For Investors, a Gateway to What?
They're pondering whether the struggling PC maker's foray into consumer electronics will lead to renewed growth or go nowhere
Last May, PC maker Gateway decided on a radical and ambitious transformation. To end years of losses -- including a deficit of $298 million in 2002 on revenues of $4.2 billion -- it would sell not only computers, where it was steadily losing market share, but also consumer electronics, for which demand was hot. What's more, it would help customers integrate various devices, so that they could, for instance, edit a home video on a PC, then show it on the family TV to the sound of a custom-selected digital tune.
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That decision came amid a restructuring that has prompted San Diego-based Gateway (GTW ) to lay off 2,500 employees, or 23% of its workforce, since January, and to set plans to eliminate 1,800 more jobs by mid-2004. Since the beginning of the year, Gateway also has closed 80 retail stores and remodeled the remaining 185 to better display its 75 new products. The net effect has been to reduce its cost of sales to the lowest level in five years. Gateway has also shuffled its management lineup, bringing in four new senior executives from places such as consumer electronics giant Sony (SNE ).
Whether those efforts will turn this caterpillar into a butterfly will become apparent this Christmas, says Megan Graham-Hackett, an analyst with Standard & Poor's. The foundation for success is there: Though price-cutting is keeping PC revenues essentially flat industrywide, unit sales are rising at a double-digit annual rate for PC makers, and Gateway still gets 72% of its revenues from PCs (see BW, 11/10/03, "PCs: The Elves Are Working Overtime").
MORE LOSSES COMING. Moreover, dollar sales in the $114.5 billion market for consumer electronics, which will provide the rest of Gateway's revenues, will grow 3.8% this year, according to market consultancy ARS Inc. Unit sales of products that Gateway is particularly stressing -- such as flat-panel TVs -- are growing at more than 50% annually.
While Gateway is hoping to ride these trends, many on Wall Street are waiting to see the money before they turn optimistic. On Oct. 23, Gateway reported a wider-than-expected, $139 million third-quarter loss -- double last year's. Its $883 million in sales were 20% below last year's.
And Gateway told analysts to expect a loss equal to 9 cents to 15 cents a share, or $29 million to $49 million before restructuring charges, in its seasonally strongest fourth quarter. Wall Street analysts have been expecting a nine-cent loss. Analysts polled by financial service First Call forecast Gateway to lose 92 cents a share, or $298 million, for the full year. The Oct. 23 news triggered a sell-off, knocking the stock down 24% on Oct. 24 to $4.62, or 32% below its 52-week high of $6.85 on Sept. 18.
"NO CONTROL." A few analysts see this as a buying opportunity. On Oct. 28, Michelle Gutierrez, an analyst with investment bank SoundView Technology, raised her rating on Gateway from neutral to outperform and set a $6 target price (the stock has since risen to $5). Yet, cautious investors might want to wait for clearer signs of Gateway's progress before jumping in, if only because "it has no control over its own destiny," says Henry Asher, president of Northstar Group, a New York-based money manager that doesn't hold Gateway shares. "Both PCs and consumer electronics are extremely competitive markets," says Bill Fearnley Jr., an analyst with FTN Midwest Research. "And they are now fighting two fights at the same time."
With more than $400 million in cash and equivalents, Gateway doesn't need additional funding to get to break-even. But it might not achieve profitability until the second half of 2005 -- and then only if its consumer-electronics sales soar, says Graham-Hackett.
The problem there, of course, is that competition is even more severe than in PCs. More than 80 companies manufacture DVD players alone. Pressured by cheaper Asian rivals, Sony, with $62.3 billion in annual sales, just announced 20,000 layoffs. And the plot is thickening, as giant computer makers Dell (DELL ) and Hewlett-Packard (HPQ ) have also entered consumer-electronics market in the past year. "This isn't the Mickey Mouse club," says Asher.
RETAILERS' EDGE? While Gateway has grabbed the No. 1 spot in sales of plasma TVs in the U.S., its success could be short-lived. Dell is expected to release its own line of flat-panel TVs in the fourth quarter. Taiwan manufacturers are moving in as well. And prices of plasma TVs have dropped 30% this year as competition has intensified.
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What's more, Gateway faces a formidable fight from retailers. Today, Wal-Mart (WMT ), office-supply stores such as Office Depot (ODP ), and even drugstores sell consumer electronics. More significant is the competition from long-time electronics retailers such as Best Buy (BBY ) and CompUSA. They may have an edge over Gateway because they attract more customers under 35, who are the biggest buyers of gadgets, says Tom Edwards, an analyst with market consultancy NPD Group. About 40% of Best Buy's customers are younger than 35, vs. 30% for Gateway, he says.
Gateway claims it isn't worried: "Our salespeople are more knowledgeable," says Chief Financial Officer Rod Sherwood. "They can demonstrate how the products fit together," he argues, while most retailers can't. Plus, he figures, Gateway's new stores -- which are fashioned like living rooms, complete with couches and fireplaces (the layout was designed by the same exec who created Starbucks' look) -- allow for better presentation. That's super-important, since 94% of consumer electronics are sold through retail stores.
RELUCTANT BUYERS.
Gateway won't enjoy this advantage for long, however. Already, retailer Circuit City (CC) is remodeling its stores to better demonstrate consumer electronics. Best Buy is pilot-testing its "digital living stores" in Arizona -- an approach similar to Gateway's. And Gateway's edge is blunted by the fact that only a handful of its 185 stores have been thoroughly remodeled, while the others simply received a facelift, say analysts.
The other obstacle is that no company has yet been able to persuade consumers to interconnect their digital devices, says Roger Kay, a vice-president at tech consultancy IDC. Most still have no desire to transfer filmed images from their cameras to their PCs to edit -- even though companies such Apple (AAPL ) have pushed this idea for months. "There needs to be a lot of evangelism," says Kay. And Gateway might not be able to afford that -- or to become a well-known consumer-electronics brand, says Fearnley of FTN Midwest.
CFO Sherwood disagrees. "Our research shows that Gateway has a broadly recognizable brand in the PC arena," he says. "And Gateway is quickly becoming associated with new, innovative digital cameras [sales of which grew 500% between August and September]. So this extension into consumer electronics hasn't been a problem, and I think the brand is extending well."
DROOPING MARGINS. Even so, Gateway still faces the daunting task of resurrecting its PC business. Even as overall PC shipments in the U.S. rose 19% in this year's third quarter, Gateway's market share fell to 3.4%, from 5.5% in 2002, according to market consultancy Gartner. To stem its losses, it has outsourced manufacturing and streamlined distribution. Still, pricing pressure and rising component prices have reduced Gateway's gross margins on PCs to 3.8%, estimates Charlie Wolf, an analyst with Needham & Co. -- hardly enough to support a sustainable business.
In fact, PCs are the one of the key reasons why Gateway's overall gross margin declined from 17% to 14% from this year's second quarter to the third. Another thorn is the ongoing Securities & Exchange Commission investigation into its past accounting practices. The SEC is investigating Gateway's revenue recognition relating to America Online (TWX ) services it bundled with new computers. It has already restated its earnings for 2001, 2000, and 1999.
Thus, most of the restructuring charges are behind Gateway, says SoundView's Gutierrez. And Gateway says its shipments of notebook PCs -- its most profitable computer category -- grew 22% in the third quarter vs. the second. Moreover, it expects consumer-electronics sales to double in the fourth quarter vs. the third.
If so, that gives Gateway a window of opportunity. The question is whether it can move adroitly enough in the face of stiff competition to take advantage of it. Only investors with an appetite for adventure may want to risk their money finding out.
