October 23, 2000

By Bill Fleckenstein

Gateway Price = $55

Fudgement day

Much was made on Friday, Oct. 13, and over the following weekend about how Gateway's numbers proved the vibrancy of the PC market. In fact nothing could be further from the truth. The stock is not an easy one to analyze because the company no longer gives out same store sales, PC unit sales, PC revenue growth or much of anything that makes analyzing stocks like this a bit more straightforward. Gateway's stance is that it is not really a PC company anymore and that it sells other things.

To assess that contention there are really two questions to consider: (1) what is the status of Gateway's PC business, and (2) what does the quality of the non-PC business earnings look like. Since Gateway wouldn't tell us how many PCs it sold this quarter -- breaking its own precedent of providing that data -- one has to infer what those numbers are to assess how it's doing on the PC side of things.

Squaring off the round numbers. . . The company says more than 50 percent of operating income came "outside the box" last quarter. (A year ago it was only 15 percent.) If one triangulates that number one can see that operating income for the non-PC business fell by something on the order of $20 million, from $130 million to $110 million. One can draw some general conclusions from that, such as it's not likely PC revenues or PC units were up much if at all.

Thus, it's fair to conclude from the results that unit growth in the PC business was not anything to crow about, which is probably the reason the company didn't provide the data. Perhaps more telling is that those weak numbers came in spite of the fact that for the same quarter a year ago (3Q99) it had 238 retail outlets and now (counting the stores-within-the-stores) there are 1,053. When you put it that way, you can see how pathetic the PC revenue growth or PC unit growth really was.

Let's take this outside. . . Regarding the quality of "outside the box" earnings -- what I like to refer to as the "just trust us" department -- the first thing that leaps out is that in the first nine months of 2000 "earnings" are up $410 million, yet cash and marketable securities have dropped by $353 million. Cash plus accounts receivable is down about $259 million because receivables are up. Ladies and gentlemen, the official term for this is "negative cash flow." Earnings are growing and the company is consuming cash -- one of the largest red lights on the balance sheet decoder ring.

Furthermore, the total revenue growth this quarter was only about 15 percent even after quadrupling the number of outlets. To put that number in perspective, at this time last year, when the number of stores had merely doubled, PC units were up 39 percent and total revenue growth was up 20 percent. Looking back over the last few years, in 1997 revenue growth was 24 percent, in 1998 it was 19 percent, 1999 was 15 percent -- so far this year it's about 13 percent, thus the decline in the growth rate continues.

Liquids drain easier. . . Turning once again to the balance sheet, at the end of 1996 Gateway's cash, marketable securities and receivables comprised about 73 percent of total assets, which makes sense when one considers the business it's in. By the end of 1997, as it launched its retail store concept, the same segment of the balance sheet was down to approximately 55 percent. It now stands at 38 percent. If one assumes that 55 percent is a reasonable bogey (as opposed to 73 percent), that's still a drop of 17 percent on the balance sheet in terms of "liquid" assets.

To put that number in perspective, 17 percent is about $765 million -- a rather large number by which to have your balance deteriorate when you consider that the accumulated revenues for the last 2 ¾ years since the beginning of 1997 is about $1.184 billion. The deterioration in the balance sheet is therefore about 75 percent of the accumulated revenue growth. Interestingly enough, if one looks at other assets, that portion of the balance sheet has exploded from under 2 percent to about 19 percent and has grown by a little more than $800 million -- curiously close to the amount the balance sheet has deteriorated. In fact, the "other" portion of current assets has grown by about $500 million, from about 7 to 15 percent of the balance sheet.

What does all this mean? The increase in the two types of other assets comprises about 130 percent of all the money the company has made in the last 2 ¾ years. These two categories of other assets comprise about 33 percent of the balance sheet, yet no guidance is given. Then again, no guidance is going to be given on any important line items.

X-actly. . . All I can say is that before it embarked on the Country Store strategy, almost all of Gateway's earnings showed up as cash or receivables and now they're in two nefarious line items called other assets. Inquiring minds can disagree as to what that means, but I suggest that the quality of those earnings is not what it appears to be. Either revenues are too high or expenses are too low. One thing is certain: There's nothing in the earnings report to lead anyone to believe that the PC business is healthy. I can't see how this is worth 50x times earnings.

As if to add insult to injury, Gateway was recently named as the subject of a class action lawsuit that alleges misleading advertising for its PC financing and credit card businesses. Stay tuned as this story evolves.