<THE BORING PORTFOLIO>
Gateway Call
Part 2 of 3
By Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (July 26, 1999) -- In its second quarter, Gateway (NYSE: GTW) continued to add outbound sales representatives at its Country Stores. The company is now at 181 reps in the Country Stores.
International business accounted for 16% of sales for the quarter. International is divided along two major geographic lines: Asia and Europe. "Europe continues to be an opportunity for Gateway. Units were slightly positive and revenue was down 14%." One highlight for Europe continues to be the UK consumer business, which grew units close to 20% and revenues at 8%. "We are seeing evidence in the third quarter that we are making very solid progress on sales. We are continuing to execute our strategy, and we're confident we'll see positive comps in Europe by the end of the year." Asia continues to grow rapidly, with 77% unit growth and 58% revenue growth. Probably the most important part of the company's Asia growth is across-the-board growth, geographically. All the company's major countries in Asia grew better than 50%.
Q2 gross margin was 22%, a record high. This is 1.4 points better than Q2 1998 and 60 basis points better than Q1 1999. Last quarter, the company did have a 50 basis point hit to gross margin from investments in ISP startup costs -- net of that, gross margin expanded by 10 basis points sequentially. Key to the record gross margin was a mix shift from consumer to business sales. Business sales carry higher margins and this is a more business-oriented quarter. Business sales as a percentage of total sales were 54% vs. 42% in Q1.
Another key to gross margin expansion was an increase in non-system income. Non-system income in the quarter exceeded 6% of total pre-tax income. Non-systems income is derived from software, financing, ISP service, additional warranty coverage, training, and other peripherals. All these elements contributed to profitability in the second quarter.
One contributor to non-system income was Gateway.net, as the company hit its goal of 400,000+ subscribers by the end of the quarter. That translates into a 200,000+ increase in subscribers for the quarter, making Gateway the fastest-growing ISP (on a percentage basis) in the country for the second quarter. Measuring on the basis of absolute number of additional subs, Gateway.net was the third-fastest growth ISP in the country for the quarter.
Also contributing to margin expansion was pricing. Component price declines were rather linear for the quarter. Gateway hasn't seen any acceleration or deceleration of cost decreases, which has allowed the company to meet its pricing objectives and leverage gross margins.
The company continued to invest in sales, general & administrative (SG&A) expenditures during the quarter. In the second quarter, SG&A investment focused on increasing Internet capabilities, systems infrastructure for scalability, international expansion, and Country Stores expansion. Despite this investment, the company was able to manage its SG&A down $10 million sequentially.
From a cash flow perspective, the ending cash balance was $1.228 billion. Operating cash flow increased $100 million. $144 million was invested in strategic initiatives, including the stock repurchase program and captive financing. Operating cash flow improvement was driven by cash conversion cycle improvement, which is now at -7 days.
Year-to-date units are up 39%, sales are up 20%, and EPS is up 37%. With a good start in July and the second quarter momentum, the company is comfortable with the Q3 consensus EPS estimate of $0.67 and full-year estimate of $2.80. For modeling the second half, the company recommends using historical trends for units, AUPs, and gross margins.
"In February, at our analyst meeting here in San Diego, we told you we'd continue building capabilities to satisfy our customers' complete computing and Internet experience. We also said we'd continue to broaden our complimentary channel efforts to give customers the best buying experience available in the industry and to allow them to do it in the way they wanted to, whether on the phone, the Web, the stores, or a combination of all three. We also said we'd diversify our revenue and profitability streams, and we'd do it all while consistently growing our share and profitability. This quarter is yet another example of this [management] team's delivery on those commitments.
"Our growth was at the high end of our historical growth trajectory. We exited with our largest backlog in history -- about 40,000 to 50,000 units above normal. We had a huge June.... We literally ran seven days a week, 20 hours a day in manfacturing in the last three weeks of the quarter and exited with very strong momentum. We're now working the backlog down and ramping further capacity for Q3 and Q4 and should be back to normal backlog levels very shortly.
"We made great progress in the sub-$1,000 market. It represents a much larger part of our mix this quarter than it had in any previous quarter... with very little degradation in average selling price. We told you that we'd enter that market more aggressively when we built our business model that enabled us to bundle more capabilities and drive more profit out of less expensive hardware units, and we've done that. Non-system revenue and income leapt quarter-over-quarter through peripherals, software, and Internet sales, causing virtually no sequential decline in consumer average selling price, despite the increased of the sub-$1,000 mix. We're going to get more aggressive in this space as the year continues to unfold and we completely prepared to deal with the so-called 'free mania' that's out there right now."
A few words on the "free PC": "First, all of our research indicates that customers are concerned [about? garbled] PCs tied to long-term ISP contracts, specifically narrowband contracts, knowing that broadband is in the near future. A lot of these deals literally have more strings attached to them than Pinocchio. Second, the demographics of those attracted is not the most profitable and we believe there are better alternatives for this group besides getting locked into a long-term deal. Third, the flexibility of our model will allow us to bundle in any way. It's what we've been arguing for the last several months. We can bundle whatever we choose.
"All the deals you see, by the way, offered by the various ISPs or online providers have all been offered to us. Of course, on this call we don't plan on signaling our competition on exactly how we'll move to the market over the course of the coming weeks. Finally... we're really disappointed, but not all that surprised, at the deceptive advertising and promotional practices that are associated with these offers. We think there's a lot of bait-and-switch going on out there. It's not good for customers and we actually don't think it's good for the long-term health of the industry. A lot of people are beginning to catch on as they look under the covers and recognize that there is no free PC out there when they recognize that they're committed to a three- or four-year contract for Internet access on a monthly basis of $22 to $25 per month. There's one thing I can say -- there's never been a free lunch and I'm not sure there's ever going to be a free lunch, and we believe buyers should beware.
"The bottom line here is that the consumer business is very strong, we continue to lead the market in innovation, and we have the flexibility to deliver despite the 'promotional gimmick of the week.'
"Another thing we're really pleased about this quarter is the progress of the business market, with units up over 30% and revenue up 12%, literally twice the growth of the first quarter. A combination of things is really driving this performance. First, very strong performance in the education market, one of the markets we're absolutely committed to and have targeted. Second is strong small business performance, which has really been aided by the Country sales force we've employed over the course of the last 6-9 months.... We'll continue to grow [the sales force] as quickly as we prudently can. You just can't double your sales force overnight. If we could, we probably would, but we're ramping that as quickly as we possibly can right now. As I told you on the last call, that sales force gives us tremendous presence." The sales force gives Gateway face-to-face presence, capabilities to demonstrate product, service capabilities at its service depots, and the power of a national and international brand. That's really beginning to pay off in the small business market.
The partners strategy the company began to talk about a year ago is really beginning to show results. "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 relationship do not exist in this relationship and we are looking forward to this being a very, very significant relationship as we go forward."
Part 3 of the prepared remarks and excerpts from the Q&A session will be presented in Wednesday's Bore Port report.
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