Boring Portfolio

New Bore Holding Powers Up
Gateway Scores

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (April. 23, 1999) -- Leveraging off this morning's work on the Fool Plate Special, here's our look at Gateway's Q1 report.

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.

For more info, see the Gateway quarterly press releases.

American Power Reports

I forgot to mention the other day that we had, pursuant to our buy announcement made last week, purchased the following company on Tuesday. Our cost basis is $28.95 per share, including commissions.

The other Boring Port holding to report yesterday was American Power Conversion (Nasdaq: APCC), the leading manufacturer of uninterruptible power supplies and power management hardware and software for the PC industry. The company also manufacturers and markets power protection equipment for communications systems, data centers, and basically anything that needs 99.999% uptime.

Pretty much everything we wanted to see for the quarter was there. Product mix and revenue growth were both healthy, with revenues growing 27% quarter-to-quarter and EPS rising 28.6%, which includes a little goodwill amortization in only this year's operating expenses. Gross margin declined a bit year-over-year, falling 71 basis points due to the addition of Silcon's lower margins and in accordance with long-standing company guidance.

Seasonality is a fact of life in APC's business, due to normal PC and server spending patterns as well as the fact that summer storms and increased power grid demands bring about increased sales in the summer. Here's how Q1 revenues have looked versus Q4, percentage-wise, over the years. I also present year-over-year revenue growth data.

               Seq.    Year-year
Q199  $277.2  -13.09%  26.65%
Q498  $318.9           26.69%
Q198  $218.9  -13.06%  27.26%
Q497  $251.7           19.82%
Q197  $172.0  -18.14%  21.46%
Q496  $210.1           48.48%
Q196  $141.6    0.07%  29.67%
Q495  $141.5           24.67%
Q195  $109.2   -3.79%  
Q494  $113.5

Inventory this quarter was up due to an increase in raw materials. WIP (work in process) and finished goods were down slightly for the quarter. Which is good in my book, as the company is expanding Asian manufacturing and will bring the Indian plant online in Q2. If you're starting up plants in India and China, it's reasonable to expect raw materials to be up.

The analysts are going to focus on the days in inventory and be worried about linearity with days sales outstanding (DSO) up. But APC covers its capital costs of carrying high inventory because it's able to lock up incremental sales with high product availability. That also gets them the follow-on business in the future, since there's a lockdown effect to winning an account. If APC equipment works well in a network, then the network manager isn't going to fool around with some other equipment. The software also adds to this lockdown effect. While over 143 days in inventory is a little high, the company is heading into the busy season here and building out global manufacturing. Here are the sequential inventory trends:

Q199 inventories:
Raw materials ~$105 million
Work-in-process ~$8 million
Finished goods ~$131 million

Q4 98 inventories:
Raw materials $88 million
Work in process $9.3 million
Finished goods $131.4 million

Again, this is part of the model. This is a high-margin, low-turns company that bears the extra capital costs of carrying a high number of stock keeping units (SKU) and a high level of inventory to meet customer demand that can come on instant notice following storms or power outages. At the low point of the year -- Q1 -- the company still generated a 23.4% return on invested capital (ROIC), versus Q4 1998 ROIC of 33.6%. That is down from ROIC of 29.6% in Q1 of 1998, due in part to a 76% year-over-year increase in average invested capital in Q1. Part of this is due to the $50 million+ year-over-year addition to goodwill. Off a larger capital base, the company's ROIC was lower but absolute EVA was up 17.3% year-over-year, which is a good performance and within the realm of what we want to see.

APC is clearly growing to its potential and is doing a good job rounding out its global manufacturing capabilities.

Here is APC's quarterly data.

Have a good weekend, Go Sabres, and we hope to see you on the ever-exciting Boring board.

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04/23/99 Close
Stock Change   Bid
APCC  +5 1/8   34.31
BRKb  -13      2474.00
CSL   -  7/8   48.69
CSCO  +4 3/16  117.38
GTW   -  7/16  69.50

                  Day     Month   Year  History
        BORING   +2.57%   6.62%   6.92%  43.56%
        S&P:     -0.15%   5.48%  10.70% 125.63%
        NASDAQ:  +1.14%   5.24%  18.15% 148.88%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    117.38   389.97%
  8/13/96  200 Carlisle C    26.32     48.69    84.95%
  4/20/99  230 American P    28.95     34.31    18.51%
 12/31/98    8 Berkshire   2244.00   2474.00    10.25%
   2/9/99  100 Gateway 20    72.38     69.50    -3.97%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  26409.38 $21019.39
  8/13/96  200 Carlisle C  5264.99   9737.50  $4472.51
 12/31/98    8 Berkshire  17952.00  19792.00  $1840.00
  4/20/99  230 American P  6659.25   7891.88  $1232.63
   2/9/99  100 Gateway 20  7237.50   6950.00  -$287.50

                             CASH    $999.27
                            TOTAL  $71780.02