Five months will not this turnaround make.

Gateway

(GTW)

investors should remember that as they prepare for the company's second-quarter earnings report in less than two weeks. The results will likely be mediocre: Analysts polled by

Thomson Financial/First Call

expect it to lose a penny a share. And the beleaguered PC maker could easily do worse: Tuesday afternoon, rival

Compaq

(CPQ)

owned up to an

uninspiring second quarter.

Either way, save your strength. The turnaround story at Gateway is going to be a long, slow, difficult process.

The A-Team

It's been more than five months since co-founder

Ted Waitt rebuilt the management team at Gateway, then reeling from the worst blowup in company history, with a group of insiders. The changes reflected the company's new focus. Consumer division chief Bart Brown would focus on rebuilding the flagship PC business. Dave Russell, senior vice president of supply-chain management, would help reduce operating expenses enough to allow Gateway to keep pace with industry leader

Dell

(DELL) - Get Report

. And CFO Joe Burke would clean up the mess created by the company's aggressive consumer financing operations.

Banks Are Open
Gateway's loans outstanding vs. origination business

Sources: Gateway, Detox.

Burke's job may be the most formidable. His predecessor,

Boston Chicken

management alumnus John Todd, had been the driving force behind the company's rapidly expanding consumer lending operations, which metastasized steadily over the past three years until blowing up late last fall. The company did about $1 billion in financing in 1998, entirely through banking partners. That sum had surpassed $2 billion in 2000 -- more than 20% of annual sales, with Gateway itself originating a quarter of the total.

Through it all, Todd touted Gateway's lending business as a customer retention tool, arguing that the steady flow of monthly bills helped the company monitor its customers and know when they needed upgrades. But it was hard to forget about the new customers that financing was bringing in, not to mention the proceeds on the interest itself. Meanwhile, critics worried about the quality of business the company was chasing with offers of low monthly payments at interest rates well above 20% and through deals with rent-to-own companies like

Rent-Way

(RWY)

.

Clean and Sober

After business imploded late last year, and under the leadership of CFO Burke, Gateway has sworn off this approach. According to its annual report, Gateway was sitting on about $780 million in uncollected financing payments by the end of 2000. It sold about $500 million of that to an undisclosed third party in February -- cash that will come in extremely handy as the company struggles to get back to profitability -- and dumped most of the rest of its bad loans shortly afterward. Financing receivables totaled just $8 million at the end of March. Though the company hasn't entirely scrapped its practice of originating loans, it has vowed to cut back on the amount of risk it's willing to take on. "We continue to do lending," says a Gateway spokesman. "But it tends to be with higher-tier credit customers."

In short, Gateway is willing to forsake sales to the poorest consumers if those sales can be made only through Gateway-backed financing. That's tough, if necessary, medicine. So far, about $100 million worth of loans for PC sales have been written off by the company as worthless. "The lending started through third parties," says one analyst who didn't want his name used. "But they wanted some of that income, and started going after the riskiest loans. It becomes very nasty, very fast. They were doing it to drive the top line, and it's having a severe ripple effect."

This ripple effect will make it very challenging for the company to achieve one of the main goals CEO Waitt outlined when he took charge: growing sales again. Year-over-year comparisons are very tough in the company's consumer PC business, which, juiced by the company's financing practices, has grown at what now seems like a supernaturally high rate in recent years. Matching those numbers, much less growing on them, is an enormous task in the current environment, where PC demand is weak in general, and especially weak in the consumer segment. Gateway has tried to spur demand by jumping headlong into the PC price war with a guarantee to undercut any competitor's prices. But analysts don't see the company posting sales meaningfully higher than their 2000 levels until the fourth quarter of 2002, according to

Multex.com

.

Back to the Future

Hurry Up and Waitt
Gateway's recent plunge

In the long run, it won't be the consumer that helps Gateway re-emerge as a growth stock. It will be small and midsize businesses, a market that many observers think Gateway is uniquely positioned to go after. Its biggest strength in this department is its Country stores, which provide sales support, training and repairs as well as any local white-box manufacturer. "They have all the benefit of the white-box guys, but with a national brand name," says David Bailey, an analyst at

Gerard Klauer Mattison

. "But their progress has been uneven. It's been a challenge for companies to break into this space. And without success in that initiative, they remain a very cyclical company." (GKM hasn't done recent underwriting for Gateway.)

As with the consumer and enterprise hardware markets, the outlook for the small-business segment isn't particularly good right now. Bank lending, critical for small businesses, is tightening. A survey released in late June by the Comptroller of the Currency, a branch of the

Treasury

that oversees banks, indicated that about half of all banks have raised their commercial lending standards in 2000. Meanwhile, Gateway is pulling back.

"Priority No. 1 there is to cut costs," says

ABN Amro

analyst Robert Cihra. "The cost structure was getting pretty bloated. The aggressive expansion of Country stores was out of hand." Gateway has closed 38 of its Country stores and fired about 10% of its workforce this year. (ABN Amro hasn't done recent underwriting for Gateway.)

For the foreseeable future, Gateway's retrenchment program will leave it focused on its core strength, the consumer market. Unfortunately, that's exactly where most observers agree a PC company doesn't want to be.