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Friday, October 23, 1998

An Investment Opinion
by Dale Wettlaufer

Gangway for Gateway

Bovine boxmaker Gateway (NYSE: GTW) gained $1 7/8 to $51 5/8 on reporting strong third quarter results last night after the bell. The number-two direct marketer of PCs reported unit growth of 43% for the quarter, strongly ahead of first half unit growth of 36%. For the quarter, 887,000 units shipped, up from 622,000 last year. For the three quarters of 1998, unit shipments looked like this:

     1997     1998   growth rate % 
 Q1   555        767     38.2 
 Q2   554        736     32.8 
 Q3   622        887     42.6

Much attention has been paid to pricing declines in the quarter, but it's not a new feature of the industry now or particularly alarming this quarter. Clearly, pricing declines during the quarter were larger than the company expected, and desktop pricing declines in the industry were greater than the average unit price decline Gateway saw during the quarter.

Overall, unit prices declined 15.4% year-over-year and 7% sequentially. However, the company's year-over-year cost of goods sold per unit declined much more dramatically, down 23%. That's compared with a quarter of bad inventory management and the UPS strike last year, but the component cost declines year-over-year should really be mentioned when talking about year-over-year price declines. Perhaps more useful, sequential component price declines and better inventory management drove a 7.18% sequential decline in cost of goods sold per unit. Year-over-year, gross margin improved by 7.84 percentage points and sequentially, gross margin improved by 20 basis points (100 basis points equals one percentage point).

However, a couple of things mitigated the price declines for the company. Just as Dell Computer (Nasdaq: DELL) has richened its product mix over the last couple years by selling servers, portables, and workstations, Gateway's product mix has sweetened with its entry into the server business in the third quarter a year ago and with improvements in laptops. Electronics contract manufacturer Jabil Circuit's (NYSE: JBL) announcement earlier this year that it won a contract to assemble laptops for Gateway was a good leading indicator of unit growth in portables for Gateway.

During the quarter, mobile PC sales were up 96% year-over-year and 38% sequentially. CEO and Chairman Ted Waitt was especially high on their FireAnt portables, which range in prices of $2,099 to $2,999 in standard configurations. Server sales increased 297%, and were up 27% sequentially.

What was interesting about the quarter was that there were brakes on the company's performance from a couple of different factors. European growth was flat, which is normal in the summer months and has been reflected in a number of companies' Q3 reports. In addition, Gateway reported unspecified component quality problems, which stretched out some delivery times and built the company's backlog to a record of approximately 50,000 units. These didn't work their way through to the customer but did take ending inventory up to 12.6 days, down from a record average low of 11.06 days during the quarter. Overall, the company's cash conversion cycle reached negative four days, and annualized return on invested capital (ROIC) was 45.7%.

For the fourth quarter, the company says it is comfortable with the analysts' mean EPS estimate. Zacks' number currently stands at $0.79, up 34% from Q4 1997. This quarter, the company reported EPS of $0.51, up from a loss last year due to inventory writedowns. For the coming quarter, the company is expecting annualized price declines of 12.5% to 21.6% (3-5% sequentially), with margins flat to slightly down, and SG&A spending up sequentially but down as a percentage of sales.