Barrons Weekday Trader ....must read....
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Weekday Trader
Gateway Holders May Pay the Price for Cheaper PCs
Lisa R. Goldbaum
Sometimes it's not so bad to play second fiddle.
Take Gateway Inc. (GTW), the second-largest direct marketer of personal
computers (behind Dell Computer (DELL), of course). The North Sioux City,
SD-based PC maker has seen its sales more than double during the past three
years, from about $2.7 billion in 1994 to nearly $6.3 billion in 1997.
Its stock performance--while trailing Dell's more than 1,300% appreciation
since 1995--is hardly second-rate, either: Gateway'sÿ shares have soared
nearly 600% since itsÿ debut as a public company at the tail end of 1993.
Investors have clearly endorsed bothÿ companies' "direct sales" approach,
in which a company builds a computer only when a customer orders one, thus
eliminating the guesswork. No fuss, no muss and no inventories.
But nothing lasts forever. Pricing pressure is now wracking the personal
computer industry.ÿ International Data Corp. analyst Kevin Hause predicts
that computers costing less than $1,500 will represent 64% of PC sales by
2001, compared with 30% last year. We recently suggested in Weekday Trader
that this price erosion is likely to cut into even mighty Dell's margins
("Can Dell Really Do No Wrong?," May 21). Gateway could be hit much harder.
And at the stock's current price levels, investors may not be so forgiving.
After hitting an all-time high near 60 at the beginning of May, the shares
settled back down to the mid-40s. But they've rebounded nicely over the
past week and a half--including a 1 7/16-point jump on Tuesday--and are now
trading at 51 1/16. At Tuesday's closing price, the shares change hands at
about 23 times the $2.25 per share analysts tracked by Zacks Investment
Research predict the company will earn in 1998--exactly in line with its
projected five-year earnings growth rate.
But some analysts think that the company may fall short of Wall Street's
earnings forecasts this year, and beyond that is a question mark. Piper
Jaffray analyst Ashok Kumar recently lowered his earnings expectations for
Gateway's second quarter ending in June to 45 cents from 47 cents, and he
thinks the stock could fall to as low as 36.
"The pricing pressure they are faced with is more acute than Dell's,"
argues Kumar. Indeed, while Dell recently reported that the average selling
price of its machines fell by 8% in its first quarter from the previous
year, Gateway's fell by a steeper 12%, Kumar observes.
And in a recent research note, Donaldson Lufkin and Jenrette analyst Kevin
McCarthy contended that Gateway's average selling prices could fall further
"given aggressive new notebook pricing and continued overall pricing
pressure in the industry," according to a report on Dow Jones Newswires.
Last month the company announcedÿ that it would cut prices on some of its
Solo notebook computers by $100 a pop. Actions such as these ledÿ McCarthy
to slash his 1998 earnings estimate for the company to $2.20 a share, from
$2.30--a nickel a share lower than the consensus 1998 estimate of analysts
tracked by Zacks.
Meanwhile, Gateway, like Dell (and Intel, for that matter), has been slow
getting into the part of the PC market that's really cooking--machines
costing less than $1,000. Customers who once thought they had to fork over
two grand for a PC that wouldn't become obsolete next week now are getting
first-rate machines for half that price--and impartial reviewers like
Consumer Reports are endorsing their move.
Gateway has put its toe in the water with its E-1000 line for corporate
users. Kumar maintains, however, that the company will soon have to take
the plunge into the sub-$1,000 PC market on the consumer side as well: Home
users currently represent 35% of Gateway's sales. But ironically, getting
into that game could shoot Gateway's margins to hell. Kumar predicts that
its operating margins, which he says peaked at 8% in the fourth quarter of
1996 and have since fallen to 6%, will drop again to 5%. Once again, what's
good for the consumer may be bad for shareholders.
Gateway also is not as diversified as rival Dell either in its product mix
or geographical reach. It's still overwhelmingly dependent on the U.S.,
from which it derives about 85% of its business. And Gateway hasn't been as
aggressive as Dell in branching out into less price-sensitive enterprise
servers and workstations. "They have not participated enough in the
high-end space to offset price erosion [in the desktop market]," ,Kumar
argues.
Several calls to Gateway officials were not returned by deadline. In recent
financial filings with the Securities and Exchange Commission, the company
has cited international expansion as one of its key areas of future growth.
Regardless of Gateway's plans, it's clear founder and CEO Ted Waitt and his
management team have their work cut out for them in trying to remain a
market leader while maintaining enough profitability to keep restless
investors at bay.
But they may find out that Gateway, which was number two on the way up,
could very well take the lead on the way down.
CORRECTION: In our May 21st Weekday Trader column ("Can Dell Really Do No
Wrong?"), we incorrectly stated that the "consumer side" of the business
represented two-thirds of Dell's sales. This is actually the portion of
revenues represented by Dell's desktop computer business, which caters to
both corporations and consumers. But because desktop machines face much
more price competition than do, say, enterprise servers, this doesn't
change our basic point that Dell's margins may be under pressure in the
years ahead.
BARRON'S Online Weekday Trader is located at
interactive.wsj.com
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