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Gateway's Big Bath

Eric Moskowitz

At the end of Gateway's (GTW Quote) third-quarter earnings period last year, CFO David McKittrick drew a big bath and took it. He threw all the company's bad news into one quarter -- the tub -- and Gateway reported a net loss of 68 cents a share, or a loss of 8 cents a share, excluding that rather sizable $113.8 million one-time charge.

On the surface, the move was a masterstroke. Although taking an initial 22% hit, Gateway shares are up 83% since the announcement. Best of all, the maneuver may have helped the company subsequently report its best gross margins in years -- 19.5% and 20.6% in the first two quarters of 1998. The company claims that declining component prices and diversification of its product line were the reasons for the strong margin numbers.

Unfortunately, the news may have been a little bit too good, say three shorts and two analysts TheStreet.com talked with. They argue that the company's third-quarter inventory writedown last year was a questionable accounting maneuver. Even if the move survives accounting scrutiny, bears charge that it was a short-term solution that won't save Gateway from deflationary pricing patterns in the hotly competitive PC industry. Essentially, they believe the company took the writeoff to get rid of obsolete inventory and then proceeded to sell that inventory over the next few quarters to pad its gross margins. Attempts to schedule an interview with Gateway's McKittrick or other executives to discuss the writedown were not successful.

Gateway's writedown last year illustrates how difficult it is for the PC industry to cope with rapidly changing technologies as well as fickle consumer tastes. While both Gateway and Compaq (CPQ Quote) had built up their inventory levels in anticipation of aggressive sales of the Pentium II chip, the consumer was already looking for lower prices and not more processing power.

The company, then, that had lean inventories and could turn products around fastest would win. That's why Dell (DELL Quote) has continued its robust growth while both Compaq and Gateway have stumbled. In the view of the shorts, this left Gateway little choice but to aggressively write down inventory to keep gross margins healthy.

The Writedown

On the face of it, Gateway's version of the story sounds quite plausible. In its 10-Q, the company cited three reasons for the writeoff. It attributed $60 million of the charge to the acquisitions of server company Advanced Logic Research and certain assets of Amiga Technologies. Another $8.6 million was tagged for severance pay for the closing of one of Gateway's foreign offices. The rest -- $45.2 million -- was due to the writedown of "computer equipment" and the abandonment of a capitalized software project. Said the company's Securities and Exchange Commission filing: "Reserves were recorded against excess and obsolete inventories still on hand at the end of the third quarter."

Not that there's anything necessarily wrong with what Gateway did. "Every company does it," says Todd Bakar, a PC analyst with Hambrecht & Quist, who does not follow Gateway and hasn't participated in any of its offerings. That's true for the most part; scores of companies have written off an acquisition, a severance package, and, yes, even inventory -- and they will again.

But Keith Fleischmann, an analyst with Fleckenstein Capital, picks this particular writeoff apart. For one, he says the company was essentially given a free opportunity to write off future expenses. "Gateway's Q1 and Q2 1998 gross margins were artificially and unsustainably inflated principally due to the large writeoff," says Fleischmann, whose firm is short Gateway.

What the company did last September was write off future, obsolete inventory as reserves, charges one money manager with a short position in Gateway. As he points out, at any time over the next few quarters, Gateway could conceivably unwind those reserves onto the income statement. The way the company has done this, he says, is by expensing an unusually small amount of inventory in the three quarters since the writedown. "Then it's just found money down the line. It's an old trick," says the money manager, who requested anonymity.

The writeoff shocked Wall Street at the time. After all, last year's third-quarter results were a big dropoff for the fast-growing PC direct seller, which had made 39 cents a share in its previous third quarter. And yet the company's inventories were flashing a yellow signal. From only $315 million in March 1997, they had mushroomed to $460 million by June 1997.

Blame the buildup on some ambitious sales goals in anticipation of Pentium II sales, Credit Suisse First Boston analyst Charles Wolf wrote in an October 1997 report. "Through an aggressive revenue forecast and inventory build, [Gateway CEO Ted Waitt] turns a perfectly good quarter into the first disaster in Gateway's history," he wrote. "Our worst fears were realized in Gateway's September quarter." (His firm hasn't participated in any of Gateway's public offerings.)

The move also kick-started the company's push to lower its inventory in a frantic bid to catch up with Dell -- whose build-to-order business model and low inventories had made it the darling of the industry. From the 1997 second quarter's highs of $460 million -- or 30 days sales -- Dell's inventories fell to $249 million (11 days sales) in its fourth quarter last year all the way to $155 million (nine days sales) by the end of 1998's second quarter, according to company reports available on SEC Edgar Online. Dell's inventory level was $288 million in its July (second fiscal) quarter, or six days sales.

But Gateway's writeoff is only a Band-Aid, say the three shorts TSC spoke with. They charge that, to maintain the 20%-plus gross margins -- which Waitt said on a recent analyst conference call was a high priority -- the company may have to make another, similar accounting move to keep up with the hyperefficient Dell machine. From 1995 to 1997, Gateway's average gross margins were a much lower 17.4%.

One such move would be to take another type of restructuring charge, says David Tice, portfolio manager of the (BEARX Quote)Prudent Bear fund. "They really can bury whatever they want to, whether it be for expenses, in-process research and development or even to reconfigure the factory floor."

Tice, who has a short position in Gateway, believes that the company's operating results will keep disappointing unless it "continues to play these games" with Wall Street. Tice is referring to Gateway's recently reported second quarter, in which the North Sioux City, S.D.-based outfit missed consensus estimates of 44 cents by 6 cents.

A company spokeswoman said Friday that Gateway is not contemplating a similar writedown at this time. That could change, of course, if the economy turns uglier. If it does, Gateway is more vulnerable than Compaq, Dell, Hewlett-Packard (HWP Quote) and IBM (IBM Quote) because of its consumer focus, argues Amir Ahari, a senior analyst with International Data Corp. "Gateway has yet to prove that it can land the corporate account, so it basically is a consumer-driven business," he explains.

"Joe Six-Pack will stop buying PCs because he isn't going to be worrying about whether his son can play the next hot computer game -- it just doesn't become a necessity any more in a downturn," says Ahari, who does not have a rating on Gateway.

Fleischmann doesn't think it will take a slowdown in PC sales to reveal Gateway's gambit. He believes that if the company doesn't make another accounting maneuver, its gross margins may start to decline as soon as the September quarter.

"The company could keep this going by playing with the [selling, general and administrative] expenses or capitalizing other costs for a while," argues Fleischmann, "but Gateway can't do it forever." (Gateway's SG&A hit 15.4% of net sales -- a 38% year-over-year increase -- in the June 1998 quarter.) Adds a more objective Ahari of International Data: "I'm holding my breath for the third quarter."

Gateway reports third-quarter earnings on Oct. 22.