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Gateway Inc. (GTW)

Q2 2007 Earnings Conference Call

August 2, 2007

Executives

J. Edward Coleman - Chief Executive Officer, Director

John Goldsberry - Chief Financial Officer, Senior Vice President

Marlys Johnson – Investor Relations

Analysts

Richard Gardner – Citigroup

David Bailey – Goldman Sachs

Kathryn Huberty - Morgan Stanley

Eric Reubel - Miller Tabak Roberts

Andrew Neff – Bear Stearns

[Vishal Gupta]

Matthew Kather - WR Hambrecht

[Rennet Alter]

Woodham Vogel – HarborView Asset Management

TRANSCRIPT SPONSOR
Wall Street Breakfast

Marlys Johnson

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 page on our Gateway.com website. Additionally, there will be accompanying slides to our presentation today, which can be accessed by clicking on the link on our homepage.

Joining me today are Chief Executive Office, Ed Coleman and Senior Vice President and Chief Financial Officer, John Goldsberry.

Before we begin I’d like to remind the audience that the presentation you are about to hear contains forward-looking statements based on manager expectations that involve risk 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. Also, all statements other than statements of historical fact are statements that could be deemed forward-looking statements.

Information about factors that could cause these results to differ from expectations can be found in today’s press release and the company’s report filed with the Securities and Exchange Commission. 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 our quarterly report on our website.

I would now like to turn the meeting over to Ed Coleman who will provide overall commentary on the company's future direction and priorities. He will be followed by John Goldsberry who will review Gateway’s second quarter financial results. Thereafter, if time permits, we will allow questions from the audience.

To allow greater participation, please limit your questions to one per person. Ed.

Ed Coleman

Thanks very much Marla and good morning everyone. Thank you very much for joining us on our call today. We’re pleased to report profitable operating and net income for the second quarter. This is also the third consecutive quarter we’ve delivered improved year-over-year operating and net income results.

Operating income was $5.6 million and net income was $1.9 million. Two keys to this quarter’s results were continuing strong performance for our world wide retail business and a significant improvement in professional.

In worldwide retail, we saw a 250 basis point improvement in retail gross margins during the quarter. And in Pro, tighter customer focus and better margin and expense management resulted in a nearly $17 million year-over-year improvement in contribution dollars.

I’m also pleased to note that our working capital remains steady at $314 million, a level that has been essentially flat for several quarters now. In cash flow, measured as operating income plus depreciation, less capital expenditures, turned positive with $7.7 million an improvement of $17 million versus last quarter.

Another highlight in the quarter was that Gateway sold its 50 millionth PC. With 22 years in the PC industry, this milestone is attributed to Gateway’s long-standing commitment to our customers and a source of pride in accomplishment for all Gateway employees worldwide.

On the customer support front, Gateway once again earned the number on designation for both notebook and desktops in Technology Business Research’s most recent corporate IP buy and behavior in customer satisfaction studies. And our North America based tech support continues to win praise from our customers.

On last year earnings calls I spent a considerable amount of time speaking to our strategy, which is to; one, reduce our cost structure, two, improve our execution, and three, concentrate on consumer markets.

In the second quarter we continued to improve our underlying cost structure. I believe we’re on track to achieve a significant reduction in SG&A as we’ve talked about before.

Regarding execution, although we’ve made a number of operational improvements in recent quarters, we still have much work ahead of us to improve in this critical area. To date, we’ve addressed the component receiving and invoice issue identified in the first quarter. We will continue to fine-tune our efforts in these areas.

However, in the second quarter, we experienced a slower than expected ramp-up of productions at our national manufacturing facility as we continue the process of in sourcing desktop production for our professional and consumer-direct business.

While we’ve made major production related improvements at the national facility since the end of June, we finished the quarter with approximately $60 million more in unshipped backlog than is typical.

To better address these and other execution issues, we’ve begun a formal company-wide business excellence initiative, utilizing (inaudible) methodology and principles.

Our increased concentration on the consumer market is reflected in the improved financial results in year-over-year growth in our worldwide retail segment. We’ve also introduced our new consumer notebook line, featuring a new advanced industrial design and offering increased connectivity and ease of use options, as well as increased customization opportunities.

During the second quarter we also brought Gateway’s award-winning FX line of high-performance PC’s to the retail channel, delivering the first quad-core desktop in retail stores from a top-tiered manufacturer.

We also introduced new retail lines of Gateway and E Machine PC’s for the back to school buying season as well as new 12-inch thin and light convertible notebook.

Our consumer focus is also reflected in the continued expansion of our international retail business. Just this week, we announced plans to expand our presence in Eastern Europe. In addition, our pilot sales program in China is going well and we hope to share more details about our plans there very soon.

To summarize, we’ve made good progress in the second quarter both in terms of financial performance and in executing our strategy. But we fully recognize that much more remains to be done.

Let me now turn the call over to John Goldsberry.

John Goldsberry

Okay, thank you Ed. Let me summarize our financial results by saying we showed continued improvement during the quarter. Gross margins increased over 200 basis points. And all segments produced positive contribution to net income. Retail revenue grew 4% year-over-year. However, overall revenue fell 8.6% due to declines in professional and direct.

We improved our year-over-year operating results for the third consecutive quarter. Operating income improved to a gain of $5.9 million from losses in Q1 and a year ago. Net income improved to $1.9 million or$.01 per diluted share.

Let me now walk through our segment results. Our retail business had a strong quarter. Our revenue grew 4% year-over-year, gross margin increased to 5.6% of revenue, up 190 basis points from 3.7% a year ago due to component cost and freight savings as well as a continued mix shift towards notebooks. Retail SG&A increased by $4 million over the prior year. The net result is that retail segment contribution grew to $26 million, up from $17 million a year ago.

This next slide shows our retail segment results. Turning to professional; our professional segment had a mixed quarter. Revenues were down year-over-year but segment contribution increased significantly. Revenue declined 31% year-over-year primarily due to greater selectivity and contract bidding and desktop unit production constraints at our national facility.

Pro margins improved to 12.2% of revenue up significantly from 4.4% a year ago. Last year was negatively impacted by $10 million in warranty and royalty adjustments, but the year-over-year improvement in gross margin was also driven by better margin management.

Pro SGNA decreased nearly $7 million from a year ago due to reduced head count, marketing and travel expenses. The net result is that the Pro segment contribution grew to $8.4, up from a loss of $8.3 million in the year ago. And this is shown in the next slide here for our professional segment results.

Direct revenue declined 30% year-over-year reflecting reduced promotional activity and desktop production constraints as well as the impact of declining deferred warranty in Internet subscription revenue. Direct margins declined 15% down from 23% a year ago primarily due to declining deferred warranty in Internet subscription revenue as well as mix shift towards lower priced notebook systems.

Direct SG&A decreased by $4 million from a year ago due to reduced head count marketing expenses. The net result is that the direct segment contribution dropped to $4.1 million, down from $9.3 million a year ago.

Turning to our consolidated results, revenue declined 8.6% to $841 million. That’s from $919 million a year ago, mostly due to declines in Pro and Direct, offset in part by growth in retail. Our gross margin increased to 7.6%, up from 5.5% a year ago reflecting the margin gains in our retail and professional businesses.

SG&A increased by less than 1% year-over-year despite an $8.4 million reduction in sales tax reserves that was reflected in our year ago results.

Net results are that operating income improved to $5.9 million up from a loss of $6.9 million a year ago. That’s the third consecutive quarter in which we’ve improved our year-over-year operating results. Net income increased to $1.9 million or $.01 per share up from a loss of $7.7 million a year ago.

Turning to our balance sheet, our working capital has been stable over the past four quarters. Working capital at the end of the quarter was $314 million, unchanged from the first quarter and largely unchanged over the past year after adjusting for the Q1 adoption of FIN-48.

Accounts payable and supply receivables both dropped to normal levels from the distorted first quarter level that were caused by component receiving and invoicing delays. Accounts payable this quarter decreased to 71 days from 81 days in the first quarter as we shortened our payables in support of our ODM relationships. Suppliers’ receivables decreased to 32 days, that’s down from 45 days due to more timely invoicing of components sales to our ODM’s.

Inventory closed up 19 days and that was due to increased finished goods as we into the back to school season. Other current assets dropped by $92 million due to improved collections largely of vendor credit programs. The net result is cash and marketable securities did decrease to $255 million from $317 million at the end of the quarter and that’s as we utilize more of our working capital in support of the business.

I guess one way to look at our cash position is to focus on cash flow. If you look at cash flow defined as operating income plus depreciation, minus CapEx, that rose to $7.7 million which was an increase of $17 million over the negative $9.3 million in Q1, and that’s an increase of $23 million over similar results fro Q2 of 2006. And what this reflects clearly is an improvement in our operating income, greater depreciation and amortization, as well as a reduction in our capital expenditures. That’s laid out in the slide that’s showing now.

We will now open the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) The first question comes from Richard Gardner with Citigroup.

Richard Gardner – Citigroup

Thank you. John, I was hoping you could give us some sense of why segment SG&A was up so much sequentially year-over-year in retail in the quarter?

John Goldsberry

If you looked at the retail slide, it pretty much goes to the improvement in gross margins. Revenues were up and gross margin was up significantly and obviously that translates into very significant increase in segment contribution.

Richard Gardner – Citigroup

Actually, John I was referring to the SG&A for the second, which looks like it was, based on the figures you’re reporting for gross profit and contribution margin, it looks like retail segment SG&A was almost doubled on a year-to-year basis, as well as sequentially.

John Goldsberry

Yeah, that’s in part due to some adjustments to our AR reserves for retail. And have dropped significantly and obviously that translates into a very significant increase in segment contribution

Richard Gardner – Citigroup

Actually John, I was referring to the SG&A for the segment which looks like it was, based on the figures that you are reporting for gross profit and contribution margin, it looks like retail segment SG&A was almost doubled on a year-over-year basis as well as sequentially.

John Goldsberry

Yeah that’s in part due to some adjustments to our AR reserves for retail. I would say approximately three quarters of the increase was due to that factor.

Richard Gardner – Citigroup

Okay, and then I’m assuming that US retail units were down more than overall retail units because retail includes international which is growing on a year-over-year basis so it looks like your retail segment in the US could have been down mid single digits year-over-year in units with all the revenue growth driven by AST increases. Could you talk about why you’re losing so much share in US retail?

John Goldsberry

You know, our share in retail varies quarter to quarter. I guess we were pleased with our domestic retail results, they were in line with budget and so I’ve got nothing but good things to say about how we feel we did in the domestic side of our retail business.

Ed Coleman

One thing I would add on the retail side of it is we tend to, historically we’ve been much stronger on the desktop side than notebook, in spite of the fact from a ratings standpoint, in spite of the fact that over the last two or three years our notebook business is growing very well. I think that as the shift from desktop to notebook accelerates, that tends to affect us perhaps more than some others. As Sam says, I think that overall we’re very pleased with retail performance for the quarter.

Richard Gardner – Citigroup

All right, thank you

Operator

The next question comes from David Bailey with Goldman Sachs

David Bailey – Goldman Sachs

Ah, yes good morning, one question and one follow up please. For the question, your cash is down over 50% year-over-year. How much cash do you need to run the business at this point?

John Goldsberry

You know David, if you look at our working capital its $314 million that compares with revenue of $900 million approximately. That’s over a months worth of working capital and while we will I think employ more of that working capital in our business, I think if you think of normal ratios of working capital sales that should be adequate to support our business.

David Bailey – Goldman Sachs

And then the other question is, you mentioned a couple of times that components were benefits for gross margin. Can you help us understand some of the magnitude of that? At least give a rank order of why the gross margin was up overall.

John Goldsberry

I guess what I would emphasize is margins in our retail business returned to what I would describe as more normal levels from levels that were depressed in Q4 and in Q1 due to a variety of factors. Looking at where we ended up this quarter in terms of actuals so as compared to our projected margins when we locked skews for the quarter the net result was just a slight improvement over what had been initially planned.

So what I would say is this quarter we returned to more normal levels as compared with the prior two quarters where we had a number of factors that certainly we talked about at our prior conference calls that depressed our gross margins in those quarters and as we’ve stated before Q1 margins were certainly hurt by increase in component costs and the fact that component costs dropped certainly eliminated that factor from hurting margins the way they have in Q1.

David Bailey – Goldman Sachs

Thank you

Operator

Your next question comes from Kathryn Huberty with Morgan Stanley.

Kathryn Huberty - Morgan Stanley

Good morning guys. John, just to follow up on the last question, what are you doing to manage component cost as we go into a tighter environment in the second half? And then on the same token do you feel that gross and operating margins can continue to trend up regardless of whether components tighten a bit over the next couple of quarters?

John Goldsberry

Okay, so components supplies are tightening, certainly they’ve stabilized in D-RAM and in panels and those component costs are starting to trend up. We are looking at some things to lock in some supplies, we’re factoring in a projected increase in those components as we look to lock skews for the back to school season as well as for the holiday season.

We certainly are focusing more attention on managing our exposure to D-RAM in particular just given some of the volatility we’ve seen over the past six months.

Kathryn Huberty - Morgan Stanley

Okay, And then just a quick follow up. What if any impact did Dell’s entry into Wal-Mart have on your retail unit growth? I know Wal-Mart is your largest retail partner.

John Goldsberry

Wal-Mart is not our largest retail partner. Clearly that’s Byers. Wal-Mart’s clearly a very important partner to us. We’re certainly aware of Dell’s entry into Wal-Mart. So far I would say we’re pleased with the level of business that we continue to get from Wal-Mart.

Kathryn Huberty - Morgan Stanley

Great, thanks so much.

Operator

Your next question comes from Eric Reubel with Miller Tabak Roberts

Eric Reubel - Miller Tabak Roberts

Good morning gentlemen and thanks for taking my call. John, on the gross margin improvement in the quarter with most of that coming from component cost reductions and power reductions in Q1, do you think that those improvements are sustainable into Q2, sorry, into Q3 and beyond?

John Goldsberry

As I stated earlier, my description of margins this quarter is that they returned to more normal levels from the depressed levels we saw in Q4 and Q1 due to unique factors in those quarters. Our margin at 5.6% this quarter was very good. Am I going to say that we’ll maintain that level for gross margin every quarter? My guess is it’ll vary; it’ll go up and down. Looking to this fall, I could see that declining a little bit but I would say that in general I would see margins staying more in this range than at the levels we saw in Q4 and Q1.

Eric Reubel - Miller Tabak Roberts

Great, thanks a lot. On inventory you said that you had put a little more finished goods in place for the ramp up for back to school. Can you give a little color on how that’s shaping up, how your inventories are in the channel and what you’re seeing from on the (inaudible).

John Goldsberry

Inventories of our finished goods increased right at the end of the quarter. The end of Q2 coincides with a big shipping season as we go into the back to school. Literally we’re talking about finished goods that just happened to arrive at our DC prior to going out the door a few days later so I wouldn’t make too much out of the fact that we saw an increase in finished goods inventory. That’s just literally reflects, you know, the stuff arrived right before the end of the quarter but before it went out the other side of the warehouse a few days later. The outlook for back to school is good.

Eric Reubel - Miller Tabak Roberts

Could you characterize your channel inventory in terms of weeks?

John Goldsberry

As compared with the end of Q4 and the end of Q1 we were extraordinarily light in terms of channel inventory. Our channel inventories did increase in Q2 by a few weeks.

Eric Reubel - Miller Tabak Roberts

Okay, thank you.

Operator

Your next question comes from Andrew Neff with Bear Stearns

Andrew Neff – Bear Stearns

If one of you could let us know if there’s been any new changes or any updates with the various discussions you’ve had with outside parties who are trying to launch corporate actions

John Goldsberry

I think that if we just go back to the discussions last year when Scott Galloway in (inaudible) made an investment and came on our board as we commented on the last couple of calls I think. Scott has turned out to be an extraordinarily valuable, hard working member of the board of directors. So we’re very pleased to have him on board.

Andrew Neff – Bear Stearns

Anything else in terms of activity or corporate initiatives that is under way that you can talk about?

John Goldsberry

I think that I talked about our key initiatives. It’s to get our cost structure right, it’s to improve our execution, we have some solutions underway there that I referred to and it’s to continue to concentrate more and more on the resources of the business and the consumer marketplace.

Operator

(Operator Instructions) Your next question is a follow up from [Vishal Gupta].

[Vishal Gupta]

Thank you. John, I was hoping you could give us the non PC revenue number for the quarter or at least as a percent of total and also non PC gross profits as a percent of total gross profits?

John Goldsberry

Ok, so non PC revenue was 12.5% of the total and that accounted for 70% of gross margin dollars.

[Vishal Gupta]

Ok, thank you.

Operator

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

Eric Reubel - Miller Tabak Roberts

I’m making my follow up, just a couple of quick housekeeping things. John, your outlook for CapEx for second half of the year if you could refresh us on that and do you see working capital becoming a source in the back half of the year?

John Goldsberry

Capital expenditures are definitely down, that’s somewhat masked a little bit in Q1 and even partially in Q2 due to the fact that the cash flow statements tends to reflect CapEx when its actually paid for as opposed to when its accrued. We have significantly reduced our CapEx budget, largely because what we needed to do is behind us on the IT funds. As a result, of cap-backs should be significantly under depreciation which is run at close to $10 million on a quarterly basis, and I would expect our cap-backs numbers to be closer to half of that in the second half of the year.

That result is cash flow, defined as operating income, minus, you know, plus depreciation and amortization minus cap backs. That should be positive; I mean clearly we're expecting to make money in the second half of the year and that coupled with a differential between depreciation and amortization, and cap backs should result in cash flow being positive in a way that adds to our working capital.

Operator

Your next question comes from Matthew Kather with WR Hambrecht.

Matthew Kather – WR Hambrecht

Hi guys. I apologize; our line got dropped there twice. Congratulations on such a dramatic margin improvement, and what I think is excellent results. I just had a question, and then again I apologize if this was asked already, we've been dropped twice. On the revenue side, preliminary data looks like you lost about 150 basis points of market share in the U.S. in the June quarter, and you mentioned that there was $60 million in unshipped backlog [per Pro under rack]. Could you talk about that revenue drop-off, and how much was function of just that unshipped backlog versus additional competition, or possibly a pause in demand ahead of your notebook refresh? Thanks.

John Goldsberry

Certainly a lot of it was in the Pro [and consumer direct] unshipped backlog that you referred to, and by the way, I apologize for your line being dropped a couple of times. We estimate about $60 million lost revenue in the quarter due to that backlog. But also in the pro business we've been making some conscience decisions as well to not pursue lower margin business, in the quest to improve the contribution of that business, and I think you see that, the impact of that, with the $17 million swing in contribution for Pro, so I think it's fair to characterize our approach to being more focused on profitability across all of our segments, and we are on top line revenue growth.

One of the things I mentioned earlier about retail volumes, in spite of the fact that we've grown our notebook business very, very rapidly over the last couple of years, we're still pretty heavily weighted, more heavily weighted to desktops. The business is going from a desktop business more and more to a notebook business, and that impacts us as well, but we were pleased to see some very significant growth in our notebooks business for the quarter.

I would characterize this as pursuing profitability first, Matt.

Matthew Kather – WR Hambrecht

So, that's good to hear. Even though you're not giving any formal guidance, maybe could you give some qualitative color about the top line growth that you’re expecting for Q3 in line of what it's been historically, do you think, with this backlog, we might see even further acceleration in Q3, any qualitative comments you can give us about the top line growth going forward in the back half of the year?

John Goldsberry

That's a little bit of a slippery slope, but we are making improvements in our production capacity at national. They're fairly dramatic improvements from what we saw in Q2. We're pleased with that, and that should certainly give us an assist. We've come out with some exciting new products for Q3 and Q4 that we think will also give us an assist, and we've got more products that we'll announce throughout the course of Q4, and we're excited about the international expansion.

Again, part of our strategy is to concentrate our resources on the consumer marketplace, that's why we're investing in European expansion, that's why we're investing in/expanding into the China market. So, we think between fixing some operational problems, coming out with new innovative products, and expanding into new markets, we're pretty excited by what we've got going on.

Matthew Katter – WR Hambrecht

Great. Congratulations again.

John Goldsberry

Thank you.

Operator

Your next question comes from [Rennet Alter]

[Rennet Alter]

Individual investor, and I'm mostly interested in your China project. What stage is it at exactly? When will it start adding to revenue and profitability? It seems to be the market these days, and I'd like to get a little more information on where we're at there.

John Goldsberry

Well, thank you very much for your question. I would just leave it with what we've publicly announced to this point. That we've started a [pile] back in June of selling our products in Chinese markets, in the China marketplace, and as I said earlier on the call, that's going well, and we expect to have some additional news to report on that in the not too distant future.

[Rennet Alter]

All right, thank you.

John Goldsberry

I'll leave it there.

Operator

At this time we have a question from Woodham Vogel with HarborView Asset Management.

Woodham Vogel – HarborView Asset Management

Yes, I was just trying to get a little bit of color on what your feedback has been on the floor of your various retail partners pertaining to the Vista related products, in particular, the extent to which the consumers are feeling that this is a motivating thing, or if they're still taking a "wait and see" in general.

John Goldsberry

I think generally in the consumer marketplace, in the retail market, it just is, Vista is the operating system that is on the machines that are shipping today. It has some additional functionality and capabilities that XP didn't have, and some are finding that useful, some people honestly don't know the difference. I wouldn't characterize it as something that's motivating people to buy. We've been saying this for some time now, we thought that there would be a bump right around the Vista launch, and then it would begin to drift back to business as usual, with normal seasonality, and in the longer term as Vista begins to fulfill it's promise, to help make the PC the hub of the hone in the entertainment standpoint, that may drive better than long term demand, but I don't think it's a motivator for why people buy a new PC today.

Woodham Vogel – HarborView Asset Management

Ok. Thank you.

John Goldsberry

You're welcome.

Operator

At this time we have no further questions, Miss Johnson.

Marlys Johnson

Thank you very much Marcus. Thank you everyone for joining with us this morning. A replay of this conference call will be available on the home page of the Gateway.com website for 24 hours and thereafter archived on the industrial relations web pages. There will be a telephonic playback of this conference call beginning this morning at 10am Eastern Time, and running until midnight Eastern Time on Saturday, August 4. That number is 706 645 991, [pass code of] 11369095.

Thank you, this concludes today's conference. You may now disconnect.

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