafter
  
 
17,872
  
 
—  
  
 
17,872
    

  

  

Total estimated cash outflows
  
$
68,087
  
$
5,693
  
$
73,780
    

  

  

 
Restructuring-related lease obligations are as follows (in thousands):
 
    
Three Months Ending December 31, 2002

   
Years Ending December 31,

   
Thereafter

   
Total

 
      
2003

   
2004

   
2005

   
2006

     
Gross lease obligations
  
$
6,614
 
 
$
17,868
 
 
$
18,050
 
 
$
14,781
 
 
$
13,677
 
 
$
50,382
 
 
$
121,372
 
Estimated sublease income (1)
  
 
(379
)
 
 
(1,698
)
 
 
(3,469
)
 
 
(6,878
)
 
 
(8,351
)
 
 
(32,510
)
 
 
(53,285
)
    


 


 


 


 


 


 


Lease obligations, net
  
$
6,235
 
 
$
16,170
 
 
$
14,581
 
 
$
7,903
 
 
$
5,326
 
 
$
17,872
 
 
$
68,087
 
    


 


 


 


 


 


 



(1)
 
At September 30, 2002, the Company had signed contractual sublease agreements covering $11 million in future payments.
 
Income (Loss) from Operations
 
Our results from operations were a loss of $10 million and loss of $70 million for the three months ended September 30, 2002 and 2001, respectively, and a loss of $6 million and loss of $427 million for the nine months ended September 30, 2002 and 2001, respectively. Included in operating results for the three and nine months ended September 30, 2002 are costs associated with our January 2001 operational restructuring resulting from reduced expectations of sublease income on vacated office and fulfillment center facilities due to the continued weakness of the real estate markets in Seattle, Washington and Atlanta, Georgia. The improvement in operating results in comparison with the prior year was attributable to an increase in gross profit; a reduction in certain operating costs including marketing, technology and content, and general and administrative; as well as a decline in amortization of goodwill and other intangibles primarily due to the adoption of SFAS No. 142. We are unable to forecast the effect on our future reported results associated with variable accounting treatment on certain of our employee stock options.
 
Net Interest Expense
 
Net interest expense was $30 million and $29 million for the three months ended September 30, 2002 and 2001, respectively, and $90 million and $81 million for the nine months ended September 30, 2002 and 2001, respectively. Interest income was $6 million for each of the three months ended September 30, 2002 and 2001, respectively, and $17 million and $23 million for the nine months ended September 30, 2002 and 2001,

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respectively. Interest income year-over-year comparisons primarily reflect declining interest rates, offset in part by increases in the average balance of marketable securities. Interest expense was $36 million and $35 million for the three months ended September 30, 2002 and 2001, respectively, and $107 million and $104 million for the nine months ended September 30, 2002 and 2001, respectively. Interest expense is primarily related to our 6.875% Convertible Subordinated Notes due 2010 (“6.875% PEACS”), 4.75% Convertible Subordinated Notes due 2009 (“4.75% Convertible Subordinated Notes”), and our 10% Senior Discount Notes due 2008 (“Senior Discount Notes”). At September 30, 2002, our total long-term indebtedness was $2.26 billion.
 
Other Income (Expense), Net
 
Other income (expense), net consisted of the following (in thousands):
 
    
Three Months Ended September 30,

    
Nine Months Ended September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Gains (losses) on sale of marketable securities, net
  
$
3,020
 
  
$
1,351
 
  
$
3,833
 
  
$
1,137
 
Foreign-currency transaction gains (losses), net
  
 
(360
)
  
 
(1,150
)
  
 
(411
)
  
 
(2,532
)
Gains (losses) on disposal of fixed assets, net
  
 
47
 
  
 
4
 
  
 
(567
)
  
 
(83
)
Miscellaneous state, foreign, and other taxes
  
 
(274
)
  
 
(1,338
)
  
 
(617
)
  
 
(5,834
)
Other miscellaneous gains (losses), net
  
 
750
 
  
 
(1,070
)
  
 
638
 
  
 
47
 
    


  


  


  


    
$
3,183
 
  
$
(2,203
)
  
$
2,876
 
  
$
(7,265
)
    


  


  


  


 
Other Gains (Losses), Net
 
Other gains (losses), net consisted of the following (in thousands):
 
    
Three Months Ended September 30,

    
Nine Months Ended September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Foreign-currency gains (losses) on 6.875% PEACS
  
$
123
 
  
$
(39,572
)
  
$
(64,637
)
  
$
29,118
 
Gains (losses) on sale of Euro-denominated investments, net
  
 
—  
 
  
 
(16,332
)
  
 
2,227
 
  
 
(22,548
)
Other-than-temporary impairment losses on equity investments
  
 
—  
 
  
 
(2,382
)
  
 
(5,362
)
  
 
(43,408
)
Gains (losses) on sale of equity investments, net
  
 
2,236
 
  
 
—  
 
  
 
12,339
 
  
 
—  
 
Contract termination, Kozmo.com
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
22,400
 
Warrant remeasurements and other
  
 
(98
)
  
 
(5,339
)
  
 
(244
)
  
 
(4,015
)
    


  


  


  


    
$
2,261
 
  
$
(63,625
)
  
$
(55,677
)
  
$
(18,453
)
    


  


  


  


 
Foreign currency gains and losses arising from the remeasurement of the 6.875% PEACS’ principal from Euros to U.S. dollars each period, which we are unable to predict, are recorded to “Other gains (losses), net.”
 
We hold warrants to purchase equity securities of other companies. Warrants that can be exercised and settled by delivery of net shares such that we pay no cash upon exercise are deemed derivative financial instruments under the provisions of SFAS No. 133. Such warrants are not designated as hedging instruments; accordingly, gains or losses resulting from changes in fair value are recognized on our consolidated statements of operations in the period of change.
 
Equity in Losses of Equity-Method Investees
 
Equity in losses of equity-method investees represents our share of losses of companies in which we have investments that give us the ability to exercise significant influence, but not control, over an investee. This

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influence is generally defined as an ownership interest of the voting stock of the investee of between 20% and 50%, although other factors, such as representation on our investee’s Board of Directors and the effect of commercial arrangements, are considered in determining whether the equity method of accounting is appropriate. Equity-method losses were $1 million and $5 million for the three months ended September 30, 2002 and 2001, respectively, and $3 million and $28 million for the nine months ended September 30, 2002 and 2001, respectively. Equity-method losses declined in the three months and nine months ended September 30, 2002 in comparison with the comparable prior year periods because past equity-method losses have reduced many of our underlying investment balances until the recorded basis was zero. Our basis in equity-method investments was $1 million and $10 million at September 30, 2002 and December 31, 2001, respectively. As equity-method losses are only recorded until the underlying investments are reduced to zero, we expect, absent additional investments, equity-method losses to continue to decline.
 
Income Taxes
 
We provided for current and deferred income taxes in state and foreign jurisdictions where our subsidiaries produce taxable income. As of September 30, 2002, we have a net deferred tax asset of $2 million, which consists primarily of state net operating losses. We have provided a full valuation allowance against the remaining portion of our deferred tax asset, consisting primarily of net operating losses, because of uncertainty regarding its future realization.
 
Net Loss
 
Net loss was $35 million and $170 million for the three months ended September 30, 2002 and 2001, respectively, and $152 million and $572 million for the nine months ended September 30, 2002 and 2001, respectively. The improvement in net loss during the three months ended September 30, 2002 in comparison with the prior year period is attributable to improvements in our results from operations and the negligible gain (versus a loss of $40 million in the comparative prior year period) associated with the remeasurement of our 6.875% PEACS from Euros to U.S. dollars. The improvement in net loss during the nine months ended September 30, 2002 in comparison with the prior year period is attributable to improvements in our results from operations, offset by losses of $65 million (versus a gain of $29 million in the comparative prior year period) associated with the remeasurement of our 6.875% PEACS from Euros to U.S. dollars. We are unable to forecast the effect on our future reported results of certain items, including the gain or loss associated with our 6.875% PEACS that will result from fluctuations in foreign exchange rates and the effect on our results associated with variable accounting treatment on certain of our employee stock options.
 
Pro Forma Results of Operations
 
We provide certain pro forma information regarding our results from operations, which excludes the following line items on our consolidated statements of operations:
 
 
Ÿ
 
stock-based compensation,
 
 
Ÿ
 
amortization of goodwill and other intangibles, and
 
 
Ÿ
 
restructuring-related and other charges.
 
We also provide certain pro forma information regarding our net loss, which excludes, in addition to the line items described above, the following line items on our consolidated statements of operations:
 
 
Ÿ
 
other gains (losses), net,
 
 
Ÿ
 
equity in losses of equity-method investees, net, and
 
 
Ÿ
 
cumulative effect of change in accounting principle

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Table of Contents
 
This pro forma information is not presented in accordance with accounting principles generally accepted in the United States. Pro forma results, which generally exclude non-operational, non-cash expenses and income as well as one-time charges, are provided as a complement to results provided in accordance with accounting principles generally accepted in the United States. Management uses such pro forma measures internally to evaluate the Company’s performance and manage its operations. The pro forma results are derived from information recorded in our financial statements. For information about our financial results, as reported in accordance with accounting principles generally accepted in the United States, see Item 1 of Part I, “Financial Statements.”
 
The following is a reconciliation of our pro forma results for the three months ended September 30, 2002 and 2001. Interim reconciliations are consistent with full-year presentation.
 
    
Three Months Ended September 30, 2002

    
Three Months Ended September 30, 2001

 
    
As Reported (1)

    
Pro Forma Adjustments

    
Pro
Forma

    
As Reported (1)

    
Pro Forma Adjustments

    
Pro
Forma

 
           
(in thousands)
                  
(in thousands)
        
           
(unaudited)
                  
(unaudited)
        
Net sales
  
$
851,299
 
  
$
—  
 
  
$
851,299
 
  
$
639,281
 
  
$
—  
 
  
$
639,281
 
Cost of sales
  
 
635,132
 
  
 
—  
 
  
 
635,132
 
  
 
477,089
 
  
 
—  
 
  
 
477,089
 
    


  


  


  


  


  


Gross profit
  
 
216,167
 
  
 
—  
 
  
 
216,167
 
  
 
162,192
 
  
 
—  
 
  
 
162,192
 
Operating expenses:
                                                     
Fulfillment
  
 
90,342
 
  
 
—  
 
  
 
90,342
 
  
 
81,400
 
  
 
—  
 
  
 
81,400
 
Marketing
  
 
26,728
 
  
 
—  
 
  
 
26,728
 
  
 
32,537
 
  
 
—  
 
  
 
32,537
 
Technology and content
  
 
52,907
 
  
 
—  
 
  
 
52,907
 
  
 
53,846
 
  
 
—  
 
  
 
53,846
 
General and administrative
  
 
18,698
 
  
 
—  
 
  
 
18,698
 
  
 
21,481
 
  
 
—  
 
  
 
21,481
 
Stock-based compensation
  
 
(832
)
  
 
832
 
  
 
—  
 
  
 
(2,567
)
  
 
2,567
 
  
 
—  
 
Amortization of goodwill and intangibles
  
 
1,212
 
  
 
(1,212
)
  
 
—  
 
  
 
41,835
 
  
 
(41,835
)
  
 
—  
 
Restructuring-related and other
  
 
36,757
 
  
 
(36,757
)
  
 
—  
 
  
 
3,994
 
  
 
(3,994
)
  
 
—  
 
    


  


  


  


  


  


Total operating expenses
  
 
225,812
 
  
 
(37,137
)
  
 
188,675
 
  
 
232,526
 
  
 
(43,262
)
  
 
189,264
 
    


  


  


  


  


  


Income (loss) from operations
  
 
(9,645
)
  
 
37,137
 
  
 
27,492
 
  
 
(70,334
)
  
 
43,262
 
  
 
(27,072
)
Interest income
  
 
5,600
 
  
 
—  
 
  
 
5,600
 
  
 
6,316
 
  
 
—  
 
  
 
6,316
 
Interest expense
  
 
(35,922
)
  
 
—  
 
  
 
(35,922
)
  
 
(35,046
)
  
 
—  
 
  
 
(35,046
)
Other income (expense), net
  
 
3,183
 
  
 
—  
 
  
 
3,183
 
  
 
(2,203
)
  
 
—  
 
  
 
(2,203
)
Other gains (losses), net
  
 
2,261
 
  
 
(2,261
)
  
 
—  
 
  
 
(63,625
)
  
 
63,625
 
  
 
—  
 
    


  


  


  


  


  


Total non-operating expenses, net
  
 
(24,878
)
  
 
(2,261
)
  
 
(27,139
)
  
 
(94,558
)
  
 
63,625
 
  
 
(30,933
)
    


  


  


  


  


  


Income (loss) before equity in losses of equity-method Investees
  
 
(34,523
)
  
 
34,876
 
  
 
353
 
  
 
(164,892
)
  
 
106,887
 
  
 
(58,005
)
Equity in losses of equity-method investees, net
  
 
(557
)
  
 
557
 
  
 
—  
 
  
 
(4,982
)
  
 
4,982
 
  
 
—  
 
    


  


  


  


  


  


Net income (loss)
  
$
(35,080
)
  
$
35,433
 
  
$
353
 
  
$
(169,874
)
  
$
111,869
 
  
$
(58,005
)
    


  


  


  


  


  


Net cash provided by (used in) operating activities
  
$
38,108
 
           
$
38,108
 
  
$
(64,403
)
           
$
(64,403
)
    


           


  


           


Basic and diluted income (loss) per share
  
$
(0.09
)
  
$
0.09
 
  
$
0.00
 
  
$
(0.46
)
  
$
0.30
 
  
$
(0.16
)
    


  


  


  


  


  


Shares used in computation of income (loss) per share:
                                                     
Basic
  
 
379,650
 
           
 
379,650
 
  
 
368,052
 
           
 
368,052
 
    


           


  


           


Diluted
  
 
379,650
 
           
 
398,361
 
  
 
368,052
 
           
 
368,052
 
    


           


  


           



(1)
 
In accordance with accounting principles generally accepted in the United States.

32


Table of Contents
 
The following is a reconciliation of our pro forma results for the nine months ended September 30, 2002 and 2001. Interim reconciliations are consistent with full-year presentation.
 
    
Nine Months Ended September 30, 2002

    
Nine Months Ended September 30, 2001

 
    
As Reported (1)

    
Pro Forma Adjustments

    
Pro
Forma

    
As Reported (1)

    
Pro Forma Adjustments

    
Pro
Forma

 
           
(in thousands)
                  
(in thousands)
        
           
(unaudited)
                  
(unaudited)
        
Net sales
  
$
2,504,326
 
  
$
—  
 
  
$
2,504,326
 
  
$
2,007,262
 
  
$
—  
 
  
$
2,007,262
 
Cost of sales
  
 
1,846,867
 
  
 
—  
 
  
 
1,846,867
 
  
 
1,482,753
 
  
 
—  
 
  
 
1,482,753
 
    


  


  


  


  


  


Gross profit
  
 
657,459
 
  
 
—  
 
  
 
657,459
 
  
 
524,509
 
  
 
—  
 
  
 
524,509
 
Operating expenses:
                                                     
Fulfillment
  
 
265,908
 
  
 
—  
 
  
 
265,908
 
  
 
265,231
 
  
 
—  
 
  
 
265,231
 
Marketing
  
 
87,804
 
  
 
—  
 
  
 
87,804
 
  
 
103,833
 
  
 
—  
 
  
 
103,833
 
Technology and content
  
 
166,569
 
  
 
—  
 
  
 
166,569
 
  
 
188,840
 
  
 
—  
 
  
 
188,840
 
General and administrative
  
 
59,034
 
  
 
—  
 
  
 
59,034
 
  
 
70,287
 
  
 
—  
 
  
 
70,287
 
Stock-based compensation
  
 
33,247
 
  
 
(33,247
)
  
 
—  
 
  
 
2,700
 
  
 
(2,700
)
  
 
—  
 
Amortization of goodwill and intangibles
  
 
4,565
 
  
 
(4,565
)
  
 
—  
 
  
 
143,496
 
  
 
(143,496
)
  
 
—  
 
Restructuring-related and other
  
 
46,731
 
  
 
(46,731
)
  
 
—  
 
  
 
176,904
 
  
 
(176,904
)
  
 
—  
 
    


  


  


  


  


  


Total operating expenses
  
 
663,858
 
  
 
(84,543
)
  
 
579,315
 
  
 
951,291
 
  
 
(323,100
)
  
 
628,191
 
    


  


  


  


  


  


Income (loss) from operations
  
 
(6,399
)
  
 
84,543
 
  
 
78,144
 
  
 
(426,782
)
  
 
323,100
 
  
 
(103,682
)
Interest income
  
 
16,902
 
  
 
—  
 
  
 
16,902
 
  
 
23,073
 
  
 
—  
 
  
 
23,073
 
Interest expense
  
 
(106,817
)
  
 
—  
 
  
 
(106,817
)
  
 
(103,942
)
  
 
—  
 
  
 
(103,942
)
Other income (expense), net
  
 
2,876
 
  
 
—  
 
  
 
2,876
 
  
 
(7,265
)
  
 
—  
 
  
 
(7,265
)
Other gains (losses), net
  
 
(55,677
)
  
 
55,677
 
  
 
—  
 
  
 
(18,453
)
  
 
18,453
 
  
 
—  
 
    


  


  


  


  


  


Total non-operating expenses, net
  
 
(142,716
)
  
 
55,677
 
  
 
(87,039
)
  
 
(106,587
)
  
 
18,453
 
  
 
(88,134
)
    


  


  


  


  


  


Loss before equity in losses of equity-method investees
  
 
(149,115
)
  
 
140,220
 
  
 
(8,895
)
  
 
(533,369
)
  
 
341,553
 
  
 
(191,816
)
Equity in losses of equity-method investees, net
  
 
(3,469
)
  
 
3,469
 
  
 
—  
 
  
 
(28,472
)
  
 
28,472
 
  
 
—  
 
    


  


  


  


  


  


Loss before cumulative effect of change in accounting principle
  
 
(152,584
)
  
 
143,689
 
  
 
(8,895
)
  
 
(561,841
)
  
 
370,025
 
  
 
(191,816
)
Cumulative effect of change in accounting principle
  
 
801
 
  
 
(801
)
  
 
—  
 
  
 
(10,523
)
  
 
10,523
 
  
 
—  
 
    


  


  


  


  


  


Net loss
  
$
(151,783
)
  
$
142,888
 
  
$
(8,895
)
  
$
(572,364
)
  
$
380,548
 
  
$
(191,816
)
    


  


  


  


  


  


Net cash used in operating activities
  
$
(198,288
)
           
$
(198,288
)
  
$
(468,902
)
           
$
(468,902
)
    


           


  


           


Basic and diluted loss per share:
                                                     
Prior to cumulative effect of change in accounting principle
  
$
(0.41
)
  
$
0.39
 
  
$
(0.02
)
  
$
(1.55
)
  
$
1.02
 
  
$
(0.53
)
Cumulative effect of change in accounting principle
  
 
0.01
 
  
 
(0.01
)
  
 
—  
 
  
 
(0.03
)
  
 
0.03
 
  
 
—  
 
    


  


  


  


  


  


    
$
(0.40
)
  
$
0.38
 
  
$
(0.02
)
  
$
(1.58
)
  
$
1.05
 
  
$
(0.53
)
    


  


  


  


  


  


Shares used in computation of basic and diluted loss per share
  
 
376,564
 
           
 
376,564
 
  
 
361,782
 
           
 
361,782
 
    


           


  


           



(1)
 
In accordance with accounting principles generally accepted in the United States.
 
Fourth quarter 2002 pro forma operating profit is expected to be between $70 million and $95 million. Full year 2003 pro forma operating profit is expected to be over $200 million; this amount could be impacted, either positively or negatively, by the investment choices the Company makes for the long term. However, any such projections are subject to substantial uncertainty. See “Additional Factors That May Affect Future Results.”

33


Table of Contents
 
Liquidity and Capital Resources
 
Our principal sources of liquidity are our cash, cash equivalents, and marketable securities. Our cash and cash equivalents balance was $328 million and $540 million, and our marketable securities balance was $538 million and $456 million at September 30, 2002 and December 31, 2001, respectively. The primary use of cash and cash equivalents during the nine months ended September 30, 2002 was, among other things, associated with funding our normal operations (including the settlement of the accounts payable associated with our 2001 holiday season), and with net purchases of marketable fixed-income securities. Combined cash, cash equivalents, and marketable securities were $866 million and $997 million at September 30, 2002 and December 31, 2001, respectively. Equity securities of $3 million are included in “Marketable securities” at September 30, 2002, the value of which may fluctuate significantly. Equity securities of $13 million were included in “Marketable securities” at December 31, 2001.
 
As of September 30, 2002, our principal commitments consisted of long-term indebtedness totaling $2.26 billion related primarily to our 6.875% PEACS, 4.75% Convertible Subordinated Notes, and Senior Discount Notes; trade payables of $348 million; and accrued expenses and other liabilities of $242 million, which includes current restructuring-related obligations of $19 million. Additionally, we are scheduled under certain of our long-term debt obligations to make periodic interest payments through 2010 in the aggregate of $936 million, and are obligated under operating leases and commitments for advertising and promotional arrangements in the aggregate of $371 million and $10 million, respectively.
 
We have pledged a portion of our marketable securities as collateral for standby letters of credit that guarantee certain of our contractual obligations, a majority of which relates to property leases; the swap agreement that hedges the foreign-exchange rate risk on a portion of our 6.875% PEACS; and some of our real estate lease agreements. The amount of marketable securities we are required to pledge pursuant to the swap agreement fluctuates with the fair market value of the swap obligation. The change in the total amount of collateral pledged under these agreements was as follows (in thousands):
 
    
Standby Letters
of Credit

    
Swap Agreement

    
Real Estate Leases

    
Total

 
Balance at December 31, 2001
  
$
77,635
 
  
$
48,498
 
  
$
40,657
 
  
$
166,790
 
Net change in collateral pledged
  
 
(19,402
)
  
 
(12,153
)
  
 
(578
)
  
 
(32,133
)
    


  


  


  


Balance at September 30, 2002
  
$
58,233
 
  
$
36,345
 
  
$
40,079
 
  
$
134,657
 
    


  


  


  


34


Table of Contents
 
The following are our contractual commitments associated with our operational restructuring, indebtedness, lease obligations, and our marketing agreements (in thousands):
 
      
Three Months Ending December 31, 2002

  
Year Ending December 31,

  
Thereafter

  
Total

         
2003

  
2004

  
2005

  
2006

     
Restructuring-related commitments:
                                                  
Operating leases, net of estimated sublease income
    
$
6,235
  
$
16,170
  
$
14,581
  
$
7,903
  
$
5,326
  
$
17,872
  
$
68,087
Other
    
 
—  
  
 
1,580
  
 
1,000
  
 
3,113
  
 
—  
  
 
—  
  
 
5,693
      

  

  

  

  

  

  

Restructuring-related commitments
    
 
6,235
  
 
17,750
  
 
15,581
  
 
11,016
  
 
5,326
  
 
17,872
  
 
73,780
      

  

  

  

  

  

  

Other commitments:
                                                  
Debt principal and other (1)
    
 
1,196
  
 
4,962
  
 
2,004
  
 
74
  
 
—  
  
 
2,188,229
  
 
2,196,465
Debt interest (1)
    
 
—  
  
 
124,871
  
 
138,074
  
 
138,074
  
 
138,074
  
 
397,234
  
 
936,327
Capital leases
    
 
2,559
  
 
7,555
  
 
624
  
 
—  
  
 
—  
  
 
—  
  
 
10,738
Operating leases
    
 
17,767
  
 
54,640
  
 
44,765
  
 
38,188
  
 
38,457
  
 
177,050
  
 
370,867
Marketing agreements
    
 
5,311
  
 
4,942
  
 
45
  
 
—  
  
 
—  
  
 
—  
  
 
10,298
      

  

  

  

  

  

  

Other commitments
    
 
26,833
  
 
196,970
  
 
185,512
  
 
176,336
  
 
176,531
  
 
2,762,513
  
 
3,524,695
      

  

  

  

  

  

  

Total commitments
    
$
33,068
  
$
214,720
  
$
201,093
  
$
187,352
  
$
181,857
  
$
2,780,385
  
$
3,598,475
      

  

  

  

  

  

  


(1)
 
Principal and interest payments due under the Company’s 6.875% PEACS, excluding those payments with a fixed exchange ratio under the currency swap hedge arrangement, will fluctuate based on the Euro/U.S. dollar exchange ratio.
 
Long-term capital lease obligations are as follows (in thousands):
 
    
September 30, 2002

 
Gross capital lease obligations
  
$
10,738
 
Less imputed interest
  
 
(814
)
    


Present value of net minimum lease payments
  
 
9,924
 
Less current portion
  
 
(8,613
)
    


Long-term capital lease obligations
  
$
1,311
 
    


 
Restructuring-related lease obligations are as follows (in thousands):
 
    
Three Months Ending December 31, 2002

   
Years Ending December 31,

   
Thereafter

   
Total

 
      
2003

   
2004

   
2005

   
2006

     
Gross lease obligations
  
$
6,614
 
 
$
17,868
 
 
$
18,050
 
 
$
14,781
 
 
$
13,677
 
 
$
50,382
 
 
$
121,372
 
Estimated sublease income (1)
  
 
(379
)
 
 
(1,698
)
 
 
(3,469
)
 
 
(6,878
)
 
 
(8,351
)
 
 
(32,510
)
 
 
(53,285
)
    


 


 


 


 


 


 


Lease obligations, net
  
$
6,235
 
 
$
16,170
 
 
$
14,581
 
 
$
7,903
 
 
$
5,326
 
 
$
17,872
 
 
$
68,087
 
    


 


 


 


 


 


 



(1)
 
At September 30, 2002, the Company had signed contractual sublease agreements covering $11 million in future payments.
 
Net cash provided by or used in operating activities consists of net loss offset by certain adjustments not affecting current-period cash flows, and the effect of changes in working capital. Adjustments to net income to determine cash flows from operations include depreciation and amortization, equity in losses of investees, and other items not affecting cash flows in the current period. Net cash provided by operating activities during the three months ended September 30, 2002 was $38 million, resulting from our net loss of $35 million, offset by

35


Table of Contents
changes in working capital of $47 million and by adjustments not affecting third quarter 2002 cash flows of $26 million (primarily associated with depreciation of fixed assets). Net cash used by operating activities during the three months ended September 30, 2001 was $64 million, resulting from our net loss of $170 million and changes in working capital of $30 million, offset by adjustments not affecting third quarter 2001 cash flows of $135 million (primarily associated with losses resulting from the remeasurement of our 6.875% PEACS from Euros to U.S. dollars, amortization of goodwill and intangibles, and depreciation of fixed assets). Net cash used by operating activities during the nine months ended September 30, 2002 was $198 million, resulting from our net loss of $152 million and changes in working capital of $226 million, offset by adjustments not affecting 2002 year-to-date cash flows of $180 million (primarily associated with losses resulting from the remeasurement of our 6.875% PEACS from Euros to U.S. dollars, depreciation of fixed assets, non-cash interest expense and stock-based compensation). Net cash used by operating activities during the nine months ended September 30, 2001 was $469 million, resulting from our net loss of $572 million and changes in working capital of $253 million, offset by adjustments not affecting 2001 year-to-date cash flows of $357 million (primarily associated with asset impairments resulting from our January 2001 operational restructuring, amortization of goodwill and intangibles, and depreciation of fixed assets). At June 30, 2002, prepaid expenses and other current assets were increased approximately $20 million because a credit card service provider unintentionally failed to make a scheduled settlement. Since this receivable was settled during the three months ended September 30, 2002, it had a positive effect on the operating cash flows of this three-month period, offset in part by an increase in prepaid advertising.
 
Cash provided by inve