Description

Gateway is an unconventional and contrarian long that has multi-bagger potential from current depressed levels. Company has been written off and market is missing a number of fundamentally good things which have happened at the company but which have yet to be reflected in the top and bottom lines of the business or recognized by the market. Part of the reason is that it has been a long road down, there are no more optimistic voices left (they are all long since dead) and also investors can point to a number of legitimate concerns. Bentley883 articulated a short thesis on March 15, 2004 and should be congratulated for getting it right at least as reflected in the stock price which has declined from $5.60 to $2.50 currently a 55% decline in about 21 months.

Now however, our thesis is that the company has done a number of things that have increased the risk reward in favor of good upside. It may take a few more years (probably within the next two years) to see real traction that will get the pendulum swinging in the other direction. When it does, we are likely to see a rapid move to the mid to high single digits as earnings expands. We think gateway should easily be trading between $5.00 to $10.00 within the next 2 to 3 years – at the midpoint of $7.50, this is a triple from current levels representing over 40% per year compounded return.

The Business

Gateway is in the competitive business of assembling and selling personal computers and accessories, including desktop and notebook computers. The company was founded in Iowa in 1985 by Ted Waitt and was originally called “Gateway 2000” The company made a big splash with its cow associated spotted boxes and ad campaigns which were very will recognized. Company went public in 1993 and had a stock price that went from around $5 per share to $100 per share in 1999 and is now back to $2.50. During this time frame, sales went from $3.67B with net income of $173M in 1995 to a peak of $238M of net income on $9.252B of sales in 2000. Unfortunately, the company made a number of bad moves (both strategically and from an execution perspective). Among others, it moved its headquarters in 1997 from Iowa to San Diego. Company also opened a number of “Gateway Country” retail stores and started selling consumer electronics – particularly Plasma TVs – a move that was ill advised – especially since it appears that these products were of shoddy quality. Instead to remaining competitive in the core business, the company lost focus and lost cost, innovation, and marketing leadership between 1999 and 2004.

While Bentley883 made a good call, we think this his criticism of the eMachines acquisition may have been premature when judged with a long-term horizon. eMachines was a profitable low end assembler of PCs serving mass retailers including chains like Best Buy. What was impressive about the company is that they could and did gain share and make money in that cut throat business – partly because they could mind their costs and execute! Consequently, the biggest benefit to Gateway from the acquisition, which was completed for $262M on March 11, 2004 was that Wayne Inouye who engineered the turn around at eMachines was now leading Gateway.

I have met as spoke to Wayne during the company’s annual analyst meeting, and what is most telling is that he seems a no-nonsense no-BS sort of fellow. We believe that the new management, led by Wayne Inouye has been focusing on a lot of the right metrics. While they inherited a mess, current management has moved with impressive speed to cut costs and position the company for both survival and also upside from current levels.
Probably the most telling metric is that when Wayne Joined the company, he got to know the company initially, but then wasted no time to take corrective action. One great thing to do, if you are intrigued by this idea is to Read the 2004 Gateway Annual Report which is on their website, particularly focusing on Wayne’s letter to shareholders.

Basically, Wayne is pursuing a “back to basics” strategy to regain cost leadership and focusing on Gateway’s core reason to exist: i.e. in his words “focused on doing one thing very well – marketing high quality personal computers with excellent service at a price that represents great value” Most impressive, to me, is the fact that he took headcount down from 7400 at the beginning of 2004 to 1900 at the end! In our experience, very few leaders, in any company, have the will and discipline to move that decisively, but it is just what gateway needed.

Because of the above moves, the company has stemmed the bleeding. After 4 consecutive years (from 2000 to 2004) of both top line shrinkage and huge operating losses (Over 2.3B cumulative operating losses), the company is now breakeven. Given where the company was at the beginning of 2004, this represents a tremendous achievement.

What is nice about the model however, is that the Company has tremendous operating leverage. While the company has more to do to get the top line solidly growing, much progress has been made. The website has been revamped, the Gateway brand is being taken back to its roots, the company is started to come out with better, more innovative products (see for example the recent success of its convertible table/notebook line which has received industry awards). Gateway is now the #3 PC market and the pond is very. In contrast to Gateway, Dell had sales in 2005 of $50 billion. Gateway is less that 10% of the size of Dell. Now that Gateway is no longer its own worst enemy, and given the size of the PC market, it would not take much to have sales increase in the next 3 to 5 years.

Balance Sheet, Valuation, and Upside

Company currently has 372M shares outstanding. At $2.50 per share, the equity market value is $930M. GTW ended 3Q 2005 with $635M in cash and cash equivalents. As mentioned previously, the company is now around breakeven on a cash flow basis. Against the above cash, the company has $350M of outstanding debt. $300M is in two convertible debentures with the conversation set at $8.63 per share.

Although 1 quarter remains for 2005, the company is expecting 2005 sales to be around $4B with GAAP earning of around 11 cents per share ($40M). The above sales are an improvement from $3.649B in sales for 2004. The earnings estimates for 2006 (without guidance from the company) range from a low of 0.14 for a high of 0.25 (with 0.18 as the mean).

Just like Dell, Gateway is one of the few NEGATIVE WORKING CAPITAL businesses – a rare and nice characteristic. This occurs because the company gets paid by customers faster than it pays suppliers (particularly in its direct businesses). Lets say that a cushion of $100M is necessary for the business itself. This means the company has net “debt” of negative $185M ($635M in cash - $100M - $350M of debt). Subtracting from $930M, we get firm value of $745M or only $2.00 per share. Therefore, the stock is trading at only 11.1x the midpoint of the 2006 estimate.

There interesting part, however, is that the company has normalized earnings power that is higher. Specifically, if the company could increases is sales by 50% over the next 3 years, sales would be $7.5B in 2008. Dell earns a 6% net profit margin and gateway has achieved as high as 5% in the past. Lets assume, however, a 3% margin for our normalized calculation. This back of the envelope calculation suggests about 0.60 of EPS in 2008. With an explosion of EPS, the market is likely to award a much higher multiple, perhaps 20 or greater. Assuming a 15 multiple, however, leads to a $9.00 price target in 2008. There is tremendous operating leverage built into the model, it will only take a relatively small improvement in sales to drive significant earnings growth in 07 and 08 and start outperforming EPS expectations at that time.

Some Hair

In full disclosure, there are things to bellyache about. Specifically:

1.) Ted Waitt – who owned 106.180M shares (28.5% of the outstanding) left the board and his chairmanship of the company in May 2005. In February 2005, however, he announced a regular scheduled (10b-1) plan to automatically sell significant portions of stock (21M) share, though he had not sold any stock since 2000. Perhaps he knows something, perhaps he doesn’t. Of course, if he was that smart, he should have sold in 2000 and 2001, etc. It feels to me like he is bailing out at the wrong time, or perhaps his ego is bruised because Wayne took over. Maybe he just wanted to diversify. After his announced sales are completed, he will still be the largest holder of the stock.

2.) A class action lawsuit was announced on Dec 13, 2005 related to Plasma TVs sold by the company (under Waitt’s leadership – maybe this is what he knew?). Apparently, the televisions produced “popping sounds” and produced a “burning odor” If true, I don’t blame them for being irate! The release was put out by a California law firm. Company has not said anything on this issue as of yet

3.) There is a lot of competition. Lenovo bought the IBM computer business, ACER is coming back, HP/Compaq is turning around.

Despite the above, we think the risk reward is heavily skewed in favor of reward. Gateway still has a good brand, lots of cash, significant operating momentum, has seized cost leadership again and has good and focused management. Time will tell whether and when the stock will reflect the potential that we see.

Catalyst

Top line growth (driven by new products and better execution) and earnings growth (driven by operating leverage and cost leadership) over the next 2 to 3 years will lead to both EPS growth and multiple expansion. 3 bagger within 3 years.