Ouch!

Rarely in the history of equity investing has a company been so harshly treated for reporting a return to profitability. On Monday evening, Gateway (NYSE:GTW), the little computer maker that (finally) could (make a profit) chirruped happily to the mavens of Wall Street that it had earned its "first GAAP profit from operations after 13 consecutive quarters of GAAP net losses." Sad to say, hurrahs, huzzahs, and tickertape parades did not ensue.

On the contrary, when the markets reopened for business on Tuesday morn, Gateway's stock got slammed. As of this writing, it's down well more than 20%. Such an illogical reaction to a company's long-awaited switch from red to black ink deserves closer inspection.

The good news
This part's easy. Gateway posted an increase in Q2 2005 sales over its performance during Q2 2004. It wasn't a lot -- just 4% year over year. But for a company that saw its sales decline in every year since 2000 before returning to an uptrend last year -- and then saw that upward movement stumble last quarter -- the resumption of the uptrend was happy news. Another pleasant surprise was that Gateway finally made it over the profitability threshold, which had just barely eluded it last quarter. In Q2 2005, Gateway posted $0.05 in profits, albeit with a huge boost from a $15.1 million settlement payment from Microsoft (NASDAQ:MSFT) and lesser gains from operations.

All of this occurred, by the way, within the context of the PC industry price war that took a toll on industry standard and Motley Fool Stock Advisor selection Dell (NASDAQ:DELL) last week. We should find out tonight how Gateway's other main rival, Hewlett-Packard (NYSE:HPQ) performed. Bearing that in mind, let's turn to.

The bad news
Take your pick. There's plenty here to choose from:

  • The company's diluted share count increased a whopping 9% -- an incredibly un-shareholder-friendly development, and totally out of line, as it threatens to deprive outside shareholders of their fair share of the profits just as the prospect of profits becomes more believable.

  • Inventories swelled more than 20%. In light of the mere 4% increase in sales, that, too, seems out of line.

  • Accounts receivable ballooned by an even worse 26%. Need I repeat myself?

Remember that the bulk of Gateway's profits came from a one-time payment from Microsoft. Combine that with the red flags planted in Gateway's inventory and A/R line entries, and the quality of Gateway's earnings becomes suspect. It seems that investors can be forgiven for holding off on the tickertape parade.

For more Foolish news and views of Gateway, read:

Fool contributor Rich Smith owns no shares in any company mentioned in this article.