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Monday, July 26, 1999

An Investment Opinion
by Dale Wettlaufer

Gateway's Solid Q2

PC company Gateway Inc. (NYSE: GTW) blasted ahead on Friday after reporting its Q2 results Thursday evening. Once again, the company demonstrated excellent progress in a number of areas, not the least of which was the income statement. Revenues grew 18% year-over-year and net income grew 47%. The quality of earnings was excellent as well -- a 143 basis point increase, year-over-year, in gross margin contributed to a 46.4% increase in operating income even as sales, general and administrative expenses as a percentage of revenues expanded by 18 basis points.

Working capital management was once again excellent, as Gateway has been a solid performer in this area for more than four quarters running. This is almost expected of the company at this point. The average cash conversion cycle was negative 7.6 days and ending days in inventory were 7.4. Invested capital expanded at a 47% annual rate sequentially while return on invested capital (ROIC) was approximately 43%. In general, a company is going to increase in value when it can expand invested capital at such rates and show returns on capital so far in excess of its cost of capital.

On a trailing basis, return on capital has been closer to 50%, but a lower ROIC in percentage terms is not unfavorable given that it's being generated on a higher capital base. In terms of economic value added (EVA) analysis, EVA has increased and thus market value added should expand.

One huge thing that didn't get much play in the press accounts I noticed (I have no idea why) is the company's deal with GE Capital Information Technology Solutions. This unit of General Electric (NYSE: GE) is one of the largest information technology companies in the world. In essence, this is a huge distribution and service arm for Gateway. From the company's conference call last week:

"Today we made a major announcement of an alliance with GE Capital Information Technology Solutions. [Gateway will partner] with them as they go into the global 2000 marketplace. This is a market we've not actually been strong in." Gateway doesn't have a lot of the "services capabilities that are required to compete in that market. GE does have those capabilities and now what we're doing is marrying our world-class build-to-order capabilities with their capabilities. Our relationship with them is unlike most relationships in the channel. And that is that we basically will build to order based on client needs, we'll ship directly to the client, we'll use our custom-integrated services capabilities to customize for the client, and then GE will take it from there. It's really a very unique relationship. We're not shipping inventory to GE. They're not sticking things on shelves, we're not negotiating price protection agreements. All the things that are so damaging in existing channel relationships do not exist in this relationship and we are looking forward to this being a very, very significant relationship as we go forward."

This is a big step forward for Gateway in the corporate arena. All of a sudden it has the market reach capabilities of a giant IT services company. This works for both companies in the deal. GE gets a build-to-order PC manufacturing partner, and Gateway leverages its strengths as a precision manufacturer. If the relationship works well, it can allow Gateway to further refine its supply chain efficiencies and get it to scale in servers, which in turn richens product mix and gives the company the possibility of an increased offense against average selling price declines. Not to overstate things, but that sounds like Dell Computer (Nasdaq: DELL) circa 1996-1997.

Granted, the company will probably cede some margins on these products by wholesaling to GE, but who cares? The idea isn't to generate pretty margins or even maximize ROIC. The goal is to maximize economic value added, or the difference between return on invested capital and weighted average cost of capital, both expressed as percentages, times invested capital. Plus, if it gives Gateway scale in the server and workstation business, it equips the company to compete much more effectively against Compaq (NYSE: CPQ) in corporate sales. After all, I think at this point Compaq is still the wounded old lion and the direct PC companies are the hyenas. Hyenas work in pack fashion on crippled competition and won't turn on each other until that competitor is dead.

In the consumer segment, Gateway is hitting on all cylinders -- 46% unit growth in consumer PCs resulted from the company's strong product offerings and price points that make sense to customers, the bundling of ISP access, financing packages, and good overall word of mouth. On Thursday President Jeff Weitzen commented on Gateway's consumer strategy for the quarter in one of the more telling comments in the conference call, indicating that the management team of Gateway is very much on the ball: "The strategy there was to go fishing when the fish were biting. That means the company would scale back marketing and competitive pricing in April and May, when consumers are less active and returns on operating expenditures are lower, and focus more on margins and profit dollars during those periods. In June, when the fish are biting, the company was aggressive on pricing and really focused on maximizing units. The company had a 'tremendous June' almost on equal in results with December, which is usually the best month of the year for Gateway. The net of all this was consumer unit growth of 46%."

As far as I'm concerned, the growing evidence that Gateway will not acquire an Internet service provider is big news, as well. Rather than paying a big premium for an ISP in hopes that the synergies generated will cover the company's required rate of return on such an acquisition, many investors would prefer to see the company remain technology-agnostic and strategically flexible. Synergies are nice, but the company had better know what it's doing if it wants to get into the infrastructure business, where hundreds of billions of dollars worth of incumbent capital and scrappy new companies are going to be working against it.

In sum, I believe the market was pleased by the financial and operational results for the quarter, overwhelmed at the huge positive in the GE Capital IT Solutions announcement, and relieved that Gateway probably won't be acquiring an ISP. Once again, there's nothing not to like here and a heck of a lot to like on the strategic front. At $71, the company is still a fine value -- I believe it will outperform the market over the next five years.

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