Gateway Credit Analysis
Using 72.5 vs. $3.41 and 35 vol. for A’s and 69.25 vs. $3.41 and 35’s for B’s, I get implied credit of about 650 over Libor using the Bloomberg model. I think there is significant risk to the credit spread. I would not recommend these converts from a credit perspective for the following reasons:
1) Gateway lacks the scale of Dell, which is more efficient, and the scope of HP and IBM, which bundle printers and services to win deals.
2) Gateway’s business model relies too much on warrantees and financing deals, which is not sustainable in the long run.
3) Company’s guidance look very aggressive, assuming big market share gains and positive operating cash flow. Given their last 3 years performance, it would be a stretch for them to hit their guidance.
4) There is a good chance that the PC cycle will turn down and/or pricing will become more aggressive. Gateway is not as diversified as their competitors to survive a price war. Gateway currently has $584M in cash and $325M in debt. The worse case scenario could have the company burning several hundred million in 2005.
Business Profile
Gateway is in a very difficult competitive position within the tech hardware industry. From a distribution perspective, 57% of revenues come fromUSretail, probably the most competitive segment of the PC market. The company sells a low end eMachines brand and a high end Gateway brand through retailers like Best Buy,CircuitCityand CompUSA. Historically, it has been very difficult to make profits inUSretail because of the high competition. From time to time, HP starts a price war in order to protect their market share and printer franchise.
The Professional segment cannot compete with the scale of Dell and or the scope of IBM. Additionally, IBM and HP will use the PCs business as loss-leaders to win service contracts. GTW is left to focus on small and medium businesses but has had little success. According to analysts and JP here in the office, GTW’s products are priced low but are inferior in terms of both quality and after-sale support. The Direct business has not done well for the company and continues to lose share.
| 1Q05 sales | % sales | Comments | |
| Direct | $150M | 18% | Declining |
| Retail | $476 | 57% | Company is making a big sales push to gain share |
| Professional | $212 | 25% | Declining |
The non-systems segment (warrantees, financing, software, other hardware) accounts for 19% of revenues but 74% of gross profits. This implies that their PC business lost money on an operating basis in an environment that is favorable for the PC business in general. If demand or pricing turns down, there is not much cushion for profits. To a large degree, non-systems sales are tied to the health of PC sales and may not maintain 19% of sales going forward.
| 1Q05 Sales | % sales | |
| Desktop | $357M | 42% |
| Portable | $286 | 34% |
| Server | $33 | 4% |
| Non-Systems | $163 | 19% |
Risks
Guidance is too aggressive.
GTW guided to $4.0 to $4.25B in revenues, which implies unit growth of 23%-27% for the next 3 quarters. With the PC units for the market expected to grow 8-9%, it would be very difficult for GTW to reach its goals. Also, if GTW were to gain that much share, HP would likely start a price war to protect its share.
HP starts a price war
HP is struggling to be profitable in retail PCs. The only way they can stay profitable is to maintain its market share. They also need to protect their printer franchise by maintaining share in PCs. HP would likely start a price war to protect their market share.
PC demand is weaker than expected.
PCs have enjoyed two consecutive years of double digit unit growth in 2003 and 2004, which coincided with a rebound in the economy and also the special Bush depreciation tax relief. With PC buying on a 3-4 year upgrade cycle, there is a good chance the lofty expectation by IDC for 2005 and 2006 will be too high.
Financials
GTW ended the quarter with $584M in cash and $325M in debt. The company expects to end 2005 with cash of at least $500M. The company expects to be operating cash flow positive for the full year 2005. Given that the company had EBITDA of -$489M in 2004, -$346M in 2003 and -$351M in 2002, it would be a surprise if management actually hit their guidance.
GTW is still in the middle of a restructuring program which includes the closure of over 300 stores and a merger with eMachines. While the company’s has shown significant costs cuts in SG&A and the store closures are coming to an end, there is no reason to believe that the company is about to turnaround the business.