Gateway Q4 2006 Earnings Call Transcript

Feb. 8.07 | About: Gateway Inc. (GTW)
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Gateway, Inc. (GTW)

Q4 2006 Earnings Call

February 8, 2007 5:30 pm ET

Executives

Ed Coleman – CEO

John Goldsberry – CFO

Marlys Johnson – IR

Analysts

David Bailey - Goldman Sachs

Richard Gardner - Citigroup

Bill Fearnley - FTN Midwest

Matt Kessler - Hembrecht

Andrew Neff - Bear Stearns

Eric Reubel - Miller Tabak Roberts

Presentation

Operator

I would like to welcome everyone to the Gateway fourth 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 and thank you. Good afternoon, everyone and welcome to Gateway's fourth quarter and 2006 earnings conference call. If you have not seen a copy of today's earnings release, please go to either the news and information page or the SEC filings page on our Gateway.com web site.

Joining me today are Chief Executive Officer Ed Coleman and SVP and CFO 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 these expectations. All statements other than statements of historical facts are statements that could be deemed forward-looking statements.

Information about factors that called cause future results to differ from these expectations can be found in today's earnings press release and in the company's reports filed with the Securities and Exchange Commission.

During this call we may discuss certain non-GAAP financial measures that is 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 to GAAP measures in the quarterly reports found on our web site.

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

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John Goldsberry

Thank you, Marlys. Let me first summarize our preliminary financial results. Revenues grew 6% sequentially, but were down 9% year over year. Revenue growth was constrained by both component shortages and also softer than normal demand in the U.S. and U.S. retail, and in Japan due to the January 2007 launch of Microsoft Vista.

One of the effects we saw is our channel inventories closed the quarter in retail at unusually low levels as retailers managed down their Microsoft XP products inventories in anticipation of bringing in fresh Microsoft Vista product. We continued to experience margin pressure during the quarter due to competitive pricing, component shortages and operational inefficiencies.

We offset that, however, in part by continuing to make progress on expense controls with SG&A declining to 6.4% of revenue down from 7.7% in the prior quarter. Net result is we had an operating loss of $4.1 million versus an operating income of $7.9 million in Q3 and a loss of $29 million a year ago. We reported net income of $8.8 million or $0.02 a share after a net tax benefit of $11.8 million.

Let me now walk through our quarterly financial results. Q4 revenue came in at $1.021 billion, this was up 6% from Q3 due to sequential increases in retail and direct revenues. These were partially offset by a seasonal decline in professional. Revenue was down 9% year-over-year with a single-digit decline in retail and more significant declines in professional and direct following the recent trend.

Gross margin dollars came in at $52.7 million in Q4, down 27% from $73.4 million in Q3 and down 25% from a year ago. Gross margin percentage decreased to 5.2% from 7.6% in Q3 and from 6.2% a year ago.

Retail margins, in terms of explaining this, retail margins declined to 2.9% of revenues, down sequentially from 4.2%. This was driven by higher costs associated with component shortages, competitive pressures and operational inefficiencies. Net result is that retail segment contributions came in at $17.1 million after retail expenses of $5 million, and that was down sequentially from $20.9 million after expenses of $5.6 million.

Professional margins came in at 5.1%, down from 13.1% in the third quarter. The decline in gross margin was due to seasonal volume declines as well as fulfillment and closed out of lower margin contracts from the first part of the year. Pro segment expenses declined nicely to $13.3 million from $16.2 million due to headcount-related expenses and better overall expense management. Net result is pro segment contribution was a loss of $4.2 million, down from $18 million in the prior quarter.

Direct margins improved significantly from 25.3%, up from 16.8% in the prior quarter. The sequential increase reflects the impact of better than expected Alliance partner revenue share. Direct expenses increased to 5.2 from 12.2 in Q3 due the decreased marketing and headcount-related expenses. Net result is direct segment contribution grew to $16 million from essentially breakeven in Q3.

SG&A expenses for the quarter came in at $65 million or 6.4% of revenue, down from $74 million in Q3 and $113 million a year ago. The sequential and year-over-year decrease is due to our continued focus on expense controls and achieving operational efficiencies. It's worth noting that Q4 of last year was also negatively impacted by a $25 million increase on our sales tax reserve.

The result is we had an operating loss of $4.1 million in Q4. This compares to an operating income of $7.9 million in Q3 and a loss of $29 million last year. The company reported net income of $8.8 million or $0.02 a share after the tax benefit, $11.8 million. This compares with net income of $18 million or $0.05 a share in the prior quarter and a net loss of $20.9 million or $0.05 a share a year ago.

As it concerns our balance sheet, we're still in the process of finalizing and reconciling our year end balance sheet. During the course of our year end close process, we identified some receipt discrepancies, which are causing us to make some further adjustments to our inventory and offsetting accounts payable accounts. We are evaluating the effectiveness of our internal controls over that particular issue. Our final results, which will certainly include our balance sheet, will be published with our 10-K filing which we anticipate in the next few weeks.

Let me now turn the call over to Ed who will provide further discussion of our future direction and priorities.

Ed Coleman

Thanks, John. Thanks also to the analysts, investors, customers and employees that have all joined us for our call today. Since joining Gateway, I've been meeting with customers, suppliers and employees, reviewing the elements of our business with the goal of identifying those key strengths we can build on in those important areas where we must and can improve.

So what have I seen and where are we going? First of all, it's apparent we've had an unaffordable expense structure. We've taken and will continue to take actions to reduce our SG&A. At our last earnings call, I had announced we had identified $30 million to $35 million in expenses that we were taking out of business. Today I can tell you that another $25 million will come out of our SG&A in 2007 on top of that initial amount. We've not stopped looking for further reductions.

Second, we must continue to focus on improving the quality of our operational processes, reducing the complexity of our business. A portion of the gross margin decline reflected in our Q4 performance was a result of poor execution and the incurring of incremental costs to make up for it.

One area that I believe will make an important difference for us is the implementation of the new Oracle ERP system in support of our retail business. We implemented Oracle at the beginning of this year. While we're going through the normal implementation hiccups and learning curve, longer term the new system and the automation and tools it brings will drive increased discipline and efficiency throughout many of our processes.

While this will help, it's not sufficient on its own. We are also implementing a broader-based process improvement program to address other key opportunities for better execution that will improve both our efficiency and our customer satisfaction.

Reducing our expense structure and interviewing process execution is important because it clears the path for us to build a company based on Gateway's unique strengths. What are those strengths? First of all, it's our brand. With 95% aided awareness, Gateway is one of the most recognized consumer brands among technology companies and it's a brand with a great reservoir of goodwill. This brand strength translated into Gateway having 14.5% of the consumer PC market in the U.S., adding 1.5 points of share in 2006. And our share of consumer purchases through the retail channel is even higher with 21% market share. This strong presence in the consumer market is a foundation for near-term product sales, including our PCs and industry-leading displays.

Perhaps more importantly is a consumer base that will be looking for exciting new ways to build and experience home and mobile-based solutions for work, entertainment and the sharing of family experiences we intend to bring to consumers in conjunction with our key partners.

Gateway's second major strength is our track record for product innovation. One of the things that struck me most since joining Gateway is the enthusiasm in the market and in the press and inside the company when we bring out an industry-leading product like the FX 530 high performance desktop or our 24" display. Critics immediately becomes fans and reignite the power of the Gateway brand.

Our third unique strength is consumer channels, particularly the relationships we have with our retail partners. The quality of these relationships is a critical asset that we constantly nurture and work to improve, by working harder than anyone else in the industry to help our retail partners grow their businesses.

In addition to our retail partners, Gateway's long-standing consumer direct channel gives our customers the necessary flexibility to find, research and buy our products whether their preferred shopping experience for that particular purchase is to buy at a retailer or from their home or office.

Given this powerful foundation of consumer brand, product innovation, and consumer channels, I think it makes sense for us to drive a strategy that concentrates our resources on the consumer market. That's what we intend to do.

As it relates to professional, over the last 18 months we've made significant investments in support of the professional business. We've brought to market fresh products for professional customers, including our new server line and more new products are coming this year. We've opened the Gateway configuration center to meet the specific needs of pro customers and we've opened our best practices center in South Dakota, the centerpiece of our 100% North American customer support approach, which is unique in the industry. The benefit of these investments is reflected in part in the number one customer satisfaction ranking for Gateway desktops by TVR at the end of last year, and by our continued improvements in service quality.

So with these major investments in products and infrastructure for pro behind us, now it's time to leverage these investments, tightly focus our professional business on those specific market segments where the pro team brings differentiated expertise and great customer relationships -- education, government and healthcare -- and aggressively manage the pro business for near-term profitability. This approach, together with improved efficiency throughout the company, allows us to shift the necessary resources and investments to the consumer market in order to deliver more frequent industrial design updates with an exciting look and feel; to drive new, more innovative consumer products; to expand our presence on retailers' shelves; to enhance our web presence, and to reinforce Gateway as a powerful consumer brand.

In short, our strategy is to drive down our cost structure, improve operational execution and reallocate our resources to concentrate on the consumer market. In doing so, I believe we'll be playing to Gateway's underlying strengths, leading consumer brand, a history of product innovation that ignites enthusiasm for the brand and outstanding consumer channels, both retail and direct.

With that, John and I would now like to open the call up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

Yes, thank you very much. I was wondering with all the cost cuts that are going on, the $20 million to $25 million on top of the $30 million to $35 million, what kind of revenue attrition are you assuming will be associated with these cuts?

Ed Coleman

I think it's a fair question, David. We're looking at this from the standpoint, particularly cost areas where we don't think it affects our front line or affects our product innovation and delivery. So we're not anticipating this to be a revenue loss scenario.

Operator

Your next question comes from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

Thank you, good afternoon. I was hoping, John, you might be willing to give us some metrics that you've given in the past. In particular, the percent of revenue that came from non-PC items in the quarter, and also the percentage of gross profit dollars that represented? And some qualitative commentary around whether changes in those items were responsible for some of the gross margin pressure you saw in the quarter?

John Goldsberry

So while we're pulling together those items, let me just address the latter part of your question immediately which is, no, it was not the source of pressure on our gross margin.

I'll address retail. There were a number of things that drove retail margins. One, we went into the quarter with a fairly competitive environment. There were some supply constraints that we faced during the quarter. A significant supplier had problems meeting commitments. I'm not going to name the specific party, but in addition, we saw panel prices and memory prices go up significantly during the quarter. The net result was we were scrambling a little bit for certain component supply, and that created some operational efficiencies.

So there were a number of factors that drove our retail margins down. Looking forward here, I think we see a path to retail margins beginning to improve. Given that we offset the decline in margins by managing our cost structure really tight, as we get some relief on the margin front that bodes well for our future results.

As concerns the specific numbers you were looking for, the revenue side, on PC revenue was 15% of the total, and given the traditional way we've calculated, 75% of the margin dollar.

Richard Gardner - Citigroup

Ed, a follow-up question for you. You obviously talked about focusing more on the consumer market and diverting resources to that segment. I'm just wondering, why even stay in the professional market? I understand that it does help you out with volume, but it only represents a little under 10% of your total unit shipments, and it seems like an area where you're going to be hard-pressed to make the investments going forward and feet on the street and so forth that are necessary to keep the momentum in that business going.

Ed Coleman

I think the momentum in that business really comes from focusing in a more targeted fashion in those segments, where we believe we have some unique expertise, depth of relationships to offer the market. So we're not going after that business from the standpoint of saying it represents 60% of the total market, let's cast a broad and wide net to get as much of it as we can. We're really focused on reaping the benefits of the investments that we've made in that business by targeting very specifically on those segments that I mentioned: patients, state and local government, and health care. We think in doing that, it can be a good contributor of profitability to the business.

Operator

Your next question comes from Bill Fearnley - FTN Midwest.

Bill Fearnley - FTN Midwest

Good afternoon. I had a question for you on a follow-up on Windows Vista. You had said you had seen some delays in the month of January. Could you give us a sense on the preliminary sell-through on Windows Vista off the retail floors, and give us a sense of what the preliminary orders are from resellers versus your preliminary expectations for the launch of Vista?

John Goldsberry

Let me just make sure people interpreted my earlier comments correctly. What I pointed out was we had a channel inventory effect during the quarter. Basically our retailers, and we're focusing here on retail purchasing, that was affected by the fact that they managed down their channel inventories. So our channel inventories ended the quarter a good two weeks lower than they normally are. So that bodes well for the future in the sense that we certainly anticipate that they will bring their channel inventories back in line with where they historically have been.

As concerns so far what we've seen on Vista, it's really too early to comment very much. As you all know, Vista launched basically right at the end of January. Certainly the early indications seem positive, but let's face it: we're basically one week into the process and I think everybody, including us, I would certainly say the retailers as well, are trying to anticipate exactly what the demand is going to be for Vista. Things look good, but it's too early to be very definitive.

Ed Coleman

I think it's fair to say we're excited about the initial kickoff of Vista, as John says, all year.

Bill Fearnley - FTN Midwest

And then on the component shortages side, what components specifically did you have the shortages on during the quarter, and are they solved here as we come into the first quarter?

John Goldsberry

Okay. I specifically mentioned memories and panels. I would say we had some hard drive shortages early in the quarter. We also had some CPU issues. At this point looking forward, supplies are far more plentiful and we're not seeing shortages of that nature.

Bill Fearnley - FTN Midwest

On the inventory issue that you mentioned as the cause for your preliminary results, are we talking about inbound receipts from suppliers, or are we talking about recognition of receipts by resellers of shipments from Gateway?

John Goldsberry

Strictly the former. What we do is we order significant quantities of components for delivery to our ODMs and what we found was our ability to precisely identify whether some of these shipments arrived right before the end of the quarter or immediately after the end of the quarter were not as good as they needed to be. It's basically a cutoff issue, but we need to get our accounting right, so we're going through the process of reconciling that before we put out a balance sheet.

Bill Fearnley - FTN Midwest

Thank you.

Operator

Your next question comes from Matt Kessler - Hembrecht.

Matt Kessler - Hembrecht

Hi. Good afternoon, guys. I was wondering if you could elaborate a little bit further for your strategy for both the professional and the direct segments for this year? You talked about in professional more new products coming in the configuration center, but you cite competitive pricing and increased competition as the reason, really, for the fall amongst a couple of others.

Specifically, how are you tightening up your target market in the professional segment? And on the direct side, given the very good gross margins in that segment, what are you really doing there to reinvigorate sales growth in that segment for this year?

Ed Coleman

On the pro side, we've done a lot of work in realigning the sales force and focusing the marketing programs more on the specific segments that I mentioned, in part because those are segments where we think that we do compete more strongly versus competition based in terms of expertise that we offer, our track record in those segments and the quality of the relationships that we have. So I would say it's a focus of the sales force and it's a reallocation of marketing support dollars towards those segments.

Regarding consumer direct, we see consumer direct as being the key part, the consumer strategy, riding alongside the retail. Far more frequently consumers make some acquisitions online and then the next time they purchase, they may be at a retail outlet depending on the nature of what that purchase is. We think we need to be in both places.

Over the last couple of quarters, we've been implementing a strategy that calls for aiming our consumer direct business more at fully configured higher end systems. That appears to be getting some traction. FX 530 high end desktop I mentioned earlier is doing very, very well, getting great product reviews, going a long way to generating excitement in the PC industry and various reviews and creating quite a halo affect for us.

We think that strategy of using consumer direct to go after the higher end, more fully configured systems is beginning to get some traction. We're going to keep at that. We think it's a great complement to the retail business.

Operator

Your next question comes from Andrew Neff - Bear Stearns.

Andrew Neff - Bear Stearns

Could you just take a moment to update us on the various shareholder initiatives? People were getting involved and wanting on board and things like that. Can you update us on any activity in the last quarter?

Ed Coleman

Sure, I would be happy to. Scott Galloway, Firebrand Partners was elected to our board last quarter. A terrific member and a terrific add to the board. The entire board is working very well together with the common objective of making this a very successful company.

Andrew Neff - Bear Stearns

Anything else?

Ed Coleman

We've announced that we are searching for an additional director. I think the announcement says the completion of that is by the end of this month. I think the corporate governance nominating committee is working hard on that. My guess is that they will deliver on that date. We'll have a new director by then.

Andrew Neff - Bear Stearns

Thank you.

Operator

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

Eric Reubel - Miller Tabak Roberts

Good afternoon, gentleman. John, if I'm looking at the SG&A for the quarter, it looks like by segment that there were some definite savings in the direct and the professional segment, but the unallocated expenses looked like they were up pretty high. Is all of that due to the Oracle rollout? How should we be thinking about that through the year?

John Goldsberry

Looking at a few numbers here.

Eric Reubel - Miller Tabak Roberts

It seemed like the unallocated was, if my math is right, about $42 million for the quarter versus $32 million last quarter.

John Goldsberry

I guess our numbers show corporate G&A being down quarter over quarter by $1.8 million. This quarter we did incur some costs that are higher than what we would anticipate going forward. We did do some rationalization of headcount and needless to say, incurred certain expenses in connection with that.

I think the good news is as we look towards achieving Ed's targeted savings levels, as we look to next year as compared with this year, I would say we made a lot of progress in Q4 in positioning us to achieve those savings. We did, earlier this year, take some further rationalization of headcount. But as we look towards even the kind of savings and reduction of costs that Ed referred to earlier, I think the good news is a lot of that is pretty well baked. We think it's quite achievable.

Eric Reubel - Miller Tabak Roberts

With respect to the cost savings that are expected, can you give us a sense of how the $30 million to $35 million that was original planned and the additional $20 million rolls in? In what quarter should we start to be seeing that felt, and what are the cash costs that will be associated with the restructuring?

John Goldsberry

You won't see 100% of the benefit in Q1, but you'll see significant benefit in Q1. We show corporate SG&A continue to drop from current levels. We also see BU expense continuing to drop. Obviously, we're also being very focused in terms of where we spend marketing dollars in terms of demand. It's coming from all categories, and we're just being very focused on expense control and trying to drive our expenses down. On a year-over-year basis, our targets for next year, we're looking at a 20% drop from what we incurred this past year.

Eric Reubel - Miller Tabak Roberts

CapEx in the quarter? Do you have a CapEx outlook for 2007?

John Goldsberry

Sure. While somebody here is just pulling the Q4 numbers, looking to next year we're cutting back significantly on CapEx. Needless to say, we've just come through a very significant CapEx program as it relates to Oracle. We did go live with Oracle the first of this year, and the net result is we see CapEx being very much reduced from what we spent this past quarter and this past year. I would anticipate CapEx to be certainly sub $20 million for the year. Looking forward, that will certainly be significantly lower than our run rate of depreciation.

In terms of the Q4 numbers, depreciation was $7.1 million in Q4 and CapEx was $17.7 million.

Eric Reubel - Miller Tabak Roberts

The debt reduction in the quarter, does that take the revolver down to zero?

John Goldsberry

Zero, yes. We ended the quarter with no borrowings.

Eric Reubel - Miller Tabak Roberts

Thanks very much.

Operator

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

Marlys Johnson

Thank you, everyone for joining with us today. A replay of this conference call will be available on the home page of the Gateway.com web site for 24 hours and thereafter archives on the Investor Relations page. There will be a telephonic replay of this call beginning tonight at 7:30 p.m. Eastern time and running until midnight Eastern time on Sunday, February 11th. That number is 706-645-9291. The passcode is 719218. Have a good evening. Thank you.

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