A Narrowing Gateway
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by Cheryl Meyer
TheDeal.com
9 Sep 2005
Personal computer maker Gateway Inc., once known for small-town charm and a Holstein-patterned logo, today is a shadow of its former self. Founded by Iowa farm boy Ted Waitt 20 years ago, its facilities used to sit in South Dakota farmland, the smell of dung perfuming the air, its sales skyrocketing. Today, it occupies two block-shaped buildings in an Irvine, Calif., business park, nestled in dull, Orange County suburbia and flanked by identical structures occupied by Deutsche Bank AG and Chapman University. At its back is a congested interstate. Through the first quarter of this year, Gateway had reported 13 unprofitable quarters - a far cry from the company that had once taken Wall Street by storm.
Now under new president and CEO Wayne Inouye, a former retail executive, Gateway is desperately trying to rebound. But shrinking margins and competitive pressures, primarily from Dell Inc. and Hewlett-Packard Co., make Inouye's challenge daunting. "We still have a great deal of work to do," Inouye admitted during its recent earnings conference call, in August.
Despite the efforts at a turnaround, experts continue to speculate about the consumer electronics maker's fate and its long-term prospects for remaining solo. The third-largest PC manufacturer in the U.S., with roughly 6% market share, Gateway derives about 80% of its revenue from computer sales. With the PC sector under constant pressure, the company could be an acquisition play.
"There are a fair number of potential acquirers out there, and the one thing Gateway really has is a well-known national brand in the U.S.," says Roger Kay, president of technology market intelligence firm Endpoint Technologies Associates Inc. "A suitor from China wouldn't be out of the question."
Rumors have surfaced for years that troubled Gateway could be bought as the company weathered one lousy year after another following its 1998 West Coast move, which by most accounts wasn't a good one. Following the relocation, which Waitt said was done to boost Gateway's talent pool, he stepped down and new CEO Jeffrey Weitzen stepped in. While Waitt chilled out in posh La Jolla, Calif., his company floundered under Weitzen, losing focus and market share. Waitt returned two years later to help revive the company, but his head wasn't in the game, sources say, and Gateway's distinctive Midwestern image vanished.
"They kept making promises they couldn't keep, and their strategy was all over the map," says Rob Enderle, principal analyst at technology research firm Enderle Group, about Gateway post-move.
Under Waitt, Gateway prided itself on its signature retail stores, which it hoped would differentiate itself from rivals. But critics complained that they were poorly placed and the stores didn't attract much traffic. Instead, the company lost about $2 billion between 2001 and 2004, largely resulting from the high cost of running its stores. The business needed a lift as it desperately tried to gain back market share and boost its brand.
So in 2004, Gateway surprised Wall Street when it announced it would acquire rival eMachines Inc. for about $262 million in cash and stock. The deal, heralded as one of the smartest in the PC sector, gave profitable eMachines more resources to grow, and provided Gateway with an international presence and a much-needed introduction to big-box retailers such as Best Buy Co. and Circuit City Stores Inc.
It also gave Gateway a seasoned management team led by Inouye, a former Best Buy executive and known cost slasher who had brought troubled eMachines back to life to post nine consecutive profitable quarters. Waitt stepped down and became chairman, eventually leaving that role as well in May 2005 to pursue philanthropic activities.
One month after closing the deal, in April 2004, Gateway closed all of its 188 cash-draining retail stores, and a few months later began selling its products at Best Buy, CompUSA and Office Depot stores. The company has since laid off roughly 5,500 employees, down from about 7,500 in early 2004, and shelved most of its consumer electronics products to focus on computers. It promised profitability in 2005, and moved the company north from Poway, Calif., to Irvine, where eMachines was based.
"Without Wayne the company would have gone down the tubes," Kay says of Inouye.
In the second quarter this year, Gateway finally recorded a net profit of $17.2 million, compared with a net loss of $339 million a year earlier, thanks in part to a $150 million antitrust settlement with Microsoft Corp. and boosts in its professional and retail units. Revenue rose slightly from the first quarter, to $873 million, and the company sold almost 1.1 million PC units, up 27% year over year. Gateway's laptops, in particular, realized 62% year-over-year growth. "We expect continued momentum throughout the year," Inouye said in the conference call.
In July, the company announced it would sell PCs at 875 Staples Inc. stores nationwide, and it gained several significant customers, including the University of Arizona, the U.S. Navy and the states of New York and California. The company also ended the quarter with $567 million in cash.
"Gateway has been meeting its commitments," Enderle says. "It makes a promise, and it fulfills that promise. That's something Gateway hasn't done for years."
But its troubles aren't over, and management's forecasts leave analysts unconvinced. Since its last quarterly earnings report, which again missed Wall Street's consensus estimates, five financial analysts downgraded the personal computer maker's stock, expressing worry that Gateway will continue to face competitive pricing pressures from its better-capitalized rivals.
"While Gateway has made progress in executing on cost, it has continued to disappoint on the revenue side, which is the success metric of a turnaround in our view," wrote Andrew Neff, analyst at Bear, Stearns & Co., in an Aug. 16 report. Bear Stearns recently downgraded Gateway's stock from "peer perform" to "underperform."
"Until we see the company executing more consistently on the top line, we believe Gateway continues to be a 'show me' story," echoed Steven Fortuna, a research analyst at Prudential Equity Group LLC, in a recent report.
And while most of Gateway's divisions had quarterly increases, its direct sales unit ? which sells products via the Web and the phone ? experienced a 26% drop in revenue sequentially, and PC shipments through the direct channel dropped 37%. Gateway blames reduced seasonal demand and its inability to discount because it wants to minimize conflict with its retail partners.
In addition, its non-PC revenue, which includes sales of software and peripherals and comprises about 19% of its revenue, declined 9% year over year. The company also reduced its full-year revenue guidance slightly.
"We are experiencing price and gross margin pressures across all business segments for a number of reasons," Inouye said. Those "reasons" include competitive pressure and component cost increases.
Sources say Gateway's problems run deep. For starters, the company is much more dependent on selling PCs than its major competitors. Unlike Gateway, Dell and Hewlett-Packard, the top two U.S. PC makers with 32% and 17% market share, respectively, can afford to discount prices. Gateway also faces competition from Apple Computer Inc., which is riding high on its iMacs and iPods, and electronics giant Sony Corp., among others.
And unlike Dell, which ramped up its business over the years by courting large enterprise customers, Gateway has traditionally focused on consumers, making it more difficult now for the company to play catch-up. To date, Gateway has been unable to establish momentum selling to large enterprises and other hefty customers, despite its recent sign-ons of New York and California, sources say.
"They were both won from Dell, but I think the company discounted significantly to win those deals," says Les Santiago, senior research analyst at Piper Jaffray & Co. Santiago recently downgraded Gateway's stock from "outperform" to "market perform."
The PC sector itself could face hard days ahead. Gartner Inc. predicts the operating environment will become more difficult in the second half of 2005 for PC manufacturers, despite a 10% increase in overall shipments this year over 2004. In August, Dell also reported lower-than-expected quarterly sales, missing analysts' estimates, and the company lowered third-quarter guidance. HP, under new CEO Mark Hurd, exceeded analysts' expectations for its third quarter ended July 31, but the Palo Alto, Calif., company also recently announced a restructuring, which will include 14,500 layoffs, or 10% of its work force.
"Full-year guidance for Gateway suggests that sales and earnings momentum will accelerate in the second half of 2005, and we believe this is unlikely given the challenges of lower PC margins, especially in the notebook segment," wrote FTN Midwest Securities Corp. analyst William Fearnley Jr. in a recent report. Gateway faces stiff competition in laptops, particularly from price leaders Toshiba Corp. and HP, he wrote.
If Gateway is considering a deal, it isn't talking. The company, publicly traded since 1993, refused numerous requests for interviews.
Analysts doubt HP, which merged with Compaq Computer Corp. in 2002, or Dell would be interested, since they wouldn't gain much that they don't already have. (In the mid-'90s, Waitt reportedly deflected a bid from Compaq, which would have left him with a personal fortune of $3 billion.)
Instead, topping the list of potential Gateway buyers is Taiwan-based Acer Inc., the world's fourth-largest personal computer retailer; electronics maker Samsung Electronics Co. Ltd., which lacks a U.S. brand and is flush with cash; and China-based Lenovo Group Ltd., which earlier this year paid $1.7 billion for IBM Corp.'s personal computer division in order to enter the U.S. market.
Sun Microsystems Inc. has also surfaced as a possible suitor. The Santa Clara, Calif., company, itself troubled and needing a management overhaul, according to some experts, could use Gateway's strength in desktop computers and Inouye's leadership expertise. Gateway, meanwhile, lacks credibility as a server vendor and could benefit from Sun's proficiency in that area, Enderle says.
"The likely acquiring partner would be some company like a Sun that's been wanting to go into the desktop business for a while but doesn't have the skill set to do it," he says. "Sun needs Gateway now more than Gateway needs Sun."
If a buyer comes calling, analysts predict Gateway could sell for roughly $800 million to $1 billion, or about 0.18 times to 0.2 times annual sales. Lenovo Group paid 0.18 times sales when it acquired IBM's personal computer division.
Whether Gateway initiates a deal remains to be seen. Experts say Gateway can survive for the intermediate term by continuing to fine-tune its business, but the company's long-term strategy ? and success ? remains a big question mark.
"Gateway is clearly out of the woods, but it still lacks the size and scope of the players who dominate this market," Enderle says. "With increasing interest by other larger companies in both Gateway's uniquely capable executive team and the company's strengthening U.S. position, its ability to stay successfully independent may increasingly be in question." |
