Gateway Struggles to Play Dell's Game - TheStreet

Updated from 5:04 p.m. EST

Gateway

(GTW)

may be getting better at playing Dell's game. But it's still not winning.

The Holstein-spotted company has been hunting down costs and mercilessly slashing them for the survival of its margins. But despite a surprise announcement late Monday that it would achieve profitability in the fourth quarter of 2001, Gateway also disclosed a most un-Dell-like drop-off in unit sales during what was expected to be a slightly positive holiday season.

Squeezed by continuing pressure at the very low end of the PC market from

Dell

(DELL) - Get Report

, Gateway has focused on midrange products and services while slashing its costs. So it will make a penny-a-share profit regardless of lower-than-expected revenues.

Still, its turnaround strategy remains unproven. And on Tuesday, peeved investors lopped 25% off Gateway's market value. This followed its warning that revenue would fall from $1.4 billion in the third quarter to $1.16 billion in the fourth, a 17% drop and a far cry from consensus expectations of $1.39 billion in revenue, as gathered by Multex.com.

Hopes that seasonal joy would return to the computer industry helped drive a 120% surge in Gateway shares since Oct. 2. But the run-up was discredited as the company lamented that unit shipments slid from 818,000 in the third quarter to just under 700,000 in the fourth.

Gateway also noted in its earnings preview that it finished 2001 with more than $1 billion in cash and marketable securities and no long-term debt. Apparently, that defense did little to sway the opinion of Moody's credit rating agency, which downgraded Gateway's credit to junk status after market Tuesday on concerns about Gateway's shrinking PC market reach and eroding revenues.

Nevertheless, Gateway is improving at the cost-structure game so deftly played by competitor Dell in 2001. Gateway will eke a profit out of its meager sales, rather than the penny-a-share loss the Street was expecting -- a marked improvement on its third-quarter loss of 17 cents a share. So investors are left to ponder Gateway's fortunes now that it seems to be making progress in reducing its expenses and moving its customers up the pricing chain but is hawking far fewer computers.

Falling Off the Box
Reality about fourth-quarter PC sales kicked in

Gateway's projected profit comes from a different strategy than the Dell model. Market leader Dell focuses on cutting costs to the bone, which allows it to slash prices while maintaining livable margins. Gateway's move to small- and medium-sized businesses will pay off in the fourth quarter, with an average selling price of $1,660, up sequentially from a depressed $1,460.

Then again, Gateway is trying hard to slim down and give its margins a boost. In August, it unveiled a dramatic plan to cut $300 million from its budget, immediately exiting several international markets and contemplating an exit from Europe and non-U.S. operations altogether. Gateway plans to eliminate 15% of its domestic and 25% of its international workforce as part of the reductions.

Additionally, Gateway is moving out of Dell's core area by courting smaller businesses, such as the personalized local service Gateway is more prepared to provide with almost 300 Country Stores. Nonetheless, the PC maker has to get its customers -- be they individuals or smaller businesses -- buying machines to succeed. Apparently, Gateway was not successful at that in the fourth quarter.

Gartner Dataquest research director Mark Margevicius points to

IBM

(IBM) - Get Report

as another competitor steering clear of the Dell path.

Monday, IBM announced it would off-load the manufacturing portion of its PC business to

Sanmina

(SANM) - Get Report

in a $5 billion deal. The move takes IBM out of the competition for cutthroat efficiencies in the supply and distribution chain and highlights its focus on providing not only PCs, but servers, integration, mainframes and networking as a package deal to customers.

That strategy, of course, is the envy of both

Hewlett-Packard

(HWP)

and

Compaq

(CPQ)

and the promise behind their proposed merger.

PC makers have to do something, because the market isn't going to get a whole lot easier in 2002, either, according to Margevicius. The analyst believes computer sales will stay "relatively flat" for the first half of the year, with potential for some improvement in the second half of 2002. "We may see a bounce, but it's not going to be a huge bounce," he says.

And so investors are left to scratch their heads over Gateway. The company's new Dell-free market trajectory may constrain its unit sales and render Gateway a small player. Then again, profitability is an unexpected silver lining to Gateway's move. The PC player's turnaround is still under way, but investors must face up to the idea of a more limited, if also protected, Gateway of the future.