Gateway Q2 2006 Earnings Conference Call Transcript (GTW)

Aug. 3.06 | About: Gateway Inc. (GTW)

Gateway Inc. (GTW) Q2 2006 Earnings Conference Call August 3, 2006 5:30 PM ET

Executives

Marlys Johnson - IR

John Goldsberry - SVP, CFO

Rick Snyder - Chairman, Interim CEO

Analysts

Richard Gardner - Citigroup

David Bailey - Goldman Sachs

Wayne Smith - Touchtone Investments

Eric Reubel - Miller Tabak Roberts

Bret Blackwell - Scotia McLeod

Operator

I would like to welcome everyone to the Gateway first quarter earnings conference call. (Operator Instructions) I would like to turn the call over to Marlys Johnson with Gateway Investor Relations. Good afternoon, Ms. Johnson.

Marlys Johnson

Good afternoon, Andrea. Thank you. Welcome to Gateway's second quarter earnings conference call. If you have not seen a copy of today's earnings release, please go to the news and information pages of our Gateway.com website.

Joining me today is Chairman and Interim Chief Executive Officer, Rick Snyder; Senior Vice President and Chief Financial Officer, John Goldsberry.

Before we begin, I would like to remind the audience that the presentations you are about to hear contain forward-looking statements based on current management expectations that involve risks and uncertainties, as well as assumptions that if they do not materialize or prove incorrect and could cause Gateway's results to differ materially from those expectations.

All statements other than statements of historical fact are statements that could be deemed forward-looking statements. Information about the factors that could cause future results to differ from expectations can be found in today's earnings press release and the Company's reports filed with the Securities and Exchange Commission.

During this call, we may discuss certain non-GAAP financial measures that are management's basis to evaluate the Company's financial performance and forecast periods. If applicable, you can find additional information on these non-GAAP measures and a reconciliation of these measures to GAAP measures on our quarterly earnings page of our website.

I would now like to turn the meeting over to John Goldsberry, who will review Gateway's second quarter financial results. He will be followed by Rick Snyder, who will provide overall commentary on Q2 developments. Thereafter, if time permits, we will allow questions from the audience. To allow greater participation, please limit your questions to one per person.

John Goldsberry

Thanks, Marlys. Let me start by summarizing our overall financial results for Q2. We had a mixed quarter. Our retail business achieved budgeted revenues, but margins declined due to certain execution issues. Our Pro business margins have started to improve. Pro actually would have had a positive segment contribution had we not made an adjustment to our warranty and royalty reserves. We continue to aggressively reposition direct away from low-end systems to fully featured configurations.

Let me now walk through our quarterly results. Gateway sold 1.17 million PC units in Q2, which was up 16% from a year ago. Q2 revenue was $919 million which was up 5% from a year ago. On a year-over-year basis, we continued to do well in retail, which posted a 21% increase in revenues. This increase was partially offset by continuing single-digit declines in Professional and more significant declines in Direct as we repositioned that business to focus on more fully-featured solutions.

Nonetheless, based on preliminary IDC data, Gateway was the fastest-growing U.S. PC company among the top five vendors on a year-over-year basis. According to IDC, we had an estimated 6.5% market share, up from 6% a year ago.

Gross profit for the quarter was $51 million, down 36% from last quarter and down 42% from a year ago. Gross margin for the second quarter decreased to 5.5% from 7.3% in Q1 and 10% a year ago.

Margins across all segments were impacted by additional warranty and royalty accruals associated with the change in management's estimates of these liabilities. We also encountered some execution issues in our retail business which hurt retail’s margins and contributed to a year-over-year decline in retail segment contribution.

Despite a $10 million increase in warranty and royalty reserves, we did see an improvement in Pro margins, which is encouraging. Pro actually would have positive segment contribution from the loss of $12 million in Q1, had it not been for the adjustment to our warranty and royalty reserves. Direct increased its segment contribution year-over-year, largely due to reduced selling costs.

On the SG&A front, SG&A expenses for Q2 were $66 million or 7.2% of revenue, down from $103.1 million in Q1 and down from $85 million a year ago. Sequential decrease was due in part to an $8.4 million reduction in sales tax reserves as well as reduced marketing spend and other expense controls. SG&A expense in Q1 of this year was high in part because it included a $14 million litigation settlement charge.

Net result is we had an operating loss for the quarter of $6.9 million in Q2. This compares to loss of $15.7 million in Q1 and a gain of $17.6 million a year ago. Q2 net loss was $7.7 million; EPS was a loss of $0.02 a share.

Focusing on the balance sheet, we ended of the quarter with working capital of $219 million, down $27 million from Q1. Cash and marketable securities ended up the quarter at $525 million, down $66 million. This was largely driven by $41 million in payments associated with previously announced legal settlements and seasonal working capital requirements.

Let me now turn the call over to Rick, who will talk about other things we accomplished during the quarter.

Rick Snyder

First of all, I'd like to thank our shareholders, employees, and partners worldwide for their continuing support. While we're disappointed with the financial performance in the second quarter, I would say we're very encouraged by the progress in Pro and Direct and excited about strong initiatives underway in marketing, manufacturing, and tech support.

Let me talk about our three business units and then some of the corporate initiatives. First of all, in the Professional area, Jim Burdick, our new head of Pro, who started on April 3 and his team made significant progress in their first quarter's work in reinvigorating Pro. We saw good sales growth and margin improvement from Q1.

Other things taking place on the Pro side is we consolidated our organization into public and business segments along more efficient geographic lines. That has improved our efficiency and also reduced our sales expense. We reorganized our sales support organizations and rolled out a more efficient order entry system. Then, another important development, the new customer portal, Gateway Select, was rolled out late last year and has had a very good response. We now have over 750 customers signed up, including 300 more in second quarter alone.

Then we're excited about the later part of the year. We have strong enterprise products plan for the second half of the year, and we're continuing to improve our focus on appropriate customer segments.

On the Direct side of the business, it's a similar story of good news. Bart Brown rejoined Gateway on March 27. He and his team made strong progress in helping fix our Direct business. At the end of the quarter, we rolled out a new product line-up that includes fully featured, fully configured systems for the more advanced user. You can go to our website and see these new configurations with starting price points of about $799 and up.

This positioning complements, as opposed to competes with our retail channel, so we repositioned it so they complement one another. We actually hope to use the Direct channel to introduce new technology that will benefit first the advanced user and then can advance really the mass market and our retail partners. So we're excited about that philosophy.

During Q2, we closed our Kansas City facility and consolidated our Direct operations in North Sioux City, which is a major expense savings. We rolled out a new, more efficient order entry system for the Direct sales force also. As we go through the year, we hope to enhance our demand generation efforts to really create more demand for the exciting product line-up we now have in place.

On the retail front, Q2 follows an unusually strong first quarter. We continue to see good growth in unit sales and revenue from a year ago. John mentioned, we are the fastest-growing PC company, largely because of the results year-over-year in the U.S.

We did have some execution and royalty payment issues that adversely impacted margins for retail. We have a good understanding of those execution issues and are addressing the situations, so I think we have a good sense of what to do there.

On the international side of retail, we're now in nearly 3,000 retail stores in Japan, Mexico, the UK, and France and we're adding retailers on a continuing basis.

On a company-wide basis, we have exciting initiatives there that are poised to launch in the second half of the year. First of all, our previously announced assembly facility, the Gateway Configuration Center, will be up and running on schedule in Q4, and that should be a major help to both the Professional and Direct sales efforts. It will also help in terms of our overall cost of goods sold through the associate vendor managed inventory sites.

On July 13, we announced the additional details of our best practice tech support center we're opening in North Sioux City. We're excited about that. That will be fully functional in Q3 and allow us to take calls again from our customers and actually allow us to be more efficient working with our outsource partners.

For the U.S. and North American marketplace, we now have all of our tech support back in North America.

On the marketing front, we continue to work on improving our marketing and message both internally and externally. One of the issues I found when I came back earlier this year is I think it's been unclear what Gateway represents, either to our customers and in many cases our employees, and we need to resolve that situation. So we have been working hard on redefining what we represent in a way that really will differentiate us from the competition. We're making good progress.

To give you a snapshot of the future, we'll save the rest for later in the year, but the core elements will include leadership and customer satisfaction, leadership and value focused innovative products, being a great place to work, and getting some solid strong financial results on a consistent basis.

With that, we're also working hard to come out with metrics that we'll share both internally and externally that will allow people to measure our progress and our future direction. We believe these initiatives really are starting to resonate well with the customer base and I hope they resonate well with the financial markets.

One topic I also wanted to address was the CEO search status. We've seen some great candidates. We are going through that process and making positive advancement there. We're on a path to hopefully have a permanent CEO on board by the September/October timeframe. As I mentioned before, I plan on remaining as Chairman of the Board to make myself available to help the new CEO with that transition.

Overall, what I'd like to say is I continue to have strong confidence in Gateway and the future direction we're moving. Through actions starting in 2004 with the merger with eMachines, we made significant progress in reducing what were very large losses to the point of having quarters with either small losses and profits. Earlier this year, it became clear that that's not what we really want. We want to have a strong, exciting business for the long-term, so we've taken actions to make that happen. The changes you've heard about and see in progress are based on common sense, clear direction, and good execution.

We have plans to turn around Pro and Direct, continue good progress in retail and improve the Company overall. We're implementing specific plans to do these things. As I said before, it will take a number of quarters for these to really show in financial results, but hopefully you can hear through the things I commented on, that these tangible things are taking place and will happen.

Thank you very much. So we will open it up to questions then.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

Good afternoon. I was hoping you might be able to give us a little bit more detail on the execution issues that you experienced in retail and also, the thought process behind the increase in warranty and royalty reserves?

John Goldsberry

During the quarter, we completed a study of our warranty reserves and concluded that we needed to add to our balance sheet reserve and also make a change in the model that we used to amortize existing warranty reserves.

So we ended up making an adjustment that had to flow through the income statement. I guess I would say that we're not increasing the warranty expense that we're accruing per unit.

As it concerns the retail side, what we observed during the quarter was we lost 1% plus of margin due to a wide variety of factors, which I'll lump in as being largely of an execution nature. These range from costing issues to excess freight to excess E&O to inventory adjustments. None of them were in and of themselves that large, but collectively, they brought our margin down from where we would like to see it in retail. These are things we have to watch all the time and we're refocusing on them to prevent them from happening in the future.

Richard Gardner - Citigroup

John, was any of the degradation in retail margins due to a significant increase in price aggression in the marketplace?

John Goldsberry

We wouldn't characterize it that way. We have a model we use to price products to our retailing partners. We were quite happy with how we had priced our products to them at the beginning of the quarter. We just allowed some things to get away from us in a way that brought our eventual retail margins in at a level that was lower than what we would have hoped.

Operator

Our next question comes from David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

I have a question and a clarification. Just on the cash balance side, can you help us understand what your cash balance target is and what your expectations are for cash flow over the next few quarters? On the clarification on the change in the warranty reserves, is that one-time in nature as you true up? Or should we expect gross margin to be somewhat lower going forward than it has been the past few quarters because of it?

John Goldsberry

I would describe the warranty accrual that we made as mostly one-time in nature. As it concerns the cash situation, I guess the first point I would make is we really focus more on working capital as compared with cash. By the figures that I mentioned, you can see that cash is larger than working capital, which means it's largely a reflection of what we're doing with the other working capital accounts.

What happens to working capital going forward will largely be dependent upon what kind of operating results we produce. We would see some additional amounts being paid down that are currently in either accrued liabilities or accounts payable that will probably reduce our cash position.

David Bailey - Goldman Sachs

Okay great. Thank you.

Operator

Our next question comes from Wayne Smith - Touchtone Investments.

Wayne Smith - Touchtone Investments

Can you talk a little bit about the SG&A expense in general? I mean, I think I've been kind of surprised how much you been able to reduce that to date, even before this quarter, and it just seems like your ability is without end. I'm just trying to get a sense of what the strategy is here, because it seems like we're getting lower and lower margins and now kind of stalling as far as the sales growth.

I'm trying to figure out whether this is somehow related to these deep cuts that continue to happen on your SG&A.

John Goldsberry

Well, our SG&A for the last two quarters, I would say it's been distorted in both directions over the last two quarters. In Q1, it was abnormally high in part because we had a large litigation settlement we had to incur. In Q2, it was probably somewhat on the low side, as was mentioned in the press release. We were able to reverse some sales tax accruals that we had previously made, which brought our SG&A number in considerably lower than what probably the normal run rate would be.

As it concerns where we can take SG&A, I stated in the past that I think we can get it certainly in the 7s, which is where we were this quarter, if not the high 6s. To me, that's a very achievable target. I think it's consistent with the business models that we have in both Pro and Direct, one the one hand where of course you're going to have higher SG&A, and then retail on the other hand where certainly the retail business in and of itself operates at an SG&A level that's considerably lower than our average.

Wayne Smith - Touchtone Investments

Year-over-year numbers, I have last year the second quarter, $873 million. I am trying to remember now. Could you just refresh my memory? Does that include the full effect of the eMachines merger?

John Goldsberry

Sure. The eMachines merger at this point was two years ago.

Wayne Smith - Touchtone Investments

So this is all year-over-year. So, the sales growth, the sales growth that you guys experienced this quarter, the rapid decline quarter over quarter from last quarter to this quarter, should we expect to see that reaccelerating in the back half of the year? As the work that you've done lines itself up and starts to come to fruition?

John Goldsberry

I would stress the year-over-year increased revenue as being the trend to look at. We had an exceptionally strong quarter in Q1 in retail. We were happy with our retail volumes in Q2. They were not at the same levels in Q1, but we were certainly happy with them in Q2.

I would caution you not to sort of look to the quarter over quarter trend because there's a lot of dynamics involved in that.

Wayne Smith - Touchtone Investments

Right. But I am just trying to get a sense of what do you guys feel like the year-over-year run rate should be, could be, is there a target?

John Goldsberry

Well, retail alone I think grew 21% year-over-year. So we continue to see business there that is growing very nicely year-over-year.

Wayne Smith - Touchtone Investments

But I am talking about for the Company in general. Should we expect it to stabilize year-over-year at kind of a 5% growth rate, or could it be lower, higher than that?

Rick Snyder

We're not giving guidance. That was something we decided Q3 of last year, so with respect to picking specific future revenue forecasts. I mean John commented on retail, our issues have been to fix Professional and Direct because we had issues there. Pro had a very good quarter. As I said in my comments we're very pleased that we had revenue growth in Professional and we also had margin improvement.

Direct is the unit that has had the largest declines in revenue. And again, we said that would take several quarters to see that change, but we made the first couple major steps. One is by redoing our configurations, which just took place at the end of Q2. Secondly, we've made massive improvements on the sales efficiency, sales front and sales management side of things. I think we're well positioned to get Direct back on a more constructive, positive path as the year progresses.

Wayne Smith - Touchtone Investments

Last question from me. Just far as inventories go, days sales inventory were pretty low but consistent with what you had been running last quarter, but a lot lower year-over-year. Is this the kind of inventory level you believe you'll be carrying, or will there be a lot more inventory at the end of the third quarter as you build up for the ship in for Christmas?

John Goldsberry

We continue to focus on doing a better job keeping our inventories down. Having said that, at the end of Q3 you may see a bit of a bump as we build up for Q4.

Operator

(Operator Instructions) Our next question comes from Eric Reubel - Miller Tabak Roberts.

Eric Reubel - Miller Tabak Roberts

Good afternoon, gentlemen. If I can ask another question on the warranty expense. As I was looking back at the Company it seemed as though warranty costs were at an industry low at about 2% of revenue in the fourth quarter and is this charge that you've taken, is it specifically in the Professional division if I understand that correctly? Or is it more across the whole product line?

John Goldsberry

I would characterize it this way. It primarily relates to accruals associated with longer-term warranties. What we've concluded is the model we were using for amortizing warranty accruals needed to reflect a greater amount of expense and calls in the later periods associated with the extended warranty. So we're changing the model we're using to essentially amortize warranty accruals. I should stress that we're not increasing the warranty expense per unit that we accrue when we sell units.

Having said that, our retail business operates with much shorter warranties. Typical retailing terms would be a one-year warranty. Three-year, four-year, five-year warranties are far more prevalent in Pro as well as in Direct. So, that adjustment had probably more of an effect in those businesses.

Eric Reubel - Miller Tabak Roberts

Thanks for clarifying that a little bit. On SG&A, you definitely talked about lowering advertising expenses and talked about making that budget more targeted, rather than the generalized branding advertising. Is this a level that we can be comfortable with going forward or can you give any view on how we should be looking SG&A without specifying guidance per se?

John Goldsberry

Okay. As it relates to the overall SG&A, SG&A this quarter was helped by the fact that we had some reversals of sales tax reserves. That is laid out in the release. As it relates to marketing expenditures, Rick, why don't you chip in on that one?

Rick Snyder

Yes, with respect to marketing expenditures, I think we'll do some incremental spending in the second half of the year. As I mentioned, we're looking to reposition better to find our brand and our marketing message, and so we're going to be doing some investing in that in a proactive fashion. So you will see us become more visible in the later part of the year.

Eric Reubel - Miller Tabak Roberts

John, just one more question on working capital. You did a good job on receivables and inventory, but payables are definitely down about $100 million.

John Goldsberry

Correct.

Eric Reubel - Miller Tabak Roberts

You've also said that you expect accrued liabilities and payables to continue to trend lower. Any guidance on working capital, or not guidance, but a view towards whether not working capital can be a source or use of cash in the second half of the year?

John Goldsberry

Well, as it relates to working capital, the things that are going to affect that obviously will be primarily operating results. We have also stated that we do have some income tax reserves that we think there's a good chance will get released. That's going to be fairly well detailed in the Q, which we're going to file either later today or tomorrow. But certainly, if we are able to release the income tax accruals, that will help working capital as well.

In terms of management of the working capital accounts, going back to the issue you raised, we actually are trying to bring days payable down a bit. That is part of sort of our overall strategy in dealing with our suppliers.

Operator

(Operator Instructions) Our next question comes from Bret Blackwell - Scotia McLeod.

Bret Blackwell - Scotia McLeod

I have been a shareholder here for a couple of years, and thinking about the Company going forward, I am just thinking in terms of the position that a company like Apple has in the marketplace and people wanting to buy because of the unique design and that type of thing. Where, in an increasingly commoditized market, does Gateway see themselves so that clients want to come in and actually buy a Gateway computer? Have you guys given that any thought?

Rick Snyder

Yes. We have given it a lot of thought, and we're actually excited about the opportunity that sits in the marketplace. There are two central things that are relevant to the external world. There are a couple of things we're doing internally. It's somewhat of a list I mentioned that I went through when I talked about our messaging.

First of all I think there's an opportunity for us to give outstanding customer experience to people. I think you look at the PC industry of the last few years, I don't think it's been a great experience for customers in the marketplace. I think it's only gotten worse by the amount of press you've seen on this topic in the way people feel about things.

If you look at the legacy of Gateway, at points in time, Gateway was the best in this industry at customer satisfaction. We're really focused. We have a lot of initiatives to get us back on that path. That includes the Gateway Configuration Center, the Best Practices Tech Support Center. We're working hard on making these things happen. We've taken near-term actions. We've actually, at the request of our customers after listening to what they had to say, we've moved all of our support back to North America already for the North American marketplace. So we're working hard on being the best. That will take some time, but we're going to get there.

The second thing is value-focused innovative products. Again, that's a legacy that we know how to do well. We have executed well. It's really not just having the hottest product in terms of being the most techie product, but having products that are really innovative that have the right inflection point, that sell well.

A couple of great illustrations, the convertible notebook we had in the past. The 21-inch wide monitor, we have been highly successful with in the marketplace. Our 19-wide is doing well right now. I think you're going to see an institutionalization of coming up with products of that quality and that design over the next few years.

So we're working hard to put those two things in place in terms of outstanding customer satisfaction and innovative, focused products. Those two things will really let us stand out and be able to go back after this marketplace, hopefully take market share from people and achieve some profitable growth.

Operator

(Operator Instructions) At this time I would like to turn the call back over to Marlys Johnson.

Marlys Johnson

Thank you everyone for joining with us today. A replay of this conference call will be available on the homepage of the Gateway.com website for 24 hours, and thereafter archived on the investor relations web pages. There will be a telephonic playback of this conference call beginning tonight at 7:30 PM Eastern Daylight Time and running until midnight Eastern Daylight Time on Sunday, August 6. That number is 706-645-9291 passcode of 34763. Have a good evening.

Operator

Thank you for participating in today's Gateway first quarter earnings conference call. You may now disconnect.

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