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Gateway's attempt to fatten the cow shocks analysts

The company's decision to back away from lucrative services and software in favor of refocusing on PCs floors a number of analysts.

    Can Gateway keep the cow from slaughter?

    Gateway, which is known for its cowhide logo, is backing away from lucrative services and software in favor of refocusing on computer sales, an area that recently has not made a dime for the company.

    "We will focus on 'box' profitability," Gateway Chief Financial Officer Joe Burke told financial analysts this week. "We will not be distracted by beyond-the-box opportunities."

    That statement floored a number of analysts, who said Gateway literally made a U-turn by abandoning a path that accounted for 100 percent of its fourth-quarter earnings. The company has a long way to go to return its hardware business to profitability, analysts warn. Such a dramatic turn now, they say, could crash Gateway.

    "I can't believe Gateway is taking its focus off of the beyond-the-box business," Technology Business Research analyst Brooks Gray said. "They can't afford to divert their attention from beyond-the-box."

    Gray noted that sales of non-hardware extras--services, training and software--carry margins of near 80 percent or 90 percent. "That's where all PC vendors need to go," he said. "That's the next business opportunity."

    By contrast, Gateway hopes to raise net hardware margins to the 5 percent range this year.

    IDC analyst Roger Kay couldn't see the logic behind Gateway's strategic shift.

    "In some ways, it's inexplicable and doesn't make a lot of sense without further explanation," he said. "It doesn't seem to be a good thing to be doing."

    Still, the company had to do something. Its cost structure is out of line and the company clearly isn't making money selling PCs, say analysts.

    For example, its expenses have swollen over the past year. Gateway's so-called selling, general and administrative expenses grew to 20.5 percent in its fourth quarter, up from 14.4 percent in the same period a year earlier. Typically, when expenses suddenly increase as a percentage of revenue, analysts say, this indicates a cost structure out of line.

    In addition, Gray said, "Gateway didn't generate any hardware income at the operating income line in the fourth quarter." With cost structure out of line and an over-reliance on beyond-the-box sales, Gateway needed to find better balance, he added.

    Also on Thursday, Standard & Poor's put Gateway's credit rating under review "with negative implications," meaning its debt could soon be in the realm of junk bonds. At its current level of "BBB-minus," the company is one notch above junk bond status.

    The question now is: Has the company shifted too far from over-reliance on services and software to overemphasis on hardware?

    "That's how it's beginning to look," Kay said.

    Store closings possible
    The timing of the change seems odd, as Gateway also trims the number of PC configurations it sells from millions to hundreds and struggles to cut costs from its infrastructure.

    However, not all analysts believe Gateway is abandoning non-hardware sales altogether. The company may just be making a temporary strategic withdrawal from software and services.

    "Gateway's goal is to put together complete solutions for customers by using beyond the box," Morgan Stanley Dean Witter analyst Gillian Munson wrote in a Thursday research note. "Current attach rates are only about one per sale, but the company seeks to increase this to 2.5." An attach rate refers to something sold with a PC, such as services or training.

    Still, Gateway has put on hold plans for 60 new retail store openings this year. The more than 300 Gateway Country stores have been at the centerpiece of the company's beyond-the-box strategy. Besides showcasing Gateway products, the retail outlets serve as training centers for customers and delivery points for software and services.

    In a Thursday research report, Prudential Securities analyst Kimberley Alexy speculated Gateway had more in mind than holding back store openings.

    "We believe select stores closings of under-performing stores will likely be announced shortly," said Alexy, who predicted the company could shut as many as 50 of the retail outlets.

    Although the store closings could impact Gateway's broader beyond-the-box strategy, other closings could be good for the company, analysts said.

    Merrill Lynch analyst Steven Fortuna said in a report Thursday that he hopes Gateway decides to close many of its store-within-a-store locations inside OfficeMax outlets.

    On Thursday, OfficeMax said that it had entered discussions with Gateway for re-evaluating the store-within-a store arrangement. OfficeMax offers Gateway operations in about 500 retail outlets.

    "Since we established our original relationship with Gateway over a year ago, the computer industry has experienced an almost 180 degree change in customer demand and direction," OfficeMax CEO Michael Feuer said in a statement.

    Cow for sale?
    Overall, many analysts expressed disbelief at the strategy pitched by Gateway CEO Ted Waitt and his new management team.

    "We walked away from the meeting feeling that it was short on substance," Fortuna wrote. But he commended Waitt "for his enthusiasm and back-to-basics approach."

    Bear Stearns analyst Andrew Neff wrote in a Thursday report that the company's plans need more definition.

    "While the company outlined a lengthy laundry list of 'things to do' as part of its refocused strategic direction, we need to see a more coherent turnaround strategy," he said.

    Gateway's profit warning Wednesday and proclamation it will slash PC prices to gain market share drove a host of revenue and earnings re-evaluations.

    Fortuna, who on Tuesday downgraded Gateway, slashed his 2001 earnings per share estimate to 35 cents from $1.42. Munson made a similar revision, 40 cents from $1.42.

    Alexy questioned whether Gateway could effectively compete in an increasingly soft PC market. January retail PC sales, for example, plummeted 24 percent year over year, according to PCData. Market researchers Dataquest and IDC next week are expected to project double-digit first-quarter declines industrywide when they release full-year 2000 PC sales reports.

    "We believe U.S. consumer revenues for the industry will likely be down 15 percent (quarter to quarter) and Gateway is clearly increasing its price aggressiveness," Alexy noted. She warned that Gateway's poor business and international markets presence leaves the company with no way "to compensate for the U.S. weakness."

    Kay couldn't see that how "it would be easy for Gateway to underprice Dell Computer and remain profitable. I just don't see the sense of their strategy, particularly in a soft market."

    But some analysts see one way that Gateway's moves make sense and wonder if the company has a bolder strategy in mind: the eventual sale of the company.

    "We feel that (Gateway) should be--and may be--exploring the option of being acquired," Neff noted. "Although management is unlikely to admit to this, as we have noted before, we feel the company is considering this scenario, which is consistent with our ongoing thesis that the PC industry is poised--actually needs--consolidation to alleviate overcapacity."

    This made sense to Gray.

    "Maybe Ted Waitt is trimming the fat off the cow in order to sell it," he said.