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Gateway, Inc. (GTW)

Q3 2006 Earnings Call

November 2, 2006 5:30 pm ET

Executives

Ed Coleman – CEO

John Goldsberry – CFO

Marlys Johnson – IR

Analysts

Brian Mansfield - Goldman Sachs

Richard Gardner – Citigroup

Katie Huberty - Morgan Stanley

Charles Wolf - Needham

Eric Reubel - Miller Tabak Roberts

Aaron Reise - Jefferies and Co

Jeff Cohen – Southpaw Asset Management

Ryan for Bill Fearnley - FTN Midwest

Presentation

Operator

Good afternoon. At this time we would like to welcome everyone to the Gateway third quarter conference call. (Operator Instructions) I would now like to turn the call over to Marlys Johnson with Gateway Investor Relations. Good afternoon, Ms. Johnson.

Marlys Johnson

Good afternoon, everyone. Welcome to Gateway's third quarter earnings conference call. If you have not seen a copy of today's earnings release, please go to the news and information pages on our Gateway.com web site. Joining me today is Chief Executive Officer Ed Coleman; and 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, 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 factors that could cause future results to differ from these expectations can be found in today's earnings press release and the company's reports filed with the SEC.

During this call, we may discuss certain non-GAAP financial measures that management uses as a basis to evaluate the company's financial performance and forecast future periods. If applicable, you can find additional information on these non-GAAP measures and a reconciliation of these measures to GAAP measures in the quarterly reports on our web site.

I would now like to turn the meeting over to John Goldsberry, who will review Gateway's third quarter financial results, followed by Ed Coleman who will provide overall commentary on Q3 developments. Thereafter, as time permits, we will allow questions from the audience. To allow greater participation, please limit your questions to one per person.

John Goldsberry

Thank you, Marlys. Let me summarize our financial results by saying we had a good quarter. Our professional business had a pretty remarkable turnaround. Pro revenues increased 5% sequentially, Pro gross margin increased to 13.1% from 4.4% in Q2, and cross segment contributions swung to a positive $18.2 million, from a loss of $8.3 million in the prior quarter. Our retail revenues grew 6% sequentially and retail segment contribution increased 21% to $20.9 million from $17.2 million in the prior quarter.

The net result is we had an operating income of $7.9 million versus an operating loss of $6.9 million in Q2. We also reported net income of $18.2 million or $0.05 a share after a net tax benefit of $8.2 million.

Before I walk through our results, let me note that in our earnings release and in our 10-Q filing, we have decided to report not only segment contribution but also segment gross margin and segment business expense in order to provide better transparency into our results and help people understand our different business models.

Let me now walk through the financial results. Q3 revenue came in at $963 million; this was up 5% from Q2 due to sequential increases in retail and professional revenues, partially offset by a decline in direct. Revenue was down 5% year over year, retail revenues increased but were offset by single-digit declines in professional and more significant declines in direct.

Gross margin dollars increased significantly to $73 million in Q3, up 45% from $51 million in Q2, but we're still down 13% from last year. Gross margin percent increased to 7.6% from 5.5% in Q2, but was below 8.3% last year.

Professional margins improved significantly to 13.1% from 4.4% in the second quarter. The improvement in gross margin was due to better margin management and operational improvements. Q2 gross margin also had been impacted by one-time increases in warranty and royalty reserves. Cross segment expenses were down and the net result was the pro segment contribution swung to a positive $18.2 million from a loss of $8.3 million in the prior quarter. Pro segment contribution as a percentage of revenue was 6.9%.

Retail margins improved to 4.2% of revenue, up sequentially from 3.7%. Our retail expenses increased slightly. The net result is that retail segment contribution increased to $20.9 million, up sequentially from $17.2 million. The sequential improvement in gross margin and segment contribution is primarily due to a shift in product mix, from desktops to notebooks as well as operational improvements.

Direct margins declined to 16.8%, down from 22.9% in the prior quarter. The sequential decline in gross margin reflects the impact of lower direct sales volume, a change in the pricing strategy of one of our alliance partners which reduced Gateway's revenue share, as well as reduced amortization of extended warranty revenue. Direct expenses increased to $12.2 million, from $8.4 million in Q2, due to an increase in marketing expense. The net results is the direct segment contribution dropped to $0.4 million from $9.3 million in Q2, as we have continue to reposition our direct business away from low-end systems to full-feature configurations.

On the SG&A side, SG&A expenses for Q3 came in at $74 million, or 7.7% of revenue, up from $66 million in Q2 but down from $78 million a year ago. The sequential increase was due to an $8.4 million reduction in sales tax reserves in Q2 due to a settlement, and increased marketing expenditures in Q3. Adjusting for the sales tax reserve adjustment, SG&A was basically flat. The year-over-year decline was due to our continued focus on expense controls and operational efficiencies. We remain committed to reducing our SG&A, as Ed will discuss in his comments.

The result is that we had operating income of $7.9 million in Q3 which compares to a loss of $6.9 million in Q2, and a gain of $18.8 million in Q3 of last year. The company reported net income of $18.2 million, or $0.05 per share, after a net tax benefit of $8.2 million.

With regard to the balance sheet, we continued to improve our management of working capital during this quarter. Working capital increases $13 million to $232 million from $219 million at the end of Q2. Net accounts receivable dropped to 27 days -- days sales outstanding -- down from 32 days at the end of prior quarter, and down from 28 days at the end of 2005. Net inventory also dropped. It closed at 13 days inventory on hand, down from 16 days at the end of Q2, and down from 19 days at the end of 2005.

Accounts payable closed at 53 days, down from 63 days at the end of Q2 and down from 67 days at the end of 2005. We continue to reduce our days payable outstanding and this is part of a strategy of strengthening our relationships with our vendors and manufacturing partners.

Cash and marketable securities decreased to $429 million from $524 million at the end of Q2. The sequential decrease basically reflects the reduction in days payable outstanding on our payables, as well as the $25 million reduction in our notes payable.

Let me note that we currently have approximately $95 million in income tax reserves attributable to past periods. We are in the process of concluding audits of these past periods and we believe that a significant portion of these reserves will be released over the next few quarters. This could benefit our reported net income for these periods and increase our reported working capital.

Let me now turn the call over to Ed Coleman, who will provide additional commentary on the quarter.

Ed Coleman

Great. Thank you, John. Good afternoon, everyone. It's a pleasure to be with you today. Over the next few minutes, I would like to take you through my thoughts on our third quarter performance and offer some of my views on the company and our direction.

As John noted, Gateway showed marked improvement in its operating results compared to last quarter. This improvement was driven by several factors, a couple of major ones stand out in my mind. First, due to a more focused sales approach and better margin management, we had much better gross margins in our professional business which accounts for 27% of our sales, delivering a 13.1% gross margin in Q3 versus 4.4% in Q2. Coupled with better expense management, this improvement yielded a significantly higher margin for Pro. In dollar terms, nearly equal to that of our retail business and in percentage terms double retail’s.

Second, our retail segment which represents 65% of our business on a revenue basis, again delivered unit and revenue growth, both sequentially and year over year and a higher gross margin 4.2% versus last quarter's 3.7%. However, retail gross margin percent was down compared to last year, as competitive pressures have intensified.

Our consumer and small business direct results were disappointing. While this segment delivered a 16.8% gross margin, the highest among our segments, it was down from last quarter’s 22.9%, primarily reflecting a change in pricing strategy from one of our alliance partners.

In addition, sales were down 3% sequentially and 44% year over year. This reflects a decision to move upstream by targeting PC enthusiasts and other high-end users through direct while avoiding channel conflicts with our retail customers, an approach that has yet to prove out.

Before coming back to a discussion of our overall business, I would like to touch on product performance. We saw very strong growth in notebooks during the quarter, and our monitor products continue to perform exceedingly well. Our continued success in the display category is validated by the fact that Gateway's 19-inch monitor was the top seller at retail in this fast-growing category in Q3, according to MTD. This month, we will be expanding our award-winning line of wide screen displays with larger sizes. Our PCs were recognized for their industry leadership with two Editors Choice Awards from PC Magazine for our all-in-one Profile 6 as well as our high performance fx510 series.

Let me now offer some additional thoughts on the company and where I'm focused. I come to Gateway with a sense of urgency. While we have many strengths, business as usual is the furthest thing from my mind. As a newcomer, I'm taking a fresh look at our strategy, business focus and our operational execution. I have met and will continue to be meeting with many key suppliers and customers to assess the quality of our working relationships, and what they are looking for from Gateway as a valued partner.

I have also spent a great deal of time with our employees, and working with our management teams to understand Gateway's current operational plans and business segment strategies. We are reviewing these strategies to assess each business unit's area of strength, competitive position and potential for future growth in order to make decisions about the company's future strategic course and to better allocate the company’s resources. At the same time, we are focused on the immediate profitability of each unit and its ability to contribute to Gateway's overall success in the market today.

The immediate opportunities for improvement are apparent. First, our cost structure is too high. Even with the overall improved gross margin performance, our corporate G&A burden is too great. Today we are looking closely at every aspect of our corporate cost structure, and weighing all costs against the core needs of each segment of our business. To that end, yesterday we initiated a corporate G&A cost reduction program that will yield $30 million to $35 million annually, beginning in the first quarter of 2007.

Second, we are not executing as well as we should, nor as well as we must. I believe we must be much more focused on operational processes, and their measurement of management and improvement, as well as product and service quality and customer satisfaction. Acting on this belief, as a first step we have identified key processes where failure to execute properly has created pocket leaks that we are working quickly and diligently to plug.

The addition of a number of other initiatives already underway are designed to improve our ability to execute more effectively for the benefit of our shareholders, customers and suppliers. These include the following:

Our Gateway configuration center in Nashville, which started production on September 28th and will enable us to further enhance our responsiveness to customer demands in the professional and direct segments.

The implementation of vendor managed inventory hubs in Shanghai and Nashville in conjunction with our implementation of the Oracle ERP system provides better visibility into and through our supply chain from component to customer delivery. In addition, we are staffing our Shanghai office with planning, procurement and quality engineering teams to make most efficient use of our Asian supply chain relationships. The Shanghai office opened on October 31st.

The best practices center, in North Sioux City, which is already helping us to better solve customer issues and increase first call resolution and customer satisfaction.

The implementation of North America-based telephone customer support for all but our international customers, to improve our customer satisfaction and differentiate Gateway from the competition. These are all intended to make us a more reliable, predictable and profitable supplier and partner.

Turning to Marketing for a moment; beginning next week, you will see our new branding campaign known as Ask and Deliver in TV spots, and in ads in a variety of other media to get our brand back in front of consumers in time for the holiday season.

Let me close by saying that we are here to win in the marketplace and to create value for our shareholders. We have two major tasks before us. The first is to assess our strategy and make changes where necessary. Secondly, with an equal sense of urgency, we are attacking today's immediate execution issues and opportunities to drive better results for shareholders, partners and customers.

We made progress in the third quarter, but we have much room for improvement. While there's no shortage of outside opinion about how best to move the company forward, I can assure you that we are working aggressively to determine our future course and how best to address both our operational and strategic issues.

With that, we will now open the call up to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brian Mansfield - Goldman Sachs.

Brian Mansfield - Goldman Sachs

I appreciate the additional disclosure on gross margins but I am just having a difficult time getting my hands around the improvement on professional if we have such a high degree of unallocated costs. It looks like to be almost roughly equal to what you reported segment operating costs are.

Secondly, you said you would take a fresh at strategy. I wanted to see, how much of a mandate do you feel like you have to define the corporate strategy going forward rather than just continuing the current path that has been put before you?

Ed Coleman

Let me take the second part of your question first. From a mandate, I think I have a mandate and a responsibility to look hard at our business model and our strategy and how we perform. I think if you look at this quarter's results, I think you can see that we are making some improvements in some key areas, but there are some other areas where I think we need to continue to take a hard look to decide whether or not we have the best model in place. I think the mandate is there and frankly I think the responsibility is there.

John Goldsberry

I am afraid I am not sure exactly what question you are asking. Could you perhaps pose the question again?

Brian Mansfield - Goldman Sachs

Sure. You talked about a contribution margin and you talked about the improvements on the pro side, specifically. But we have a large portion of unallocated costs, just larger than you would expect from a company your size. I would imagine that, specifically, the pro on the direct side would take a larger portion of those costs and if we were then to fully burden the segments, I have a feeling the operating margin might look a little bit different.

John Goldsberry

Okay, so just to make it clear in terms of what amount of additional disclosure that we are providing, previously we only reported segment contribution. That would have been, of course, equal to gross margin dollars by segment minus BU expenses, which we are now disclosing so that you can see what is there.

Now as it concerns your question about the size of the unallocated costs, I think the point that you are making is a very good one. I think going back to Ed's comments, we do recognize that our unallocated costs are too high, and one of the things we have embarked on here is an aggressive program to reduce those unallocated expenses.

You are right, more of those expenses should rightly get allocated to pro and direct and we do not break that out in terms of our external reporting, but that certainly would be a correct assessment. What we are trying to do at this point is rectify that situation so that pro and direct do not have to carry an undue amount of corporate G&A burden.

Brian Mansfield - Goldman Sachs

Thank you.

Operator

Your next question comes from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

Thank you very much. I had a couple of questions, I think for John primarily. One John, in the past you have been willing to give us what percentage of gross profit dollars came from the non-PC categories. I was hoping you could do that again.

Secondly, I was hoping you might be able to give us some sort of sense of what the duration of the non-PC item revenue streams is. In other words, I know a lot of that stuff is extended warranty and Internet service, but you have acknowledged in your release that a lot of it is related to units that are sold through the direct channel which have been declining pretty precipitously.

The question is, when do we start the sharp decline in direct units shipments over the past two quarters have an impact on the very profitable non-PC revenue stream?

John Goldsberry

Okay. So focusing on direct. Two things were significant as it relates to non-PC revenue that impacted direct margins. The first is we are seeing a fairly significant drop off in revenue share from a certain Internet service provider who has in the past used people like ourselves to drive membership, but who has recently moved to a basically free model. I don't think it's appropriate for us to identify them by name but I'm guessing you can probably figure that out. So that is impacting revenue share that we previously used to get from that party for the direct business.

The second thing that also impacted margins in direct is a roll-off of extended warranty revenue. We moved in late 2004 to use a third-party provider or insurer of our extended warranties. That changed our business model. Previously, of course, we assumed those obligations and then we amortized that revenue over time. Given that we're now selling extended service contracts on behalf of a third party, we move to essentially recognizing the margin up front. The residual or legacy warranty revenue is running off and that is also impacting direct margins.

Richard Gardner - Citigroup

The question though, John, had more to do with the fact that I would suspect that most of the non-PC revenue that you generated is related to sales through the direct channel and maybe some through the professional channel as well. Given the sharp drop-off that you're seeing in direct, when do we start to see that reflected in the drop-off in non-PC revenue?

John Goldsberry

I would honestly see that happening fairly quickly. Non-PC revenue is quite different in direct as compared with retail. In retail, non-PC revenue, to a large extent, represents sales of stand-alone monitors. That is a good business for us and there is a mix change taking place here as retail becomes more significant.

You are correct that as direct drops off, the high attach you get of relatively high margin products in the direct space, that is dropping off in line with the drop in direct revenues. But I would say that happens, by and large, that's happening in the same quarter as the drop off in revenues in direct.

Richard Gardner - Citigroup

John, are we correct that 65% to 70% of gross profit dollars in the quarter were from non-PC items this quarter?

John Goldsberry

That is correct.

Richard Gardner - Citigroup

Okay, thank you.

Operator

Your next question comes from Katie Huberty - Morgan Stanley.

Katie Huberty - Morgan Stanley

Hi, guys, good evening and welcome to the team. Just going back to the pro business first, you mentioned in the press release that you reduced headcount, travel and marketing expenses. To what extent can you continue to restrict those costs and still go out and return that business to growth over time?

Ed Coleman

I think there are a couple of thoughts there. One, the changes that were made there in many ways were. not draconian cost reductions as much as they were smarter ways to organize sales territories on a geographic basis, as opposed to a number of different industry segments, where we had people flying across different parts of the country to cover like customers. A little bit inefficient for actually covering the opportunity. Again, it's not draconian, it's just better sales management.

Katie Huberty - Morgan Stanley

Okay. Ed, just given your background with the channel, how do you view the channel versus direct for Gateway's professional strategy?

Ed Coleman

The channel provides some opportunity for us, but I think we are predominantly a direct marketing organization and we'll continue to be a direct marketing organization into key industry verticals, where we have real strength like education, both K through 12 and higher ed as well as state and local government. I think we have terrific opportunities in smaller medium business, which in many cases can be covered more effectively with outbound telemarketing capability than it can be with geographically dispersed field sales force. But I think we have significant opportunity there.

John Goldsberry

Katie, going back to your first question as it relates to BU expense levels, if you do the math, BU expenses were still in excess of 6% of sales. That is certainly not an unusually low level, it just reflects the fact that we've been at higher levels. But I think if you look at competitors, 6.2% BU expense as a percent of sales in pro is still a very healthy level.

Katie Huberty - Morgan Stanley

A last question on retail. You were able to continue to grow the business year over year, but sequential performance in the retail division specifically was worse than normal trends. Can you just walk through the cross currents of seasonality, channel inventory and competition that got you to where you ended up in the quarter?

Ed Coleman

I don't think there is any question that retail environments become more competitive this year, wholly. I think we performed well in spite of that. Relationships with our key third party retail partners continue to be strong. There are many areas where I think we've shown terrific performance. Notebooks have been a real highlight for us this year, as have the monitors.

There are some supply constraints in the industry as well, and some impact. I think we will see some additional churn as we look at the Vista launch towards the end of January. But there are a lot of dynamics and moving parts in retail.

John Goldsberry

As it relates to Q3, Katie, there definitely was a change in channel inventory effect. We came out of Q2 a bit heavy and we ended up the quarter better. So adjusting for that effect, our real growth if you will, in Q2 was probably a little lower than reflected in our numbers and our real growth in Q3 was probably a little bit better.

Katie Huberty - Morgan Stanley

Okay, great. Thanks so much guys.

Operator

Your next question comes from Charles Wolf - Needham.

Charles Wolf - Needham

Yes, you mentioned Vista in the previous question. As I understand it, the consumer version will launch around January 30th. What impact do you think the anticipation of that launch could have on fourth quarter sales?

Ed Coleman

I think it's fair to say that we believe that the launch of this coupled with some component constraints that are industry wide, will have a negative impact on retail fourth quarter and we anticipate that retailers will probably exit the quarter with unusually low inventory levels. They anticipate that this.

Charles Wolf - Needham

Do you think there will be pricing pressures during the quarter to reduce inventory levels?

Ed Coleman

As I had said earlier there are some interesting dynamics there, because you have that going on but you also have strong underlying demands matched up against a number of different supply channels, different types of components that can offset some of this.

John Goldsberry

Charlie, I think you know our model in retail is one where we build to orders so while the business is competitive in Q4, we will not have to cut price to move inventories. What the retailers end up doing to clean up their inventories is of course another matter. It's certainly possible that people will aggressively push stuff through to clean up inventories prior to January when they will want to bring in clean product.

Charles Wolf - Needham

Just as a final question, you did note that competitive pressures were pretty severe in the quarter. I was just wondering was that a HP effect or was it more pervasive than that?

John Goldsberry

I think we've noted in prior quarters that HP is certainly competitive and they remain so.

Charles Wolf - Needham

Okay, thanks a lot.

Operator

Your next question comes from Eric Reubel - Miller Tabak Roberts.

Eric Reubel - Miller Tabak Roberts

Hi, good afternoon gentlemen. A couple questions. What was CapEx and depreciation in the quarter?

John Goldsberry

Depreciation I believe was $8 million. We also had non-cash compensation expense associated with stock, $2 million and CapEx was $14 million.

Eric Reubel - Miller Tabak Roberts

Great. On the restructuring program, you've announced that it is expected to achieve $35 million of annualized cost savings beginning in Q1 '07. What benchmark or level are you basing that off for total OpEx and do you have a sense of what the cash restructuring charges will be?

Ed Coleman

We're making that statement relative to 2006 expense levels and that'll take the form of expense reductions in a variety of areas, including headcount. We do expect to incur some severance costs in Q4 in connection with reducing headcount.

Eric Reubel - Miller Tabak Roberts

As I understand it the total amount of annual savings will be based off the ending full year '06 SG&A?

John Goldsberry

Correct.

Eric Reubel - Miller Tabak Roberts

If I can turn to working capital for a minute, payables have definitely seen a trend towards increasing and you've taken those down, John, how should we be thinking about working capital and total cash through, let's say, Q4?

John Goldsberry

Well I mean we've seen the drop in cash. I think if you do the math, it's very directly attributable to our change policy in terms of net days, days payable outstanding on our payables. That, coupled with the fact that we chose to reduce the amount of our notes payable by $25 million. So those things definitely account for the change in cash.

In terms of Q4, we do have some payments that we'll be making in Q4, so I guess I would say that I would probably anticipate that cash would drop during Q4 by a modest amount.

Eric Reubel - Miller Tabak Roberts

Just a clarification. Did you say that 65% of the gross margin dollars were from non-PC revenue?

John Goldsberry

Correct.

Eric Reubel - Miller Tabak Roberts

Thank you.

Operator

Your next question comes from Aaron Reise - Jefferies and Co.

Aaron Reise - Jefferies and Co

A couple of quick financial questions. You mentioned the depreciation, amortization and the CapEx for Q3. What are you expecting for fiscal year '06 for both of those?

John Goldsberry

I don't have that number offhand, we can try to get back to you with that figure. I would say that what we've incurred in Q3, both in terms of CapEx as well as depreciation, will probably continue in Q4 at approximately those levels. So based on what we've reported for Q1 and Q2, you should be able to do the math, but we'll be happy to call you.

Aaron Reise - Jefferies and Co

Okay. And then what was your gross interest expense for Q3?

John Goldsberry

Gross interest expense was $1.5 million.

Aaron Reise - Jefferies and Co

Alright. Thank you very much, gentlemen.

Operator

Your next question comes from Jeff Cohen – Southpaw Asset Management.

Jeff Cohen - Southpaw Asset Management

Thanks for taking the call. During the quarter there was an unsolicited bid to buy the retail segment of the company, and there wasn't much commentary provided to the public about the process or the thinking at the company. The bid was just rejected.

I'm wondering if you can provide some commentary now in terms of the thinking that went into that? Any process that there was around it, maybe a counter-proposal if there was one? Anything that would help us understand how the company approached that beyond what was said in the releases?

John Goldsberry

So we've tried to observe good governance procedures in responding to that offer as well as some of the requests that have been made by the group that had filed. The issue was referred to our board. More recently, the issue from the filing group has been referred to our governance and nominating committee. We certainly took the offer very seriously. Goldman Sachs was retained to help evaluate the offer. Independent counsel was retained. After a fairly extensive study, the board concluded that that particular offer was not in the best interest of the shareholders.

I guess I'll note just a few things; although, I don't want to speak directly for the board. But the retail business is obviously a key business segment for us. I think you have to ask some questions about if you separated retail from the other businesses, what kind of scale would you have in those businesses? So a lot of considerations went into the board's deliberations.

As to the specific things that caused them to come to that conclusion, I'd have to refer to them. But let me assure you that issue was addressed from the point of view of what was in the best interest of our shareholders.

Jeff Cohen - Southpaw Asset Management

It did seem though from the public filings again that there was some flexibility in the bid and that there were alternatives that were amenable to the prospective buyer. Was there any counter-proposal made by the company to consider alternative structures or pricing?

John Goldsberry

I think honestly I've responded to that question as much as I'm probably in a position to respond. I don't think I can answer that question further.

Jeff Cohen - Southpaw Asset Management

Okay. Ed, if you could just weigh in here a little bit and just share your view about M&A and shareholder value and how you look at the process.

Ed Coleman

Well first and foremost, my focus and my sense of urgency is around business performance. As I said in my comments, I think we have two major tasks ahead of us. One is to look hard at our business model: what's working, what's not working and evaluate it from that perspective. Are we allocating our resources in the right areas, in the right segments of our business? That's one task and we're working hard on that and conducting that review.

Secondly is to look at the execution issues, the operating issues that we have to make sure that we're identifying how we can perform better whether it's from a cost management standpoint, from a process management standpoint, from a service delivery, product quality, customer satisfaction standpoint. And if we perform well, that in my mind is job one to create shareholder value.

Jeff Cohen - Southpaw Asset Management

Does that mean that you are not open right now to the possibility of a sale of the company or other strategic alternatives as a means of creating shareholder value?

Ed Coleman

What it means is that my focus is on company performance. I'm not going to comment beyond that on other alternatives that are out there. Our focus is on figuring out what's best for this company, for the shareholders overall of course. But I think job one is to demonstrate that we can perform, and we'll evaluate other alternatives. Our Board will evaluate other alternatives if and when and as they're presented to the Board.

Jeff Cohen - Southpaw Asset Management

Okay. Thank you.

Operator

Your next question comes from Ryan for Bill Fearnley - FTN Midwest.

Ryan for Bill Fearnley - FTN Midwest

I just have a quick question on the number of customers that were signed up for Gateway Select at the end of the quarter. I think you said you had 750 at the end of 2Q?

I think a little earlier you mentioned our made some comments on the operational improvements in the Pro segment, I just wonder if you could provide any extra detail or color on the retail segment, the operational improvements there? Thanks.

Ed Coleman

We're scurrying around to see if we know the number of Gateway Select and I'm not sure we're going to be able to get you that number.

On the operational improvements, we talked about some of them on the cost side in terms of just organizing their sales territories more effectively and organizing those in a way that we're focused on revenue per rep, gross margin dollars. We're also on the sales side of things, being more selective in terms of focusing our sales efforts where we have solid performance, solid reputation from an industry standpoint. So you'll find that about 80% of our Pro business is in the public sector. A great deal of it is education both K through 12 as well as in the rest of state, local government and federal. So I think we're doing a better job of identifying who our key accounts are, selling to them in a concentrated dedicated way and for the next tier of accounts down, providing a more efficient sales coverage model than perhaps we've had.

Ryan for Bill Fearnley - FTN Midwest

Okay and then I believe in the release it also mentioned operational improvements in the retail segment. Can you guys provide any color on that?

John Goldsberry

This takes the form of a variety of things; freight, E&O charges, just a variety of things that factor into how well did we perform in delivering product to our customers once we have orders for those customers? It is multi-faceted, falls into a number of categories.

Ryan for Bill Fearnley - FTN Midwest

Okay thanks.

Ed Coleman

As concerns the number of Gateway Select it’s close to now 900.

Ryan for Bill Fearnley - FTN Midwest

Okay great. Thank you.

Operator

Your next question comes from Eric Reubel - Miller Tabak Roberts.

Eric Reubel - Miller Tabak Roberts

Hey gentlemen. I’m trying to get my arms around the business model here going forward and thinking of the company in terms of having a hardware business sold through multiple channels that have a low single-digit gross margin and then a non-PC products that had a very sizeable gross margin in the upper 20s, low 30% range. How should I be thinking about the company’s model here going forward? If you could comment on that big picture.

Heading into fourth quarter with respect to normal seasonality, 3Q may have been a little weaker. How are you seeing the fourth quarter. There’s been some commentary in the market about some component shortages. There’s been some discussion of motherboard shipments being significantly reduced. Any comments on the seasonality going into 4Q in the general business model? Thanks.

John Goldsberry

I think one of the things that I think creates difficulty for people on the outside looking in and trying to understand our business model is you really can’t talk about a single business model across our segments. It is with that view in mind that we have made a decision to report gross margins by segment as well as expenses by segment because the business models vary significantly by segment.

Given that that’s the case, I’m going to suggest that we set up a call with you to talk through the business models for the different segments because you really can’t talk about a single model across all segments. Retail is a very different business model, very low gross margin model with a lot of leverage in terms of the expense structure, very little attach that has anything remotely close to a 20% gross margin. So what I would suggest is we take that offline and talk it through, I would be happy to share that with you.

Eric Reubel - Miller Tabak Roberts

Okay thanks.

John Goldsberry

In terms of Q4, there are a couple of looming issues in Q4. Vista is one. That’s more of an issue on the consumer side of the business than it is in Pro, obviously. Pro customers are going to be slow to migrate to a new operating system. But it will impact Q4. One can ask certainly the question whether this was the right time to be introducing a new operating system. But in any event it is what it is.

As it relates to component shortages, there’s no question about it there are some component supply issues out there. We have been scurrying to address those and to minimize the impact on the quarter. Early in the quarter there were chip issues. More recently there have been issues relating to other components and the challenge for us is obviously to manage through all of that in a way that minimizes the impact on our business results.

Eric Reubel - Miller Tabak Roberts

Thank you.

Operator

At this time, you have no further questions. Do you have any closing remarks?

Ed Coleman

Let me just thank all of you for participating on the call. I would like to thank all Gateway associates for their hard work and efforts in the quarter. I look forward to more of the same hard work and effort and dedication in the current quarter. Thanks very much.

Marlys Johnson

Thank you, Ed. A replay of tonight's conference call will be available on the home page of the Gateway.com web site for 24 hours and thereafter archived on the investor relations pages. There will also be a telephonic playback of this conference call beginning tonight at 7:30 pm Eastern time and running until midnight Eastern time on Saturday, November 5th. That number is 706-645-9291 and the pass code is 8918711. Good evening.

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Source: Gateway Q3 2006 Earnings Call Transcript
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