Friday, April 23, 1999
DJIA 10665.33 -61.85 (-0.58%) S&P 500 1349.82 -9.01 (-0.66%) Nasdaq 2553.95 -7.66 (-0.30%) Russell 2000 428.78 -0.07 (-0.02%) 30-Year Bond 95 6/32 +8/32 5.58 Yield

An Investment Opinion
by Dale Wettlaufer

Gateway Scores Hat Trick

Direct PC company Gateway (NYSE: GTW) scored a hat trick once again this quarter. Goal 1: Outgrow the industry; Goal 2: Good capital management; Goal 3: Turn in good margins and make investments to grow the business. In the worst Q1 sentiment environment that I can remember, the bovine box company grew unit sales 42% year-over-year, nearly three times worldwide unit growth. In the U.S., Q1 unit sales into the consumer market grew 61%, tripling industry growth in the U.S. consumer market and giving Gateway a 25% share in that market, according to the company.

One nice thing about this data is that you don't have to figure out if it's sell-in or sell-out and you don't have to figure out if management is giving you the most economically meaningful numbers. Gateway doesn't have a couple of different models that they have to mess with. They have a few different distribution methods, but they're all direct, as Ted Waitt pointed out so many times yesterday, emulating Michael Dell. If Waitt's executive team is thinking like Michael Dell's, and not just sounding like it (which would be cynical to say, and which I doubt due to the numbers over the last year), then they're on the right track.

Some more numbers: Gross margin expanded 194 basis points year-over-year, resulting in a 33.9% increase in gross profit dollars on a 21.7% increase in revenues year-over-year. Sticking that extra 194 basis points of margin in the bank or sending it back to shareholders would be a bad idea since Gateway is generating increasing returns on capital. What it did in Q1 was the same thing it did last quarter -- it's pouring that back into operations, expanding its outbound business sales force operating from its nearly inventory-free Gateway Country stores. It's stepping up advertising and marketing to build brand equity; and it's increasing its inbound sales and service people infrastructure to handle volume, close the sale, and keep the customer happy. As a result, the company poured more sales dollars into SG&A to the tune of 14.7% of revenues, up from 13.5% last quarter and 13.2% in Q1 1998.

Far from being a problem, these are investments that increase the intrinsic value of the company even though they're being expensed and they don't come at the expense of an overall margin decline worthy of concern. In a seasonally-slower Q1, operating margin expanded 37 basis points year-over-year, though some analysts might be fixating on the sequential decline in operating margin. Gross profit dollars were down $47.8 million and SG&A spending was down less than $1 million. Far from being unintentional and a bad sign, that's discretionary spending the company is engaging in, which many investors and commentators seem to have a problem with (whether it's capitalized or immediately expensed) when they're looking at a single point analysis rather than thinking about things inside a discounted cash flow or economic value added perspective.

Cash conversion cycle for the quarter was excellent. Gateway calculates it a little differently with better information and a little different way of looking at it than I, but I get negative 4.7 days calculated with average balance sheet data. Ending days COGS (cost of goods sold) in inventory was 9.08, but I believe that's being pushed up a little bit with things other than manufacturing-related COGS coming through the income statement. Double-digit same-store sales growth at Gateway Country stores likely resulted in better than 100% return on invested capital (ROIC) for the Stores and overall ROIC was 62.5%, adding back $4.7 million in additional warranty float to net operating profit after taxes (NOPAT).

Taking out that addition to NOPAT, whatever flavor you prefer, ROIC was 59.4% (both annualized). Counting Q4's addition to warranty float in ROIC, return on capital in Q4 was 89.3%. Not counting it in, ROIC in Q4 was 80.6%. All are great numbers. Q4 is definitely helped by that extra float and current liabilities in the busiest quarter reducing Gateway's net investment in the business. Yes, some people are going to focus on that, as well, but these are spectacular numbers that point to an economic model that is pretty hard to beat.

On an EVA (economic value added) and DCF (discounted cash flow) basis, I have the company worth well over $90. This quarter's progress added to the intrinsic value of the company, though I recognize that the value of a well-run PC company is not always going to be recognized through the second and third quarters. Maybe so, maybe not. But I don't rely on the market to tell me what things are worth.

In the meantime, I think this points to the fact that the PC industry is quite alive and that Gateway, along with Dell, is taking the economic returns that are to be found in this still-attractive industry away from other companies. EPS of $0.62, up 29%, on a 22% sales increase is excellent, as are the capital management data and the steady increase from last year in return on capital. Unless the PC industry dies tomorrow or next year, this company is worth a lot more than the current market quote.

Note: Gateway is a holding of the Fool's Boring Portfolio. Also, for more info, see the Gateway quarterly press releases.


Online auctioneer eBay (Nasdaq: EBAY) was bid up $12 13/16 to $184 13/16 this morning. The company announced a new "personal shopper" feature last night that will notify users of specific items up for sale through e-mail using keywords and a price range.

Cable TV operator Cox Communications
(NYSE: COX) plugged in $2 3/4 to $75 1/4 after announcing that it will buy cable systems serving more than 260,000 customers in Fairfax County and Fredericksburg, Virginia, from Media General (AMEX: MEG.A) for $1.4 billion in cash. Cox expects to close the deal late this year.

Cable TV operator MediaOne Group
(NYSE: UMG) raced ahead $7 1/4 to $76 3/4 this morning on news of a buyout offer from AT&T (NYSE: T). MediaOne already agreed to be acquired by rival Comcast Corp. (Nasdaq: CMCSK) about a month ago. AT&T's unsolicited counter-offer is worth $58 billion, or $87.375 per share -- $30.85 in cash and 0.95 of an AT&T share -- based on AT&T's close yesterday of $59.50. AT&T would also assume $4.5 billion in debt and preferred equity. Comcast advanced $1 11/16 to $69 5/16 this morning while AT&T lost $3 3/16 to $53 9/16; head back to today's Breakfast With the Fool for more.

Coffee maker and marketer Chock Full O'Nuts (NYSE: CHF) brewed up gains of $3 to $9 3/8 after confirming in a press release that it turned down an unsolicited $10 1/2 per share offer to be bought out by Sara Lee Corp. (NYSE: SLE). Chock Full O'Nuts called the offer inadequate and opportunistic. The offer represents a nearly 65% premium to yesterday's closing price for the coffee company's shares.

Online brokerage E*Trade (Nasdaq: EGRP), which announced plans to split its stock 2-for-1 after the market's May 21 close, advanced $6 23/32 to $102 23/32. It would represent the stock's second such split of 1999.

E-commerce intermediary Priceline.com (Nasdaq: PCLN) added $11 5/8 to $88 following its placement on Goldman, Sachs & Co.'s "recommended list."

Earnings Movers

Albany International
(NYSE: AIN) up $1/4 to $22 1/2; Q1 EPS $0.38 vs. $0.35 last year; estimate: $0.34

American Power Conversion (Nasdaq: APCC) up $3 1/4 to $32 7/16; Q1 EPS $0.36 vs. $0.28 last year; estimate: $0.32

Bemis Co. (NYSE: BMS) up $2 5/8 to $35 7/8; Q1 EPS $0.35 vs. $0.41 last year; estimate: $0.38

K-Swiss Inc. (Nasdaq: KSWS) up $5 to $42 3/8; Q1 EPS $1.15 vs. $0.31 last year; estimate: $0.75

Lam Research Corp. (Nasdaq: LRCX) up $1 9/16 to $35 11/16; fiscal Q3 EPS loss of $0.38 vs. loss of $0.13 last year; estimate: loss of $0.48

Molecular Devices Corp. (Nasdaq: MDCC) up $3 1/8 to $27; Q1 EPS $0.20 vs. $0.15 last year; estimate: $0.19

Pixar (Nasdaq: PIXR) up $3 1/2 to $45; Q1 EPS $0.02 vs. $0.08 last year; estimate: breakeven

Student Loan Corp. (NYSE: STU) up $2 3/4 to $40 5/8; Q1 EPS $1.16 vs. $0.84 last year; no estimate

Synopsys Inc. (Nasdaq: SNPS) up $1 to $44 1/4; fiscal Q2 pro forma EPS $0.60 (before charges) vs. $0.44 last year; estimate: $0.60

uBid Inc. (Nasdaq: UBID) up $7 1/2 to $58 5/8; Q1 EPS loss of $0.27 (before a charge) vs. loss of $0.12 last year; estimate: loss of $0.34


Programmable logic devices maker Xilinx (Nasdaq: XLNX) slid $5 3/16 to $47 15/16 after reporting fiscal Q4 EPS of $0.24 versus $0.20 last year, matching the Zacks mean estimate. However, Prudential Securities cut its rating on the firm to "accumulate" from "strong buy."

Digital audio and video tool creator Avid Technology (Nasdaq: AVID) slipped $5 1/8 to $14 1/16 after reporting Q1 EPS of $0.10 (excluding acquisition-related charges), down from last year's $0.31 and below the Zacks mean estimate of $0.20. Hambrecht & Quist cut its rating on the firm to "market perform" from "buy."

PC hard disk drive supplier Maxtor Corp. (Nasdaq: MXTR) slumped $1 7/8 to $5 11/16 after reporting Q1 EPS of $0.17, which was in line with the Zacks mean estimate. However, the company said a "very aggressive pricing environment" will put downward pressure on Q2 earnings. Merrill Lynch and Hambrecht & Quist both lowered their ratings on the firm this morning.

Electronic payment software developer Transaction Systems Architects (Nasdaq: TSAI) slid $7 7/8 to $29 1/8 despite posting fiscal Q2 EPS of $0.34 compared to $0.27, topping analysts' mean estimate of $0.30. However, BT Alex. Brown lowered its rating on the company to "market perform" from "buy."

Healthcare services provider United Payors & United Providers (Nasdaq: UPUP) was down $2 9/16 to $18 3/16 after selling 2.5 million shares in a secondary offering at a price of $19 per share, which is below yesterday's close of $20 3/4 per share.

Global satellite and paging company Iridium World Communications (Nasdaq: IRID) fell $1 5/16 to $15 3/4 after CEO Edward F. Staiano resigned yesterday, less than a month after CFO Roy Grant announced his decision to step down. Salomon Smith Barney, Goldman Sachs, and Credit Suisse First Boston reduced their ratings on the company.

Secure e-commerce transaction technologies firm VeriSign (Nasdaq: VRSN) dropped $19 11/16 to $127 after reporting a Q1 loss of $0.08 per share versus a loss of $0.27 per share a year ago, which was not quite as bad as the loss of $0.10 per share expected by analysts surveyed by Zacks. Nonetheless, Morgan Stanley Dean Witter lowered its rating on the firm to "neutral" from "outperform."

Wholesale food distributor and supermarket operator Richfood Holdings (NYSE: RFH) tumbled $4 3/8 to $11 5/8 after Carlisle, Pennsylvania-based Giant Food Stores, which is owned by the Netherlands' Royal Ahold N.V., said it will not renew its roughly $600 million a year food supply contract with Richfood when the contract ends later this year. Richfood said the decision will trim $0.15 to $0.20 per share from its fiscal 2000 earnings and $0.28 to $0.33 per share from its earnings thereafter.

Health and beauty aid products distributor Allou Health & Beauty Care (AMEX: ALU) lost $2 1/8 to $11 after announcing it has sold a controlling interest in its Fragrance Counter online subsidiary to a private investment group led by The Sudbury Group for $37.5 million. Sudbury plans to turn the business into "an Internet portal for beauty and well-being."

Oil and gas drilling equipment and machinery manufacturer Varco International (NYSE: VRC) slid $1 7/16 to $10 7/8 after saying the worldwide slowdown in drilling activity due to the ongoing oil supply glut resulted in Q1 EPS of $0.18, down from last year's $0.23 and a penny below the Zacks mean estimate. The company also warned that the full effect of the slowdown on its revenues will not be felt until late this year or early next year.

Critical Path (Nasdaq: CPTH), which provides e-mail hosting services to Internet service providers, Web portals, and corporations, was sent down $18 to $99 3/8 after reporting a Q1 loss of $0.77 per share, down from $0.28 last year. The company also announced four new contracts, including a deal to offer America Online's (NYSE: AOL) business users e-mail outsourcing services.

Programmable logic devices maker Lattice Semiconductor (Nasdaq: LSCC) slipped another $3 5/16 to $42 after falling 23% yesterday following its decision to buy Advanced Micro Devices' (NYSE: AMD) Vantis logic-chip division for $500 million in cash.

Telecommunications, cable, and Internet services provider Log On America (Nasdaq: LOAX) gave back $5 1/4 to $29 3/4 this morning after rising 250% yesterday following its initial public offering of 2.2 million shares at a price of $10 per share.


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