Description

OVERVIEW
--- The combination of: progressively deteriorating fundamentals in its core business, a non-competitive business model, a history of unsuccessful serial restructurings and poor execution, a failing diversification strategy, a desperate acquisition, a projected 50% drop in future cash & book value per share and an excessive current valuation; all point to significant downside risk and the potential for the stock to decline +50% or more in the next 12 months. Contrary to the recent enthusiasm from some Wall Street analysts (which appears to have not considered some basis facts) and the recent 35-40% rise in the share price tied to the acquisition of eMachines, it appears the stock is overpriced on any reasonable profitability metrics and commensurate with the decline in cash and book value, has significant downside to about $2 per share in the next 12 months. Thus, a short position in the shares is recommended.


THE KEY POINTS & CATALYSTS THAT SUPPORT MY RECOMMENDATION FOR A SHORT POSITION IN THE SHARES INCLUDE:

--- GATEWAY’S FUNDAMENTAL POSTION IN ITS CORE BUSINESS CONTINUES TO DETERIORATE AND PAST SERIAL REPOSITIONING MOVES HAVE PROVEN UNSUCCESSFUL: Based on fundamental trends over the last 2-3 years, it’s clear that Gateway has been in a death spiral that historically most technology companies that enter, never seem to reverse. The company has been engaged in a serial restructuring program over the last few years with its move to become a consumer electronics “brand integrator” being the latest iteration, and one that appears to have very mixed results. Each reincarnation of the company has been announced with great fanfare; however, none of the prior changes have proven successful in turning the company around. Despite continuous restructurings, the company’s business model/cost structure is at a competitive disadvantage to its major competitors, its sales are about 40% of the 2000 levels, its market share has declined precipitately, growth has been consistently & sharply negative, market share has eroded notably, profitability has been negative in 12 of the last 13 quarters and it the road to profitability remains unclear. Noteworthy, and maybe most telling, for the last 4 years, financial results in the all important seasonally strong December quarter (when it should have the most wind at its back) have come in meaningfully below expectations, even this year, in one of the best periods for sales in the consumer electronics (CE) market in quite some time.

--- THE EMACHINES ACQUISITION IS A DESPERATE MOVE AND ONE THAT FLY'S IN THE FACE OF HISTORICAL PRECEDENT: On one hand, the acquisition of eMachines by Gateway (which just closed last week) appears to look like a good move on the surface given its relatively attractive purchase price, a well regarded CEO and some of its business practices that could help Gateway address several of its major problems. However, after a more thorough analysis it appears that the acquisition is a very desperate move that may not have the desired results that management and some analysts are touting because: several of the major benefits of the merger are highly questionable, it may create new problems in the form of channel conflicts, it fly’s in the face of both the history of failed acquisitions among technology companies and Gateway’s consistent inability to execute on any of its previous strategies and, maybe most importantly, the company’s all important cash position (which has recently helped provide a floor for the stock) is about to decline significantly because of the merger. The eMachines acquisition represents the latest attempt by Gateway to re-invent itself. However, make no mistake about it; Gateway’s acquisition of eMachines is defensive in nature and appears to be a last ditch, bet the ranch move. Furthermore, the merger seems to suggest that the company’s latest iteration of its strategy, trying to be a CE “brand integrator” was not seeing the expected results that management expected and they needed to change their game plan fast. Note, that despite recording healthy CE growth in Q4, the results were still below the company’s stated goal of doubling revenues on a sequential basis, hurt by a slowing in sales momentum in digital TV’s (Gateway’s lead CE product line) in what should have been its seasonally strongest quarter. Thus, given the company’s past unsuccessful moves to re-invent itself and the execution challenges associated with the deal, one could argue that this merger is Gateway’s most desperate and/or riskiest move to date. Moreover, the acquisition of eMachines represents the latest in a long list of mergers in the technology market that have been announced in the last decade; almost all of which seem never to deliver the expected longer term synergies and financial results. While some mergers appear to have early success based on cost reduction initiatives, the real hurdle yet to be overcome by any of the large scale combinations is related to demonstrating incremental growth. Thus history suggests that the Gateway/eMachines merger will be no different than the rest.

--- THE BENEFIT OF GREATER UNIT VOLUMES AND LOW COST PROCUREMENT MAY BE OVERSTATED AND MAY NOT MAKE THE NEW GATEWAY SIGNIFICANTLY MORE COMPETITIVE: Management and most analysts are pointing to the greater volumes and low cost procurement as the major benefits to Gateway from the eMachines acquisition. While greater volumes may help Gateway’s cost structure somewhat, the benefits may be overstated, will not give the company the same economic advantages as its major competitors and alone may not be enough to make a big difference to offset current operating losses. On the surface management’s comments that eMachines will about double their volumes and move the company to the third largest PC supplier in the US sounds good from cost of components basis. However, looking at the statistics differently, even with the acquisition of eMachines, Gateway will only be the eight largest PC supplier worldwide with a market share of just about 3%, versus industry leaders Dell & HP, both of which have market shares in the high teens. That still puts the combined company at 5:1 disadvantage relative to two of its major competitors relative to trying to leverage scale of size benefits. Likewise, a number of analysts have pointed to Gateway’s ability to leverage eMachines’ low cost product procurement activities to lower its costs and make its products more competitive. This may be true relative to repositioning Gateway’s low end desktop offering. However, Gateway will still have to use more traditional build-to-order (BTO) manufacturing to satisfy the needs of many of its customers (i.e. high-end consumers and professionals), who require customization. Nonetheless, while there is likely to be some savings associated with the merger, it is important to bear in mind that these factors alone are not going to change the fundamental picture for the company. The major problem Gateway faces from a cost perspective is the overhead tied to its retail stores. While a number of stores will likely be closed this year, which will help bring down its cost structure, management still insists that it will need to keep its own retail presence to showcase its CE products, like big screen plasma TV’s, and to act as a local VAR for its SMB selling efforts in the professional market. Thus, at the end of the day, selling multiple products through multiple distribution channels (the tag line of the merger) is not a low cost strategy and will mean that the new Gateway will still be challenged from a cost perspective.

--- GATEWAY APPEARS TO HAVE LOST ITS ABILITY TO DIFFERENTIATE ITSELF WITH “DISRUPTIVE” PRICES IN THE CE MARKET, WHILE THE TWO 800-POUND GORILLAS COULD PRESSURE PC PRICES: In the Fall of 2002, when Gateway introduced its first big screen plasma TV, the company differentiated itself and made a significant impact on the market with its “disruptive” prices in the CE market. Prices in many cases were about 50% of the leading brand name CE competitors. As a result, Gateway brought the price of a 42” plasma TV to mainstream price points, thereby expanding the potential size of the market and became the leading vendor in the market. Gateway hopes to replicate this strategy with an expanded range of CE products, including: LCD TV’s, digital cameras, DVD players/recorders and MP3 players. However, the competitive landscape has changed dramatically in the last few months and as a result, Gateway’s sales momentum already appears to be showing signs of slowing. The major brand name CE competitors, who may have been caught off guard by Gateway’s aggressive pricing moves, have woken up and reacted quite aggressively. Noteworthy, a recent comparative analysis I completed of various different size plasma TV’s from about two dozen vendors now shows that many competitors with stronger brands than Gateway (Panasonic, Sony, Phillips & JVC, for example) now offer products at or close to Gateway’s product, in some cases with better technology (i.e. higher image contrast ratios up to 6x better) and some B-brands (Sampo, Samsung, Daewoo, BenQ & Akai, for example) offer products below Gateway’s price. Additionally, a separate price comparison I completed of digital cameras shows a similar pattern. For example, when announced, Gateway’s 5MP digital camera was priced at a significant discount to the traditional brands. However, now a number of other established brand name CE vendors also offer 5MP products at or close to Gateway’s $300 price point. Thus, it appears that the window of opportunity for Gateway to offer “disruptive” prices has closed fast as competition in the market has intensified. Noteworthy, is the recent entry of a number of new Asian competitors (including some of the actual component suppliers) as well as both HP & Dell. Thus, it’s likely that competitive pricing pressures in the CE market will only get worse, making it harder for Gateway to differentiate itself with “disruptive” prices in the future. Separately, in the PC market both eMachines and Gateway have probably not been on the radar screen of either HP or Dell. Both of these two 800-pound gorillas have been focusing on other aspects of their respective businesses and to a fair degree eMachines was not big enough or positioned to be a threat, while Gateway was giving up plenty of share on its own doing. With this merger, the new Gateway may now be viewed as more of a threat. Given the combination of the very slim margins in the eMachines model and the significant financial resources of these two competitors, they could turn the heat on for a while by taking a more aggressive pricing stance in the low end of the consumer sector which could take all the profits out of the sector for a period of time. A recent sign that this already may in fact be occurring is the fact that Dell just began offering on its web site a $399 (after mail-in rebate) desktop PC that is clearly targeted at eMachines.

--- CHANNEL CONFLICT ISSUES CALL INTO QUESTION ONE OF THE KEY TENENTS OF THE ACQUISITION: On one hand, Gateway’s strategy of selling multiple products through multiple distribution channels sounds appealing. Indeed, most Wall Street analysts have highlighted Gateway’s ability to sell its CE products through eMachines traditional retail distribution channel of over 7,000 locations as a major growth opportunity of the merger without looking at the possible negative impact. This strategy also means that Gateway will have to manage the issue of channel conflict tied to Gateway selling similar products direct that eMachines will be selling through its retail channel partners. Past precedent in the industry shows that it has been a very difficult balancing act for technology companies to sell through both retail and direct channels. History shows that retailers will likely view Gateway as more of a competitor than a partner, due to the issue of who owns the customer. Recent history in the PC sector does not bode well for Gateway, as in the past both Apple & Dell have had mixed results in trying to sell through both channels simultaneous, with the latter abandoning its efforts. Also, HP/Compaq’s moves to increase the direct mix of their sales, has caused some channel conflict issues with its major distributors. The early feedback from retailers is mixed and suggests these concerns are warranted. On one hand, the recent announcement by Office Depot to carry Gateway notebooks is a modest positive. However, other reports indicate that initial sentiment from other retailers on the eMachines/Gateway merger is fairly negative, with retailers fearful that Gateway (via registration card data) will try to move customers to either direct sales or its own stores. One report indicates that some retailers are currently planning on cutting back on eMachines shelf space for Spring planning. In one case a major retailer who had not received shipments of new product from eMachines in a number of months has made a decision to reduce future orders because of the gateway relationship. Separately, I understand that one major casualty of the merger is a Gateway test in Wal-Mart, which may have been delayed indefinitely. Moreover, channel conflict aside, another significant question that arises is why these CE retailers would want to sell Gateway’s products. As we previously pointed out, Gateway is not delivering unique or new technology to the market and its pricing is no longer a major point of differentiation. A quick walk through any of the major CE retailers shows there already is no lack of products in the areas Gateway wants to penetrate. Retail self space is not infinite and for every product added one has to be dropped. In addition, while management often speaks about its strong brand, the recent decline in its PC sales may suggest that its brand is not as strong as they believe. Outside of the PC market the Gateway brand may have even less awareness. Finally, with major brand vendors like HP & Dell preparing to launch their own family of CE products, the level of competition will create more competition for shelf space among these retailers and may leave Gateway/eMachines branded products out in the cold.

--- GATEWAY’S ONCE STEADY CASH POSITION WILL DROP SIGNIFICANTLY IN THE NEAR FUTURE, WHICH REMOVES SUPPORT FOR THE STOCK AND NOTABLY INCREASES THE DOWNSIDE RISK IN THE SHARE PRICE: As most Value Investors Club members are well aware, a significant decline in a company’s projected cash flow and cash position normally do not bode well for the stock price. Thus, the expected significant deterioration in Gateway’s balance sheet in the near future is very noteworthy for value oriented investors. To date, the one positive constant in the Gateway story over the last few years has been its healthy cash position in excess of $1B. Despite the numerous financial shortfalls and losses over the last few years, the healthy cash position has helped provide support for the share price. For example, at the end of Q4 FY 2003, Gateway had cash of about $1.089B, which equates to $3.36 per share. However, looking forward, there are a number of factors which will either negatively impact the cash position or dilute the amount on a per share basis. These include: 1) the use of $30M to pay for the eMachines acquisition and the 50M increase in the share count, 2) management has stated that it will use about $100M of cash in 1H 2004 for merger costs, restructuring and growth, 3) costs to close a number of under performing retail stores (which I estimate at $50-75M), 4) the scheduled December 2004 conversion of a Series A preferred stock note (22M shares) and 5) the likelihood that AOL will call their Series C preferred $200M note in December of this year (it is likely that Gateway will opt to pay off the note in stock, which will add an another 38M shares). Considering all these factors, it is likely that cash will drop from $3.36 last quarter to about $2 per share at year end. However, this analysis does not take in to consideration either that expected continued operating losses will negatively impact cash and the fact that if eMachines is going to continue to grow anywhere near the high rates of the recent past it will have to need cash (or else they would likely not have sold out in the first case). Given that the shares have already sold below cash in the recent past, this significantly increases the downside risk in the shares.

--- BOOK VALUE HAS DETERIORATED CONSIDERABLY, AND WILL LIKELY DROP ANOTHER 50% TO ABOUT $1 PER SHARE IN THE NEXT YEAR, CREATING FURTHER DOWNSIDE FOR THE SHARES: The combination of Gateway’s significant operating losses and its numerous restructuring programs has resulted in a significant and consistent decline in book value over the two years. Noteworthy, shareholders equity has been cut in half from the level of $1,438M at beginning of FY 2002 to $722M at the end of FY 2003. During this time, book value per share has dropped from $4.42 to $2.23, with tangible book at $2.18 per share. Moreover, in the future book value is projected to see another precipitous decline tied to continued future operating losses and the likelihood of further restructuring moves. Considering operating losses of about $170M (consistent with analysts expectations) and a conservative estimate of an additional $100M associated with store closings and other restructuring moves, shareholders equity should decline another 38% and approximate $450M by the end of FY 2004. As a result, tangible book (excluding any goodwill associated with the eMachines acquisition) should approximate $1 per share on the increased share count (assuming repayment of the AOL $200M note in stock). This decline in shareholders equity and the overall decline in the quality of Gateway’s balance sheet has not been focused in on by Wall Street analysts and is likely to not be well received by investors when it does or materializes. Thus, the widening of the gap between the current share price and expected book value is another factor that creates more downside potential in the share price.

--- THE VALUATION OF THE SHARES IS EXCESSIVE, EVEN GIVEN A WILDLY OPTIMISTIC SCENARIO FOR THE MERGER COMBINATION AND THE RECENT ENTHUSIAM FOR THE STOCK IS MISPLACED: Following the announcement of the eMachines acquisition, the shares have jumped about 35-40% on the heels of two Wall Street analyst upgrades and general enthusiasm from investors that the merger will address many of the company’s problems and that the company will get back to profitability in 2005. As previously detailed, it appears that some of these more bullish views may have faulty analysis or the implications of the merger and further changes in the company’s financial position may not have been fully thought through. However, even if you were to assume the most wildly optimistic earnings scenario (my more realistic preliminary estimates for the combined company are listed below), it appears that the stock price is over valued. For example, if you take consensus analyst revenue estimates for Gateway of $3.35B in 2004 and assume a 10% reduction due to store closings (which could be conservative) and apply a 25% growth rate in 2004 & 2005 to eMachines current sales of $1.1B (which is likely too optimistic), you get a total revenue estimate for the combined company of about $4.72B in 2005. As for profitability, a wildly optimistic scenario would be to assume that profitability will turn around overnight and in 2005 the new Gateway can deliver the same 2% profit margin that eMachines returned in 2003. Nonetheless, if you assume this degree of profitability and apply a tax rate at Gateway’s traditional 35% level (NOLC’s should be viewed as non-operational as they are short term in duration), the combined company will return net earnings of about $61M, or about $0.15 per share on the expanded share count (assuming the 50M shares associated with the acquisition, the conversion of the AOL Series A preferred & the Series C note being called). This equates to a P/E multiple of almost 37x 2005 earnings. To put this valuation in perspective, Dell, the ‘gold standard” in the PC & server hardware market as to delivering consistent profitability and superior ROIC, is currently valued at only 22x calendar 2005 Wall Street analyst consensus EPS forecasts. Noteworthy, recently the stock was upgraded to a “Buy” rating by one Wall Street analyst who valued the shares at a $6.50, saying the shares should be valued at a price/sales multiple of .35x. As value investors we know the logic behind this analysis is flawed, in that using a price/sales valuation metric to argue for a higher share price for an unprofitable company rewards it for continuing to sell an even greater amount of product at unprofitable levels, which would only destroy capital and shareholder value faster. Another analyst points to the price/sales multiple being below the pre-bubble historical range to say the shares are cheap. However, contrary to current fundamentals, during that prior period Gateway had healthy sales growth, was solidly profitable and generating a healthy amount of cash. A fact that undermines the comparison!

--- THE SHARES HAVE RECENTLY SOLD AT THE $2 PER SHARE LEVEL, WHEN FUNDAMENTALS WERE BETTER, WHICH FURTHER SUPPORTS THIS PRICE OBJECTIVE: The 52-week range of the shares is $2.02-$6.85 per share. It was only a year ago in March 2003 when the shares traded at the $2 per share level (consistent with the price objective articulated in this report) following poor financial results in the 2002 holiday selling season and in front of further restructuring efforts. However, what is notable is that when the shares last traded at the $2 per share level Gateway’s fundamentals were arguably much better than they are today! For example, since the shares bottomed last year, Gateway has repeatedly missed its quarterly forecasts, including the all important Q4 2003 period, when most CE competitors had good results. Also, at that time trailing 12 month sales were 23% higher, with market share trends at about commensurate levels. Also, book value per share was 73% higher ($3.85 then vs. $2.23 now), the outlook for cash flow was to remain neutral during the year (compared with a notable drop now expected) and the share count was not projected to rise significantly as is not expected. Interestingly, another point that Wall Street analysts have missed is the expected notable increase in the share count in the future (+34%) compared to the relatively flat level over the last few quarters, is actually helping to artificially reduce the current losses on a per share basis and will negate any meaningful EPS leverage in the future should fundamentals improve. What is also interesting to bear in mind that at time the shares last bottomed, they sold at a discount to both cash and book value per share. Thus, this suggests that the $2 price target is not unreasonable in a less bullish environment for technology shares and/or if Gateway fails to execute once again.

ESTIMATES

Preliminary Estimates
Gateway & eMachines Combined ($ in millions)

2003 2004 2005
Total revenues 3,402 4,299 4,500

COGS 2,875 3,646 3,809
Gross Profit 527 654 691

Operating Expenses 845 792 759
Operating Profit (318) (139) (68)

Interest Income 19 12 8

Pretax Income (300) (127) (60)
Net Income (300) (127) (60)

Avg. Shs. Out. 324 370 435
EPS ($0.96) ($0.37) ($0.20)

Note: FY04 estimates assume eMachines merger completed 3/12/04

Catalyst

--- Q1 (March) results will likely show a continuation of the weak sales and margin trends in Gateway’s core PC business, disappointing traction in its CE business and may be below current analysts expectations (although the integration of eMachines results may cloud the picture somewhat), while sales from eMachines could show some cutbacks from retailers.

--- The company is planning a meeting for Wall Street analysts in the Spring. At that meeting it is likely that more details of the eMachines merger will be discussed. Cost reduction moves will likely be articulated and be well received by analysts. However, some of the challenges (i.e. channel conflict) as well as the negative cash flow and book value implications, which have not been understood by analysts, will also be discussed.

--- The announcement of quarterly results for both the June and September quarters will likely show tangible signs of the negative fundamental and balance sheet trends I have discussed.

--- The lack of any synergies from the merger in yielding incremental growth in the either the back-to-school or holiday selling seasons in the second half of this year will likely be viewed negatively by investors.