Description

Gateway is a business which has been in turnaround mode for so long that I believe many investors have thrown in the towel. The stock is trading near its multiyear low. New CEO Ed Coleman has embarked on a cost-cutting strategy which I believe shows real promise in generating near-term profitability. Add this to the company's bargain basement valuation, and I believe GTW offers investors a significant opportunity with low risk.

GTW was written up as a buy once before on VIC at a much higher valuation. That writeup offers a good background on the company and its travails. This writeup will focus on what has changed since then.

In 2006, GTW basically broke even on revenue of $4B. The company did most of its business through retailers such as Best Buy and Costco. Gross margins suffered, falling to about 6.5% from 8.4% in the prior year. SG&A declined, but not as fast as an investor might hope. In short, 2006 was another in a string of disappointing turnaround years for GTW.

Still, I believe the market is undervaluing GTW's remaining prospects. The company's Price/Sales ratio is 0.15, compared with Dell's P/S of about 1. In spite of years of mismanagement and losses, GTW is nowhere near bankruptcy. Its brand name remains relatively untarnished, it has strong vendor relationships and, most importantly, its products continue to move. With a 21% market share in US retail, GTW is a legitimate contender in the PC-sales market.

This thesis has two basic components. First, I believe if GTW's valuation falls much futher, an opportunistic buyer could abandon the turnaround, strip the company of cash and profitable revenue streams. Second, I believe Coleman's turnaround strategy has a good chance of success, and with GTW's significant revenue streams, even a modest level of profitability will provide investors with strong returns from here.




1. Downside

GTW has 371M shares outstanding. At the recent price of $1.63, the market cap is $605M.

Like most PC manufacturers, GTW relies on quick turnaround and careful management of Accounts Receivable / Accounts Payable to keep its working capital as low as possible. Unlike Dell, which pays it suppliers after receiving the money for products, GTW sees the two cashflows at about the same time. This is because GTW's sales mix is now heavily tilted toward retail (76% of sales).

Still, the company has a large amount of spare cash on its balance sheet. In 2006, GTW's cash position moved between a low of $320M and high of $500M, with no short-term debt. Also, GTW will receive about $58M of cash from a lawsuit settlement with Microsoft across the next 18 months. This brings the nadir of the cash cycle to about $380M.

The company has two big non-working-capital-related liabilities -- $300M of convertible debt due 2009 (1.5% interest; converts at $8.63/share) and 2011 (2% interest; same convert price) and a $95M liability connected to income-tax disputes.

Were an acquirer to purchase the company, they could likely extract $360M in cash from the business without disrupting operations. At current prices, this would leave $245M in equity value for a $4B-sales business. Last year, Lap Shun Hui offered $450M for just the retail segment of this business (http://news.com.com/Gateway+buyout+bid+a+call+to+others/2100-1003_3-6108895.html). Another comparable is Lenovo's purchase of IBM's Thinkpad division, with $12B in annual revenue, for $1.75B. (http://news.com.com/Lenovo+completes+buy+of+IBMs+PC+business/2100-1042_3-5691487.html). Another comp: In 2002, GTW paid $262M to purchase just the eMachines segment of its business.

I believe GTW's retail sales would have compelling value to an acquirer. Since the HP/Compaq merger removed one competitor from the marketplace, retailers interested in maintaining multiple vendors have an incentive to keep doing business with GTW.


2. Upside

GTW's former turnaround strategy relied on revenue growth. Previous CEO Inouye set SG&A levels in such a way that a doubling of revenue was required to achieve significant profitability. Coleman aims to make the company profitable at current revenue levels. This strikes me as a safer and more predictable strategy.

While not out of the woods by any means, GTW has undertaken a major cost-reduction push while at the same time quietly increasing its market share from 6.4% in 2004 to 7.2% in 2006. In 2006, GTW had 14.5% of the US consumer market and 21% of the US retail market.

GTW aims to improve profitability by cutting SG&A and boosting gross margins with more rational and compelling product lines. Both pushes are beginning to bear fruit.

On the SG&A front, GTW's immediate aim is to cut $55M to $60M in annual costs, from a 2006 spend of $309M. Q1 of 2007 saw a reduction to $62M, net of $3M in one-time litigation costs. By the end of 2007, management aims to have SG&A below 6% of revenue. While management has talked about SG&A numbers as low as 3% of revenue, I believe a reasonable minimum target is 5%.

On a free-cash-flow basis, management's cost-cutting is aided by the recent completion of an Oracle CRM integration. Capital expenditures for the balance of 2007 should come in at $10M, significantly less than the $30M of depreciation. According to management, this delta should persist in coming years, representing an annual excess free-cash-flow of at least 0.5% of revenue.

Management's cost-cutting should put the company in a position where, at recent gross margin levels (6 to 6.5%), operating free-cash-flow stands at between 0.5% and 1% of revenue.

GTW's trickier turnaround comes on the gross margin front. The company's gross margins are actually a blend of high-margin items such as monitors and warranties combined with low-margin PCs. While management does not provide breakdowns, in recent quarters these high-margin products have represented more than 75% of the company's total gross margin. This is a problem, and I believe management is taking effective steps to improve the situation.

For starters, Gateway products have begun to win awards and gain more traction in the press (http://www.pcmag.com/article2/0,1759,2086286,00.asp).

Next, market forces are turning in favor of retail and against the direct-sales model -- witness Dell's recent Walmart announcement. From channel checks and discussions with management, I believe part of this trend mirrors consumers' shift from desktop computers to laptops. Take a look at this chart from HPQ's financials:

'000s	Q1 2006	Q1 2007
Laptops	2,815	4,094
Desktops	3,560	3,904

GTW has seen similar trends, with a decline in desktop sales and a small (2.3%) increase in laptops. Consumers want to buy laptops at retailers so that they can touch and feel the product before buying it.

Third, I believe management when they say that Q4 and Q1's gross margin numbers of 5.2 and 4.9%, respectively, were anomalies. Both periods suffered from consumer uncertainty surrounding the Vista launch, and in Q1 GTW had to expedite shipping on products to make sure systems arrived in time for the launch. This was a result of Microsoft providing OEMs final copies of Vista too late in the cycle.

Fourth, other PC sellers, and GTW in past years, have achieved retail gross margins in the 6-8% range. Combined with the higher-margin direct sales and non-PC businesses, GTW should be able to attain an average gross margin in the 6.5-9% range.

Finally, the PC market continues to expand, and GTW is pushing into international markets. Right now, international sales represent 9.5% of GTW's sales. Just this past week, the company announced they are moving into China through a third-party reseller. While revenue expansion may not increase gross margin as a percentage of revenue, an absolute increase in gross margin dollars is helpful. This is because the company is targeting a relatively fixed SG&A infrastructure which can service an expanded revenue base. So, higher gross profit should translate fairly directly into higher operating profit.

GTW already has enormous operating leverage owing to its $4B in annual revenue. And, the company's enormous net operating losses mean income taxes should not be a consideration for years to come. So, at current revenue levels, for each 1% of operating profit generated by the business, GTW will see about $40M of free cash.

Assuming little improvement in gross margin and management success in cutting SG&A to 5.5% of revenue (net of the free-cash-flow delta discussed above), the company should generate $40M of free cash. Taking what I consider to be more median assumptions -- some improvement in gross margin combined with the cuts -- cash flow could easily rise to 2% of revenue, or $80M on a $605M valuation. And that's not considering the above analysis which suggests that $360M of cash could be extracted from the business to lower the equity value (through buybacks, a buyout, etc.)

As a comparable, HPQ's turnaround in PCs has seen operating profits rise from 3.5% of sales in early 2006 to 4.8% in early 2007. While I would not expect GTW to see this level of absolute success due to its lower product pricing, I believe management can come close.

Should management succeed in this more modest turnaround, I believe the equity valuation will grow significantly, perhaps to the $3-5 per share range.

Catalyst

- Scott Galloway, from activist investors Firebrand Partners joined the board in late 2006.
- Harbinger capital and Brandes own big chunks. Harbinger bought in last fall.
- Management's initiatives should begin creating better results in Q2 of this year.
- There is continual rumor swirling around GTW of a possible acquirer. I believe my downside analysis shows how this is not far-fetched.