Here’s the entire text of the prepared remarks from Gateway’s (ticker: GTW) Q3 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
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Marlys Johnson, Investor Relations
John Goldsberry, Senior Vice President and CFO
Wayne Inouye, President and CEO
Rebecca Runkle, Morgan Stanley Dean, Witter
Les Santiago, Piper Jaffray & Company
Charles Wolf, Needham & Company
Good afternoon ladies and gentlemen, and welcome to your 2005 Gateway, Incorporated Earnings Conference Call. My name is Rob, and I’ll be your operator today. Throughout this conference, all lines will be on a listen-only mode.
At this time, let’s turn the conference over to your host for today’s call, Ms. Marlys Johnson.
[Marlys Johnson, Investor Relations]
Thank you, Rob. Good afternoon. Welcome to Gateway’s Third Quarter 2005 Earnings Conference Call. If you have not seen a copy of today’s earning release, please go to the News and Information pages on our Gateway.com website. Joining me today is President and Chief Executive Officer, Wayne Inouye, and Senior Vice President and Chief Financial Officer, John Goldsberry.
Before we begin, I’d 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 Securities and Exchange Commission.
During this call, we will discuss certain non-GAAP financial measures that management uses as a basis to evaluate the company’s financial performance and forecast future periods. You can find additional information on these non-GAAP measures and a reconciliation of these measures to GAAP measures in today’s earnings release and on the News and Information page of our website.
I would now like to turn the meeting over to John Goldsberry who will review Gateway’s third quarter financial results, who will be followed by Wayne Inouye 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.
[John Goldsberry, Senior Vice President and CFO]
Thanks Marlys. Let me start by quickly summarizing our financial results. We had a good quarter. Revenue came in a $1.019 billion, slightly before analysts’ expectations, and up 17% from Q2. Operating income was $18.8 million, up from $17.6 million in Q2. Due to lower other income and a higher tax provision, net income was $15.1 versus $17.2 million in Q2; EPS came in at $0.04 versus expectations of $0.03 and $0.05 last year.
So, now let me walk through our operating results beginning with unit volume. Gateway sold 1,167,000 PC units in Q3, up 16% sequentially, and up 25% from a year ago. The increase in unit sales on a sequential basis reflect seasonal trends, but it also reflects market share gains and direct. The increase in PC unit on a year-over-year basis reflects significant market share gains in U.S. retail. On a year-over-year basis, we were the fastest growing Windows-based PC company in the U.S. among the top five PC vendors. Notebook unit volume, one of our targeted areas for growth, increased to 360,000 units in Q3, up 40% sequentially and more than double a year ago.
In terms of segments, retail unit volumes increased to 872,000 units in Q3, up 16% sequentially, and up 44% over a year ago. Retail notebook sales increased to 231,000 units, up 40% sequentially and up 213% from last year. Both direct and professional experienced sequential growth which we believe is evidence that we’re making progress in these businesses. Professional unit volumes increased to 224,000 units in Q3, up 6% sequentially despite being down 7% last year.
Whole notebook volumes increased to 70,000 units, up 25% from Q2 and up 17% on a year-over-year basis. Direct unit volumes increased to 71,000 units in Q3, up 48% sequentially despite being down 15% from last year. Direct notebook volumes increased to 35,000 units in Q3, up 86% from Q2 and up 18% from year ago levels.
Looking at the income statement, Q3 revenue was $1.019 billion which was above analysts’ expectations and which represents a 17% increase over Q2, and an 11% increase over last year. The sequential increase primarily reflects seasonal trends and market share gains, while the year-over-year increase primarily reflects market share gains in U.S. retail.
Gross margin dollars increased to 85 million in Q3 from 87 million in Q2 and 92 million in Q3 of ’04. Gross margin percentage for the third quarter dropped to 8.3%, from 10% in Q2 and 10.1% last year. The sequential and year-over-year declines in gross margin percentage are primarily due to strong growth in the retail business, which has lower margins, as well as competitive pressures in professional, and to a small extent, retail.
We continue to drive down SG&A expense. It dropped to 78 million in Q3, or 7.6% of revenue, from 85% or 9.7% of revenue in Q2, and from 154 million or 16.8% of revenue in Q3 of last year. We continue to manage our SG&A expense down in order to maintain a balance between cost levels and the gross margin characteristics of our business.
Lastly, we recognized 11.6 million in benefit from our Microsoft agreement, which was down from 15.1 million in Q2 based on lower qualifying spend under the agreement. The net result is that we had operating income of 18.8 million in Q3, up from 17.6 million in Q2 and up from a loss of 61.7 million in Q3 of last year.
I should mention that included in the results for Q3 are a number of one-time items netting out to approximately a $1 million gain. After lower other income and a higher tax provision, Q3 net income was $15.1 million, which compares to 17.2 million in Q2 and a loss of 59.3 million a year ago.
EPS came in at $0.04, which was above expectations at $0.03, and which compares to $0.05 in Q2 and a 16 cent loss a year ago.
Turning to the business units, retail revenue increased to 601,000 in Q3 which was up 23% sequentially, and up 47% from Q3 of ’04. Contribution income from the retail segment was 26.6 million in Q3, which was relatively flat as compared to 26.3 million in Q2, but was up 113% from last year.
Based on preliminary MTD estimates, our U.S. retail desktop market share increased 7.2 points year-over-year, from 26.6% in Q3 of ’04 to 33.8% in this quarter. In notebooks, Gateway’s U.S. retail market share more than doubled, from 4.6% in Q3 of ’04 to 10.3% of this quarter. These year-over-year market share gains in U.S. retail reflect strong increases from both our Gateway and eMachines brands.
Our desktop market share did decrease sequentially, slightly from 35.9% in desktops, and our notebook market share decreased from 12.5% in Q2.
Professional revenue increased to 286 million in Q3, up 5% sequentially, despite being down 12% from last year. Contribution income for the professional segment declined to 7.8 million in Q3 compared to 18.1 in Q2 and 23.8 million in Q3 of last year. The decline in contribution income sequentially as well as on a year-over-year basis was due to margin pressures due in part to a trend in the professional segment towards consolidated purchasing by customers. While the segment remains a competitive business, we are encouraged with the sequential volume and revenue growth, and with our recent success in winning large important contracts which Wayne will review in his discussion.
Direct revenue increased to 132 million in Q3, up 19% sequentially despite being down 27% from last year. Contribution income for the direct segment increased to 14.7 million in Q3 from 8.2 million in Q2 and down from 24.5 million in Q3 of ’04. The sequential increase in contribution income is largely attributable to the significant increase in unit volume. Our unit growth outpaced the industry by over three times. We really feel we are turning the corner in this business given the sequential increases in volume, revenue, contribution margin as well as market share.
As it concerns our balance sheet, during the quarter we instituted changes to better manage our working capital. As a result, let me draw your attention to the fact that our cash and marketable securities increased by 68 million to 635 million, driven by a 49 million decrease in inventory and an $84 million increase in accounts payable, offset by a $97 million increase in other current assets. This increase in cash and marketable securities represents the largest quarterly increase we’ve seen in ten quarters.
Turning to guidance, with respect to the remainder of 2005, we’re comfortable with the annual revenue and earnings guidance we issued at our last conference call. However, as stated in our release, effective in 2006, we will be adopting a policy of not providing revenue or earnings guidance.
Let me now turn the conference call over to Wayne who will address our progress in other areas of the business.
[Wayne Inouye, President and CEO]
Thanks, John, and good afternoon to everyone. First off, I want to thank our employees for all their hard work this quarter. Keep it up.
Now, I’d like to focus on other developments that are important to our long term growth. Recently, we announced several exciting new products. These include a new line of PCs targeted at small business; the successful launch of our 21-inch flat panel TFT monitor for professional and consumer; and the rollout of our next generation convertible notebook which targets all our segments.
We are rolling out our new convertible PC which features the power and mobility of a notebook combined with the flexibility and creativity of a tablet with a new marketing campaign. Bill Gates introduced this product at the recent Microsoft Business Summit. We are delighted at the support we are getting from Microsoft in launching this product which highlights their tablet operating system.
Our advertising campaign, which started last week, is designed to highlight the attractive features of this innovative product, and to show how it can help small businesses and educators as well as consumers. The new campaign is also designed to bolster Gateway’s brand image as a source of innovative products.
The new convertible notebook has received rave reviews and it has been launched simultaneously through all our channels. Introducing the product in early October, we have taken orders for nearly 20,000 units to date. This product is on track to becoming the best selling convertible notebook in the world, and we expect to be Microsoft’s largest customer for their tablet operating system. We dedicated special pages of our website to educate consumers on the benefits of a convertible notebook. Please take a look at www.gateway.com/convertible.
We also made progress in the international retail. We recently expanded our presence in Japan through the addition of one of Japan’s leading national retailers, Yodobashi Camera. Just a little slight reset here. The product I was talking about, introduction tying with two of our corporate objectives, which have been the gross sales of our notebooks and TFT monitors. We have achieved significant market share gains in notebooks, up 40% sequentially and up more than 100% from a year ago. And our TFT monitor sales are up 26% sequentially and nearly 160% year-over-year.
As you can see by the numbers, Gateway retail business remains strong. In the U.S., Gateway sales of notebooks in Q3 outperformed the U.S. retail market on a year-over-year basis by nearly 500 percent. Gateway sales of desktops outperformed the U.S. retail markets by 800 percent. And we don’t have a small base, either. With our recent product introductions, and our understanding of how the retail market operates, we believe we’re very well positioned for Q4, the busiest quarter of the year for retail PC sales. Gateway and eMachine units are now sold in more than 7,000 stores in the U.S. and Canada.
We also made progress in international retail. We recently expanded our presence in Japan through the addition of one of Japan’s leading national retailers, Yodobashi Camera. With this addition, Gateway and eMachine brands are now sold through approximately 600 retail stores in Japan. In total, Gateway and eMachines PCs are sold in more than 2,000 retail stores outside the U.S. and Canada. Recently, we announced two new partners in the UK, Staples and Comet. And just this week, we announced the availability of Gateway desktop PCs at Telnor, a subsidiary of Telmex, Mexico’s leading telephone company. And we continue to explore additional expansion plans in Europe. Stay tuned for that.
Professional remains a very competitive business, but we are making progress. Overall, unit volume increased 6% on a sequential basis, and notebook volumes increased 25% on a sequential basis. More importantly, we continue to win key contracts that bode well for our future growth. In the past six months alone, we have won a number of key contracts with federal and state government agencies, universities and high profile businesses.
These include Department of Interior, a contract for two notebook models; Social Security Administration, a contract for desktops and notebooks; Department of Defense dependent schools, a contract for 1,800 notebooks for students and teachers at schools abroad and in the United States; United States Navy, a contract to provide products and services to personnel worldwide; United States Air Force, a contract to provide nearly 10,000 customized Gateway desktops and services to the U.S. Air Force globally; State of California - Gateway was chosen to provide technology across three major categories, desktops, notebooks and displays; State of New York, a contract to support the PC aggregate purchase for the State of New York; California Highway Patrol, we were selected by the CHP as a vendor for new notebooks for patrol cars. This deal will place more than 1,000 convertible notebooks in squad cars. But remember, if you are caught speeding in California, it’s not my fault. University of Gateway was selected to be the university-wide provider of notebook and tablet computing products for students, faculty and staff. South Dakota State University; the University selected Gateway convertible notebooks to support the University’s innovative curriculum and interactive learning programs. This deal brings Gateway convertible notebook technology to 2,400 students and faculty. University of Arizona. Gateway was selected as campus-wide provider of computing products and services. Churchill Downs. The home of the Kentucky Derby selected Gateway as the exclusive provider for client and enterprise technology improvements to the world-renowned horse racing venue operator.
We’ve realized relatively little revenue on most of these contracts to date. However, they do position us to receive significant revenue in the coming quarters. And importantly, these wins demonstrate that Gateway’s government, education and business customers have confidence in our products and services. Professional continues to be a very competitive segment. At Gateway, we continue to lay the groundwork to put plans in place for long term success, including improving our core operational matrix, leveraging a cache of services, software and peripherals, and revamping our supply chain to better serve these customers. We are focused on growing our market share revenues in gross margin. We’re confident we’re on the right track in pro to drive the kind of revenues and margins we and our shareholders expect. And we hope that the results from the coming spring and summer education and government purchasing cycles will demonstrate we have the path to profitability in pro.
Our direct business is also making progress. Overall unit volumes increased 48% sequentially and our notebook volumes increased 86 percent. We believe that this business will benefit significantly from our new advertising campaign which is designed to drive business to both our retail partners as well as our website, and our 1-800-GATEWAY telephone number.
We also believe that we have opportunities to grow our sales to small businesses, and we recently introduced a new line of desktop products designed for that market. We continue to improve our operations and supply chain in order to support long term growth. This past quarter, we strengthened our management team in this area with the addition of Bruce Riggs, formerly of Dell and Quanta. Bruce has our operations and customer care area. We continue to drive our costs down and we will continue to improve our delivery times, product quality and performance on replacement parts. Our performance in these areas has never been better.
In Q3, we also made an important decision to open a new U.S. manufacturing plant sometime in 2006. The new facility is designed to support our professional business. We expect to make further announcements regarding this facility later this quarter.
In closing, we remain committed to posting profitable sustainable growth over the long term with a keen focus on keeping our costs among the lowest in the industry. While we continue to face challenges, we are pleased with the progress we’re seeing in our financial results. With that, we’ll be happy to take your questions.
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