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Golden Gateway
Guidance from the #3 PC maker disappointed Wall Street but investors may be overreacting.
August 16, 2005: 12:22 PM EDT
By Paul R. La Monica, CNN/Money senior writer

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Cowabunga! Shares of Gateway have plunged this year after a strong second-half rally in 2004.
Cowabunga! Shares of Gateway have plunged this year after a strong second-half rally in 2004.
Rusty Gateway
Gateway trades at a discount to all of its main PC rivals.
Company†Price-to-sales*†2006 P/E†
†* based on fiscal 2005 revenue estimates as of 08/16/05
†Source:††Thomson/First Call

NEW YORK (CNN/Money) Ė For fans of Gateway, the PC maker known for its bovine-themed corporate logo, there's good news and bad news. (Or is it moos?)

First, the good news. Gateway is finally back in the black.

The third largest U.S.-based manufacturer of PCs reported its first quarterly profit (on a generally accepted accounting principles (GAAP) basis) in more than three years Monday. What's more, the company said it is still on track to post its first annual profit since 2000.

Now, the bad news. Gateway, citing pricing pressures in the notoriously cutthroat PC industry, lowered its sales and earnings guidance for the year.

Gateway said it should generate revenues of $3.9 billion to $4.0 billion and earnings, excluding restructuring charges, of 13 to 15 cents for all of 2005. Analysts were expecting sales of $4.08 billion and pro-forma earnings of 16 cents a share.

Investors had a cow as a result of the news.

Shares of Gateway (Research), already down more than 35 percent this year before the second-quarter release, plunged another 18 percent Tuesday morning.

Wall Street has written off Gateway several times during the past few years only to see the stock bounce back. I think Gateway bears will be proven wrong again. Here's why.

Cash is king and market share is improving

Gateway has been able to keep generating a healthy amount of cash to keep it afloat during tough times. The company has $567 million in cash, a significant amount when you consider that the market value of the company is just $1.2 billion. Cash increased from about $530 million at the end of the first quarter.

"Tech is fickle in terms of product lifecycles and investor infatuation and disgust so we invest in companies that have financial wherewithal to stay in business," said John Buckingham, manager of the Al Frank fund, which owns Gateway. "If Gateway didn't have all that cash on the balance sheet, it probably wouldn't be with us today."

What's more, Gateway's PCs do appear to be in fashion again. The company is starting to make a nice comeback since its merger with eMachines last year. Gateway reported a 27 percent gain in PC shipments during the second quarter.

That outpaced the unit growth of top rivals Dell (Research) and Hewlett-Packard (Research), according to tech research firm IDC. As a result, Gateway's share of the U.S. PC market rose slightly, to 6 percent from 5.3 percent a year ago.

In addition, Gateway said that shipments of notebook computers -- which tend to be more profitable than desktops -- rose 20 percent from the first quarter and 62 percent from the same period last year.

"This is a good first step. Gateway had solid year-on-year growth," said Loren Loverde, an analyst with IDC. "Having strong results in the second quarter shows they are getting things in line and that they could have momentum in the second half."

Sure, Gateway still has a lot to prove to Wall Street. It shut down all its retail stores and cut about 4,000 jobs over the past year in order to boost profits. Investors now want to see earnings growth that is generated from actual demand.

During a conference call with analysts, CEO Wayne Inouye conceded that the company's biggest challenge going forward will be to keep adding customers, especially corporate and government customers, without sacrificing profits.

"It's all about building a base in professional market," said Inouye. "We have to have a compelling product and a compelling price and it's costing us a little more to get in."

MSFT settlement raises earnings quality concerns

There are also questions about how Gateway plans to account for the $150 million it will be receiving from Microsoft as part of a settlement of antitrust litigation.

Gateway said Monday that it will book the money, which it will receive in quarterly increments until 2008, as operating income since the majority of the proceeds must be spent on marketing and promotional initiatives for Gateway products that run on Microsoft's software.

The company stressed that it consulted with the Securities and Exchange Commission on this point. In fact, Gateway delayed the release of its second-quarter numbers twice because it was seeking guidance from auditors and the SEC about how to account for the Microsoft windfall.

But in future quarters, analysts will scrutinize Gateway's results to see how much earnings increase without the money from Microsoft.

"We do not believe that investors should be willing to pay the same multiple for earnings produced by a legal settlement conferring temporary benefits for the next 3.5 years," wrote Citigroup analyst Richard Gardner in a report Tuesday.

Still, all this skepticism appears to be factored into Gateway's stock price. Shares trade at 23 times the 14 cents per share mid-point of Gateway's new earnings guidance for 2005, which may seem steep. But the stock trades at just 12 times 2006 earnings estimates and only 0.3 times estimated 2005 revenues, notable discounts to Dell and HP as well as Apple (Research).

Finally, if Gateway's stock continues to struggle, that could increase the possibility of a takeover in the future. Gateway's cash could make it attractive to a private equity firm. And several tech companies have agreed to be taken private through leveraged buyouts (LBOs) this year.

For a look at more hardware stocks, click here.

For more personal technology news, click here.

Analysts quoted in this story don't own Gateway and their firms have no investment banking ties to the company.

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Written by: Paul R. La Monica
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