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November 28, 2000

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Subject:  Cockroach Theory
Author:  ToddFinances

Wall Street has a penchant for attempting to predict the future before it actually happens. Both Hewlett-Packard (NYSE: HWP) and Dell Computer (Nasdaq: DELL) have disspointed Wall Street recently so the logic is extrapolated to include Gateway (NYSE: GTW) regardless of what the CEO professes. As a result, the stock price is sharply corrected to include a PC slowdown in anticipation of the soft sales. As shareholders, we ask ourselves, is this price correction warranted?

On April 23rd, Dale Wettlaufer wrote an article on Gateway entitled: "Gateway Scores Hat Trick". This is an interesting article as it touches on Return on Invested Capital (ROIC) and Economic Value Added (EVA). Companies with high ROIC and growing EVA scores have been shown to offer growing stock prices over time. Dale states: "On an EVA and DCF basis, I have the company worth well over $90". More recently in August, Richard McCaffery wrote an article on GTW putting ROIC at 26.5%.

We can compare that to the ROIC of Coca-Cola (NYSE: KO) for 1996-1998 of 24%, 29% and 24%. Obviously the return with sugar water is quite high and the strong brand name gives KO a strong moat around its business. Now Gateway is no Coca-Cola. Gateway sells a commodity while KO sells a brand name.

My point is quite simple. If GTW can continue with their good capital management and maintain a high ROIC and even grow it with their sales of "computer-related" products and services then the stock price will go up accordingly. This life-jacket of ancillary products and high margin services may help to counter any softening in box sales. In fact, Valueline reduced their 3 to 5 year sales projection by 18% mainly because box prices are falling. Yet, they only reduced their EPS projections by only a nickel as margins are expected to increase from 10% to 12%.

The repeat business from the training classes offered is also appealing. 60% of all customers who buy at GTW buy at least one training class and 80% of those who take one class return for another. So not only are the high margin businesses of GTW growing, the repeat pattern encourages continued strength.

As a new shareholder who bought at $33/share I thought it was interesting to view a negative scenario for GTW. Based on an EPS of $1.85 and a 5 year horizon, GTW could grow EPS only 15% (half of what is expected) and be awarded a P/E of only 15 due to a slow economy and GTW would be valued at $55.81. That's an 11% annual return from a price of $33 which is just above the long-term stock market average with stocks.

If you change the EPS growth rate to 20% (33% lower than expected) and put the P/E at 20, GTW jumps to a price of $92 at the end of 5 years which correlates to a 23% annual return from a price of $33.

So we have to ask ourselves, if GTW performs as expected by many analysts, Valueline and the S&P Reports how nice is the upside here? I like to invest in a good business when the pessimism is factored in and the upside remains generous. So even if the bear case comes to fruition, an investor can still make a return greater than that of bonds.


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