By Megan Graham-Hackett
At Gateway's (GTW ) annual analyst meeting in California, held in late February, the PC maker was expected to introduce new strategies and a new management team headed by co-founder and former CEO Ted Waitt. In fact, things went along quite predictably until the final presentation of the meeting. After the close of the market Feb. 28, Gateway announced a sharply reduced forecast for 2001 and that it had restated 2000 results based on the completion of its year-end audit.
The lowered guidance was expected, but the cut was deeper than analysts had projected - we thought the downside in estimates could reach $1.00 for the year, but our new model now projects just $0.25 for the year.
A FEW REVISIONS.
What happened? The company restated results for the first three quarters of 2000, and "revised" full year financial results to reflect the adoption of new accounting principles, and the new accounting treatment of certain items. The net effect was to reduce 2000 revenues to $9.6 billion from $9.65 billion, while EPS results for the year were lowered by $0.22. The largest impact ($0.14 of the EPS reduction) owed to a larger write-down of the company's investments in tech stocks. There was also a charge of $0.03 in the loan-loss reserve of the company's finance receivables portfolio due to change in the accounting methodology.
The good news is that the revisions suggest a more conservative accounting methodology for Gateway under the helm of its new CFO, Joe Burke. This is especially true for key areas such as its investment portfolio and financing activities, which are critical areas to watch for any tech company.
Regarding the earnings revisions, more ominous issues loom. The company lowered guidance to break-even operating results for the first quarter of 2001, and for the first half. The prior guidance from previous management had been for Q1 EPS of $0.21 (S&P carried an estimate of $0.14), and Q2 EPS of $0.23. The company had also guided for full year EPS of $1.44, revenues up 3% and gross margin around 22% in the second half of the year.
As mentioned above, going into the meeting we believed, given the current PC pricing environment, that the company's revenues and gross margin guidance were vulnerable and that 2001 EPS could be closer to $1.00. We believed that a p-e multiple of 15X-17X that estimate was fair, and thus with Gateway shares trading within that range, we kept our hold recommendation.
However, during the course of the meeting, the company presented slides showing a dramatic fall-off in close rates -- customer satisfaction. Meanwhile, Gateway's cost structure has ballooned to the point that it is not in line with its industry peers. This will add an additional hurdle to Gateway in what is already a difficult PC environment. Thus, we changed our revenue estimate, and instead of 2% revenue growth, we now believe revenues could be down 7-8%. We also believe gross margin for the year will be challenged by the pricing environment. With the shares vulnerable to a further cut in management's expectations for 2001, we changed our recommendation to avoid.
The company does have a sound strategy for improving its cost structure. The biggest bang is expected to come from streamlining the number of products it offers - Gateway plans to reduce the number from more than 20 million to the hundreds. This saves the company in development costs, enhances sales force productivity, and improves costs related to managing inventories and supply relationships. Also, the company has implemented certain sales force strategies, which its says has enabled close rates and sales activity to improve since January.
While the coherence of the strategy was good, it was not revolutionary. Broadly speaking, Gateway intends to focus on improving its cost structure, customer value and service. Now, all PC vendors talk about this, but we believe prior management at the company let these key strategic areas be marginalized while it focused on BTB (beyond the box sales, meaning financing, service, software and peripheral offerings to augment the price of the PC), and growing retail points of presence (its Country Stores and store-within-a-store concepts). The new Gateway team has distanced itself from a maniacal focus on BTB to emphasize PC unit sales, and will keep the number of Country Stores at around 300. To get to this level, GTW may close a few stores, and this stands in contrast with prior management's goal to open about 60-80 this year.
The new team has some well-regarded individuals from Gateway's past, as Waitt joked that he called around and said he was "getting the band back together." Heading the consumer division is Bart Brown, who spent 12 years at Gateway. Joe Burke is the new CFO, having joined Gateway in 1995. Mark Hammond, co-founder of GTW, is in charge of operations. New faces include Sue Parks, who actually was named in charge of the Business division in September 2000. Heading up international efforts is Martin Coles, who has experience with Pepsi and P&G.
The company admitted that its visibility on 2001 results was limited, but as mentioned above, it still maintained that it could meet prior guidance of 2%-3% revenue growth. Based on our earnings model, the company will need to see a solid recovery in the PC market during the second half of the year to meet this goal. Given the current clouded outlook on PC demand for the second half, and GTW's cost structure at a competitive disadvantage, we believe this will prove challenging.
Furthermore, other PC companies get an offset to weak U.S. PC demand by benefiting from better growth internationally, sustained growth in notebooks and PC server sales. Gateway does not participate to the same degree as its peers do in these relatively stronger markets. Thus, compared with its peers, Gateway is in a difficult competitive situation -- in a difficult market. We would avoid the shares until the company's operational strategy has a chance to gain traction. That will require a more stable PC market, which is at least six to nine months away.
Graham-Hackett is Director of Technology Research for Standard & Poor's