Newsletter Value Investor Insight carried an interview on June 30th with Oliver Kratz, head of Deutsche Asset Management's Global Thematic Equities group. Kratz manages nearly $5 billion in assets, including the DWS Global Thematic mutual fund that has returned an annual 25.9% – vs. 18.7% for the MSCI World Index – since he took it over in mid-2003.
Gateway falls in the distressed camp. The company has a market cap of around $580 million, which is about 15% of annual revenues. It’s been struggling for years to find its place in the market, but it still has 95% brand recognition and is the third-largest personal computer maker in the U.S., with around 7% market share. We like Gateway today for a few reasons. The company has suffered from a variety of component pricing and supply problems in the past, but we’re expecting improved operational execution under the company’s new CEO, Edward Coleman, who took over in September of last year.
Margins appear to have stabilized and even though the shares are priced as if the company is losing lots of money, the business today is roughly breakeven. They’re working on rejuvenating the product line, trying to learn something from Apple’s success by injecting some fresh design and component elements into their PCs. They should benefit somewhat in this from having both the Gateway and eMachines brands. eMachines allows them to compete at lower price points without cheapening the core brand, something Dell is now confronting as it starts selling through Wal-Mart.
We also consider the personal-computer business to be a relatively attractive one. While the delay in acceptance of Microsoft’s Vista operating system has depressed PC sales growth in the past two quarters, we generally see the PC upgrade cycle today as more structural than cyclical, with users regularly looking to increase productivity through PCs with the latest features, like wireless capacity or flash memory. Overall PC shipments are expected to grow 12% in 2007 and 11% in 2008, which is quite healthy. Are there still excess costs to cut as well? OK: No, this isn’t a cost-cutting play – the company is already lean. They do have a business-to-business sales and service division that could be shut down or sold, which we think would have a positive impact on margins.
What upside do you see in the share price, currently around $1.55?
OK: If you take as a conservative starting point that IBM sold its PC business to Lenovo for 20% of revenues and apply that to Gateway’s depressed trailing 12- month sales of $3.9 billion, you’d have a share price over $2.10. But in that case Lenovo wasn’t getting the benefit of the IBM brand, so we’d expect any sale of Gateway to be at a premium to that. Looking at this from a global perspective, I think Gateway is ultimately an acquisition candidate for a foreign buyer. I doubt anything would happen until management improves the operating performance and profitability, but the company’s U.S. market position could be acquired for significantly less than it would cost to create or market a new brand in the U.S.
The big Asian companies, for example, are such experts at making things, but there are certain things – like a brand and market share – that you can’t make overnight. Gateway has that. In the meantime, the company has stopped losing money and there’s real optionality on their doing something exciting on the product side.
We also think they have opportunity to expand internationally – they’ve recently entered the Chinese market and we expect similar announcements involving Europe and the rest of Asia. With little downside from the current share price, some very interesting things could happen on the upside.