SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2001
Commission file number 0-22784
GATEWAY, INC.
| Incorporated in Delaware
| I.R.S. Employer Number 42-1249184 |
14303 Gateway Place, Poway, CA 92064
Telephone number
(858) 848-3401
Securities registered pursuant to Section 12(b) of the Act:
|
Title of each class Common Stock, par value $.01 per share Preferred Share Purchase Rights |
Name of each exchange on which registered
New York Stock Exchange New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [ ]
The aggregate market value of the voting stock held by non-affiliates of the registrant on January 30, 2002 (based on the last sale price on the New York Stock Exchange as of such date) was approximately $1,130,285,771. At such date, there were 323,972,895 shares of Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Gateway’s definitive proxy statement relating to its 2002 annual meeting of stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year to which this Report relates, are incorporated by reference in Part III of this Form 10-K.
Forward-Looking Statements
This Annual Report on Form 10-K, including “Business - Factors That May Affect Gateway’s Business and Future Results” set forth below, contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they do not materialize or prove incorrect, could cause the results of Gateway, Inc., together with its subsidiary companies (“Gateway” or the “Company”), to differ materially from those expressed or implied by such forward-looking statements. All statements, other than statements of historical fact, are statements that could be deemed to be forward-looking statements, including any projections of results of operations, revenues, financial condition or other financial items; any statements of plans, strategies and objectives of management for future operations; any statements regarding proposed new products, services or developments; any statements regarding future economic conditions, prospects or performance; statements of belief and any statement of assumptions underlying any of the foregoing.
The forward-looking statements contained herein involve risks and uncertainties including, but not limited to, general conditions in the personal computing industry, including changes in overall demand and average unit prices, general economic conditions, competitive factors and pricing pressures, including the impact of aggressive pricing cuts by competitors and the Company’s pricing and marketing strategy; shifts from desktops to mobile computing products and information appliances and the impact of new microprocessors and operating software; the ability to transform the Company to a digital technology solutions provider and restructure its operations and cost structure; component supply shortages; short product cycles; the ability to access new technology; infrastructure requirements; risks related to the shutdown of the Company’s company-owned international operations, including the loss of related net sales and access to international markets; ability to grow in non-PC or “beyond-the-box” business; risks of minority equity investments; increased inventory costs; risks relating to new or acquired businesses, joint ventures and strategic alliances; changes in accounting rules, the impact of litigation and government regulation generally; inventory risks due to shifts in market demand; changes in product, customer or geographic sales mix; change in credit ratings and the impact of employee lay-offs and management changes. To learn more about the risks and uncertainties that the Company faces, you should read the risk factors set forth in Gateway’s Securities and Exchange Commission periodic reports and filings, including but not limited to the items discussed elsewhere in this Report. The Company assumes no obligation to update these forward-looking statements to reflect events that occur or circumstances that exist after the date on which they were made.
PART I
Item 1. Business
General
Gateway is a leading direct marketer of personal computers (“PCs”) and related products and services, which are also referred to as digital technology solutions, for individuals, families, small and medium businesses, government agencies, educational institutions, and large businesses in the United States. Gateway develops, manufactures, markets, and supports a broad line of desktop and portable PCs and servers and offers diversified products and services that are “beyond-the-box,” including communications products (such as Internet access services), financing programs, peripheral products, software, services and support packages and training. In 2001, the Company streamlined its cost structure, improved product quality and customer satisfaction, strengthened its balance sheet and pursued its strategy of transforming the Company from a traditional manufacturer of PCs to a leading provider of personalized digital technology solutions by leveraging Gateway’s existing retail footprint, its brand position and its beyond-the-box products and services.
The Company is one of the leading suppliers of PCs to the U.S. consumer market, with an estimated market share greater than 10% in 2001 based on revenue, according to International Data Corporation (IDC) quarterly statistics. Gateway’s strategy is to deliver the best value to its customers by offering quality, high-performance digital technology solutions that include PCs and other products and services employing the latest technology at competitive prices and by providing outstanding service and support along with quality Internet access. Internet users can access information about Gateway and its products and services at http://www.gateway.com.
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Gateway was incorporated as “Gateway 2000 Inc.” in Iowa on August 15, 1986, merged into a South Dakota corporation of the same name effective December 29, 1989, merged into a Delaware corporation of the same name effective February 20, 1991 and changed its name to “Gateway, Inc.” effective May 25, 1999. Gateway’s common stock trades on the New York Stock Exchange under the symbol GTW. The corporate headquarters for Gateway is located in Poway, California.
Business Segments
Until September 30, 2001, Gateway organized its business operations into four operating segments: (a) the consumer segment in the United States, (b) the business segment in the United States, (c) Europe, the Middle East and Africa (“EMEA”), and (d) Asia Pacific (including Australia). During the third quarter of 2001, the Company closed its EMEA and Asia Pacific company-owned operations, and also reorganized its domestic business and consumer operations into a single sales organization. For further information on the Company’s operating segments see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 13 of the Notes to the Consolidated Financial Statements.
Business Operations
Direct Marketing and Distribution. Gateway sells its technology solutions directly to customers primarily through three complementary distribution channels – phone sales, web sales, and Gateway’s nationwide network of retail stores. Gateway’s stores allow customers to obtain information from highly trained sales representatives and test products. Unlike traditional retail stores, Gateway’s stores generally maintain only a limited inventory of computers for sale, keeping inventory risks and related costs low. Customers can order a computer while at the store, can visit the Gateway website later and place an order over the Internet, or can call to ask further questions and order their computer over the telephone. Gateway believes that approximately 45% of its consumer customers take advantage of at least two of these channels before making their purchases.
As of January 31, 2002, Gateway had 277 retail stores in the United States, allowing customers direct interaction with sales representatives. Customers can also order products over the telephone up to eighteen hours a day and seven days a week in the U.S.
Gateway believes that this direct distribution and multi-channel approach provides several competitive advantages. First, Gateway believes it can offer competitive pricing by avoiding the additional markups, inventory and occupancy costs associated with distributors, dealers and traditional retail stores. Second, by alleviating the need for the high levels of finished goods inventory required by traditional retail channels, Gateway believes it can respond more quickly to changing customer demands – offering new products on a timely basis and reducing its exposure to the risk of product obsolescence. Third, Gateway believes that working directly with customers promotes brand awareness and customer loyalty and is instrumental in Gateway’s high customer satisfaction ratings.
Gateway markets its products directly to customers, primarily by placing advertisements on television, newspapers, magazines, radio, the Internet, the Company’s Internet website, local promotions and trade show appearances. Gateway believes its creative marketing, including use of its famous trademarked “BLACK AND WHITE SPOT” design on product packaging, has helped generate significant brand awareness and a loyal customer base.
Gateway has sold over 25 million PCs to date, and maintains a database of its customers. To provide a broad range of products and services to these customers, Gateway has introduced a number of marketing and communication techniques. These include sales catalogs, customer magazines, and the Gateway Moola credit card that gives consumers a rebate applicable toward future Gateway™ purchases. Gateway’s web site offers information about Gateway events, new product offerings and technical support advice. In addition, regular surveys of Gateway’s customers provide valuable marketing, service and product information.
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Business Sales. During 2001, the Company’s business sales and marketing activities focused on its core market segments: small and medium business, education and government. In 2001, the Company’s Business Solutions centers in Gateway’s stores and approximately 240 dedicated Business Solutions Advisors addressed the technology needs of small and medium business clients. To complement its business sales efforts, Gateway also deploys a program of approximately 200 third-party Network Solutions Providers who work with the Company’s Business Solutions Advisors and business sales force to deliver localized consultation and integration services to business, education and government clients in essentially all the top markets across the United States. Gateway’s sales force also demonstrated technology leadership in the education market through the Company’s work with K-12 schools and higher education institutions.
In addition to its retail store and telephone sales channels, Gateway has enhanced customer sales options with Internet-based tools. The Company offers business, education and government clients personalized websites, called eSource sites, to facilitate their order and order management requirements. Additionally, the Company has developed the Gateway eMarketplace to facilitate both online purchases and sales of a wide range of technology and products that help businesses run.
Gateway’s Custom Integration Services (CIS) program is designed to reduce the time and expense associated with the deployment of new business systems. Gateway’s CIS group accelerates technology deployment for clients through factory installation of unique software images, development of image restoration products and asset tagging installation of customer hardware and software to meet clients’ individual requirements.
Growth Initiatives. In 2001, the Company streamlined its cost structure, strengthened its balance sheet, improved product quality and customer satisfaction, re-established a technology leadership position and pursued its strategy to transform the Company from a traditional manufacturer of PCs to a leading provider of personalized digital technology solutions by leveraging Gateway’s existing retail footprint, its brand position and its beyond-the-box products and services. As part of the shift toward providing digital technology solutions, the Company is turning its nationwide network of retail stores into local technology resource centers, serving as hubs for cross-functional sales, service and marketing teams that will provide customers with increased personalization and local service and support. In 2002, the Company intends to gain sales momentum and unit volume growth through the adoption of a more aggressive product pricing and marketing strategy. At the same time, the Company intends to continue to develop and refine its solutions leadership as it diversifies its revenue stream with the introduction and expansion of new products and services, including Digital Infrastructure (such as communications products, broadband Internet access services and financing programs), Digital Solutions (such as peripheral products and software) and Digital Services (such as services and support packages and training).
For a discussion of certain risks associated with Gateway’s operations, see “Business - Factors That May Affect Gateway’s Business and Future Results” beginning on page 9 of this Report.
PC Hardware
Gateway offers its customers a broad line of Gateway-branded PCs and servers. Gateway markets its PCs with recommended configurations, but customers can also custom-configure PCs with a choice of microprocessor clock speeds, memory, storage capacities, as well as other options. The following are the key products within this class:
Desktop PCs. Gateway offers a series of desktop PC products, developed to serve targeted customer segments. Desktops represented over 60% of net sales in 2001.
Portable PCs. Gateway offers a series of Solo® branded portable PC products to provide portable computing capabilities for users who operate in both a mobile and networked environment. The systems can be designed for either home or business use and a number are available with docking stations and various multimedia applications. Portables are a growing element of Gateway’s business, representing about 15% of net sales in 2001.
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Servers. Gateway principally offers Gateway-branded servers for business customers. Every Gateway server has an adaptable design and can be custom built with a variety of options to fit the customer’s needs.
Digital Technology Solutions
A key element of Gateway’s growth strategy is expansion of “beyond-the-box” product and service offerings, which are products and services sold in addition to the base PC. Gateway offers an assortment of beyond-the-box products and services together with PCs as “digital technology solutions”. Beyond-the-box offerings include communications products (such as broadband and narrowband Internet access services), financing programs, peripheral products, software, services and support packages and training.
Digital Infrastructure.
Communications. Gateway offers a variety of Internet access service options and networking products and services. In November 1997, Gateway became the first major PC manufacturer to offer nationwide Internet provider service directly to its customers. The gateway.net® Internet service offered electronic mail, narrowband Internet access, and an array of news, entertainment, family-oriented topics, weather, sports, Internet tips and tutorials. In October 1999, Gateway entered into a strategic relationship with America Online, Inc. (“AOL”) to accelerate distribution of each company’s products and services, including Internet service. During the first quarter of 2001, the Company modified its strategic alliance with AOL to discontinue the gateway.net service and to convert existing gateway.net customers to the AOL branded Internet access in order to improve customer experience. The Company continues to market AOL narrowband Internet access service under the strategic alliance, and as of the end of 2001, over 1.5 million Gateway customers were using AOL under the strategic alliance.
During 2001, the Company established marketing relationships with a number of leading cable broadband Internet access service providers and began actively marketing broadband Internet access services to its customers. Adoption of broadband Internet access by customers also presents the Company with the opportunity to expand its sales of networking products and services, including wired and wireless solutions and associated installation and maintenance services. By the end of 2001, Gateway was able to offer cable broadband service to its customers in 60% of the United States and plans to expand its relationships to cover substantially all of the consumer cable market by the third quarter of 2002. The Company also intends to expand broadband service offerings for the business market and to establish high speed (3G) wireless communication service offerings during 2002.
Financing Programs. In 2001, the Gateway finance program, principally through third-party financing partners, provided over $1.2 billion through financing programs directed toward purchasers of Gateway™ PCs. For business customers, Gateway maintains relationships with a number of leasing companies to provide leasing options tailored to meet the needs of business customers. During 2001, Gateway terminated new consumer financing for its own account and now provides financing primarily through its third-party financing partners.
Digital Solutions.
Peripherals, Software and Other Computer-Related Products. Gateway markets printers, scanners, digital cameras, personal digital assistants (PDAs), monitors, CD burners, storage devices, surge protectors and other PC accessories that are manufactured by leading companies in their respective markets. Gateway also markets a broad range of software offerings, from entertainment and productivity applications for the consumer market to vertical applications for various segments of the commercial and institutional markets. Peripherals, software and other computer-related products are sold in all three of the Company’s sales channels, including online through Gateway’s “Accessory Store” on its website at http://www.gateway.com, where more than 30,000 SKUs are available.
Digital Services.
Services and Support. Gateway provides customers with a number of additional offerings beyond the Company’s standard warranty, service and support packages included with a typical product purchase. These fee-based services include extended warranties, repair service and technical support, home and office installation and integration services, software application support, network support, technology planning and consulting and outsourcing of IT support for businesses. Gateway has partnered with a number of third parties to provide and strengthen Gateway’s fee-based service offerings to consumers and businesses of all sizes. In addition, with its nationwide network of stores, Gateway offers a unique ability among PC manufacturers to service directly what it sells.
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The Company also offers services to enable its customers to create and maintain websites and conduct business over the Internet. Product offerings range from domain registration to web site design and hosting, as Gateway offers customized e-commerce sites for commercial accounts that tailor the product offerings and procurement practices to the customer’s specifications.
Training. Through Gateway’s nationwide network of retail stores, Gateway now has approximately 4,200 classroom seats throughout the country, offering training on general PC usage, popular third-party software, Internet usage and networking services to consumers, businesses and institutions. Gateway also offers a unique, Gateway-branded multi-media training solution that combines instructor-led, CD-ROM and Internet-based training classes that enhances customer convenience and accessibility.
Product Development
Gateway’s expenditures on research and development in each of the last three years were less than 1% of net sales. The Company primarily relies on close and cooperative relationships with a wide range of third-party suppliers and other technology developers for research, development and engineering and to evaluate the latest developments in PC and solutions-related digital technology. Gateway believes that these relationships, together with the Company’s own engineering staff, market information obtained from Gateway’s direct customer relationships, the flexibility of build-to-order manufacturing, low inventory and short production lead times allow Gateway to rapidly introduce and deliver appealing new products, product features, software and services to the market. In 2001, Gateway was the first major PC maker to take orders for PCs with Microsoft Windows XP software pre-installed and to ship PCs with this operating system directly to its customers. Further, in coordination with leading third-party suppliers, Gateway works to develop integrated digital solutions designed to address the personal, entertainment and business needs of its customers. Gateway believes that its strong relationships with its suppliers will continue to give Gateway access to new technology and enhance its ability to bring the latest technology to market on a timely basis. Direct relationships with its customers also enable Gateway to obtain valuable market information, which it uses to assist in developing new product offerings.
Manufacturing
Gateway has designed its manufacturing process to provide a simplified line of products with standardized recommended configurations as well as products that are “build to order” or custom-configured to meet customer specifications. Gateway uses production teams to assemble most of its desktop PCs and servers with each member of a production team trained to do several tasks, increasing flexibility and efficiency. Gateway also uses third-party suppliers to manufacture portables and certain desktop PC products on behalf of the Company. Gateway’s production and quality assurance teams ensure that products meet Gateway’s quality specifications and applicable regulatory requirements. Each PC is generally shipped from Gateway’s manufacturing facilities ready-for-use, with an operating system and certain application software already installed. Replacement parts are also generally shipped directly from Gateway or its suppliers to its customers.
Gateway’s desktop and portable computer manufacturing operations in North Sioux City, South Dakota and Hampton, Virginia have been assessed and certified as meeting the requirements of the International Organization for Standardization (ISO) 9002. ISO 9002 certification recognizes Gateway’s compliance with international standards for quality assurance.
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Product Warranties and Technical Support
Gateway believes that quality and reliability have become increasingly important to technology buyers’ purchasing decisions. Gateway works closely with its suppliers to develop high-quality components, manufactured to Gateway’s specifications. Gateway believes that customers judge quality by evaluating the performance and reliability of a company’s products, as well as its ability to provide comprehensive service and support for its PCs. To provide superior service and support to its customers, Gateway utilizes trained third-party technical support contractors as well as its own customer and technical support representatives to assist customers with the resolution of technical questions relating to Gateway’s products.
Product Warranties. Gateway provides competitive warranty packages on all of its manufactured products, ranging from one year to five years. In many cases, customers have the option of customizing their limited warranty to suit their particular needs.
E-Support Solutions. Gateway’s e-support solutions approach combines preloaded automated system diagnostic software and online diagnostic and computer maintenance programs to deliver automated technical support for its customers.
Other Technical Support Options. Gateway provides a number of other basic technical support options to its customers through its website, as well as through a variety of other methods, including e-mail, fax, and telephone support. Many of these technical support options are available to customers without charge. To expand the range of choices available to customers, Gateway has also introduced a number of fee-based support options, ranging from software tutorial services for consumers to advanced network support for small and medium-sized businesses.
Patents, Trademarks and Licenses
Gateway holds a number of U.S. and international patents and has a number of U.S. and international patent applications pending. In addition to its own engineering resources, Gateway works closely with PC component suppliers and other technology developers to develop products based on the latest PC technology. Patents are sought for inventions that contribute to Gateway’s business and technology strategy. Gateway has obtained patent licenses for certain technologies where such licenses are necessary or advantageous, some of which require royalty payments. In addition, Gateway has entered into patent licenses and cross-licenses to obtain access to other technology, and licenses its own patents to others in return for royalty payments. Trade secrets developed by Gateway are protected through formal procedures that include employee agreements and confidentiality agreements with other entities.
Gateway owns and uses a number of trademarks on or in connection with its products and services, including Gateway, Your:)Ware, the “BLACK AND WHITE SPOT” design, the Gateway Stylized Logo, Gateway Country, gateway.net, Solo, and “You’ve Got a Friend in the Business”, among others. Many of these trademarks are registered in the United States and other countries, and numerous trademark applications are pending in the United States and other countries. Gateway believes the GATEWAY and the famous “BLACK AND WHITE SPOT” design trademarks have strong brand name recognition in the United States marketplace and in many countries throughout the world.
Because software used on Company-manufactured PCs generally is not owned by the Company, Gateway has entered into software licensing arrangements with a number of software developers, including Microsoft Corporation. For example, Gateway has licenses with Microsoft Corporation for Windows XP, Windows ME, Windows 2000, Windows NT, Windows 98 and Microsoft Office software products, among others. Software and materials developed by Gateway are protected by copyright in the United States and internationally.
Competition
The PC industry is highly competitive, especially with respect to pricing and the introduction of new products and product features. Gateway competes primarily by adding new performance features to products while minimizing corresponding price increases. Gateway believes its direct sales model, dedicated retail stores, customer service and support, and sales offering of technology solutions are additional competitive advantages.
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Competitive factors in Gateway’s markets include price, availability of new technology, variety of products and features offered, availability of products and software, marketing and sales capability, and service and support. Gateway believes it competes favorably with respect to these factors.
Gateway seeks to achieve a low-cost operating structure to offer products at competitive prices. In addition to the cost advantages of marketing and selling its products directly to its customers, Gateway endeavors to minimize overhead expenses. During the first three quarters of 2001, Gateway operated manufacturing facilities in South Dakota, Virginia, Utah, Ireland and Malaysia, locations with relatively low costs associated with facilities, work forces, transportation and taxes. To further reduce costs, Gateway subsequently closed its manufacturing facility in Utah and its manufacturing facilities in Ireland and Malaysia in connection with the discontinuance of its international operations. Gateway’s in-house engineering personnel work closely with component suppliers in developing and implementing new technology, reducing the investment usually associated with a traditional, in-house research and development group.
Gateway’s results of operations, however, could be adversely affected if it is not able to introduce new products or product features as quickly as its competitors or if its competitors offer products with comparable features at lower prices. In recent years, Gateway and many of its competitors have regularly lowered prices, and Gateway expects these pricing pressures to continue. In particular, softness in the PC market in late 2000 and in 2001 has led a number of Gateway’s competitors to aggressively cut pricing to spur sales and gain market share. The Company adopted a more aggressive pricing and marketing strategy in its core PC business at the beginning of 2002 to address the competitive environment.
International Operations
During the third quarter of 2001, the Company discontinued its company-owned international operations outside of North America in order to focus on its core U.S. consumer and business operations. During 2001, international net sales accounted for 9% of total Company net sales, a decline from 14.2% net sales in 2000. Prior to the Company’s exit from its overseas markets, Gateway had operated in Europe, the Middle East and Africa since opening a sales, service and production facility in Dublin, Ireland through Gateway Ireland Ltd. in 1993, and in the Asia Pacific region since establishing operations in Japan in 1995. In connection with this decision, Gateway terminated manufacturing operations in Dublin, Ireland, and Malacca, Malaysia. Gateway has entered into contracts with third-party service providers to provide technical support and customer service to its customers outside of North America.
In 1999, Gateway entered the Canadian market with product, service and support offerings for Canadian business, government and education customers. During 2000, Gateway expanded its presence in Canada with the opening of retail stores to sell products and services to small businesses and consumers. Although the Company closed its stores in Canada in 2001, it continues to actively market and sell products and services in Canada directly via telephone, Internet and through a local reseller.
Employees
As of December 31, 2001, Gateway had approximately 14,000 employees in the United States. In January 2002, the Company announced a workforce reduction to reduce the number of employees in the United States to approximately 11,500. Gateway believes its employee relations are generally good.
Backlog
Gateway’s backlog of unfilled orders was approximately $55 million at year end 2001 and approximately $70 million at year end 2000. The Company does not believe that backlog is a meaningful indicator of sales that can be expected for any period, and there can be no assurance that the backlog at any point in time will translate into sales in any subsequent period, particularly in light of the Company’s policy of allowing customers to cancel or reschedule orders under certain circumstances.
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Seasonality
Gateway’s operating results have been subject to seasonality and to quarterly and annual fluctuations. Factors involved include new product developments or introductions, availability of components, changes in product mix and pricing and product reviews and other media coverage. Historically, Gateway’s sales have increased in the third and fourth quarters due, in part, to back-to-school and holiday spending; however, in the fourth quarter of 2000 and the third and fourth quarters of 2001 sales did not follow the historical trend in light of adverse general economic and industry trends and, in the case of the fourth quarter of 2001, the Company’s focus on increasing margins rather than unit sales at the lower-end of the market.
Factors That May Affect Gateway’s Business and Future Results
The statements contained in this report contain a number of forward-looking statements based on current management expectations. In addition to other information contained in this report, the following factors could affect the Company’s future business, results of operations, cash flows or financial position, and could cause future results to differ materially from those expressed in any of the forward-looking statements in this Report.
The PC Market and General Economic and Business Conditions. Gateway’s revenue growth and profitability depend significantly on the overall demand for personal computers and related products and services. Since late 2000, general demand for computers and computer-related products has declined as a result of market maturation and declining economic conditions. This has adversely impacted demand for Gateway’s products and services. If general economic and industry conditions fail to improve or continue to deteriorate, demand for the Company’s products could be adversely affected, as could the financial health of the Company’s suppliers and resellers. In addition, the terrorist attacks that took place on September 11, 2001 have intensified the economic and political uncertainties that affect the global economy and the Company’s operating results and financial condition. During the weeks immediately following the September 11, 2001 attacks, the Company experienced a drop in demand across all markets and products. Future terrorist attacks, national and international responses to terrorist attacks, and other acts of war or hostility could materially adversely affect the Company. Continued uncertainty about future economic conditions has also made it increasingly difficult to forecast future operating results.
Competitive Market Conditions. The Company has encountered increasingly aggressive competition in its industry with numerous competitors vying for market share. Competition is driven in large part by price and availability of new technology and products. A number of the Company’s competitors have aggressively cut prices to spur sales and gain market share in light of recent softness in the PC industry, particularly in the fourth quarter of 2001. The Company believes it can counter these competitive forces by reacting more quickly to expected and perceived customer product requirements and desires, aggressively reducing its own prices, and by maintaining relationships with its suppliers to bring products quickly to market. There can, however, be no assurance that this strategy will be successful in an ever-changing marketplace. In addition, while the Company expects the industry trend of declining average unit prices for PCs to continue, Gateway has mitigated the impact of falling prices and changes in product mix by continuing to diversify its revenue stream with new products, software bundles, Internet services, financing and other service and support offerings. However, if lower PC prices are not offset in the future by increased sales volume or sales of higher-priced PC’s or other products and services or by reduced costs, Gateway’s profitability could be adversely impacted.
Corporate Restructuring and Infrastructure Requirements. In 2001, the Company embarked on an aggressive cost reduction strategy that significantly decreased the size of the Company’s infrastructure as well as on a strategy to transform the Company from a traditional manufacturer of PCs to a leading provider of personalized digital technology solutions. In particular, during the first and third quarters of 2001, the Company approved restructuring plans to, inter alia, reduce its workforce, close certain retail locations, consolidate facilities, redefine its information technology strategy, discontinue substantially all consumer lending activities, and exit certain other activities, including its Company-owned international operations which accounted for 9% of total Company net sales in 2001. In addition, the Company curtailed its retail expansion plans in 2001, closed a number of retail stores, and exited certain indirect sales activities. In the first quarter of 2002, the Company continued its cost reduction strategy with an additional announced workforce reduction and further site closures.
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The Company plans to transform itself into a leading provider of personalized digital technology solutions by better leveraging its existing retail footprint, its brand and its beyond-the-box products and services. There can be no assurance that the Company’s strategy of focusing on its core domestic markets, reducing costs and increasing sales of non-PC products and services will be successful in the event of sustained adverse economic industry conditions. Moreover, the Company’s business creates ongoing demands for personnel, facilities, information and internal control systems and other infrastructure requirements. If the Company is unable to maintain and develop its infrastructure while reducing costs, it could experience disruptions in operations, which could have an adverse financial impact.
Suppliers. Gateway requires a high volume of quality components for its products and solutions offerings, substantially all of which it obtains from outside suppliers. While Gateway attempts to have multiple suppliers for such components, in some circumstances it maintains single-source supplier relationships which may in part be due to the lack of alternative sources of supply. If the supply of a key material component is delayed or curtailed, Gateway’s ability to ship the related product or solution in desired quantities and in a timely manner could be adversely affected. In cases where alternative sources of supply are available, qualification of the sources and establishment of reliable supplies could result in delays and possible reduction in net sales. In the event that the financial condition of Gateway’s third-party suppliers for key components were to erode, the delay or curtailment of deliveries of key material components could occur. Additionally, Gateway’s reliance on third-party suppliers of key material components exposes the Company to potential product quality issues that could affect the reliability and performance of its products and solutions. Any lesser ability to ship its products and solutions in desired quantities and in a timely manner due to a delay or curtailment of the supply of material components, or product quality issues arising from faulty components manufactured by third-party suppliers, could adversely affect the market for its products or solutions and lead to a reduction in the Company’s net sales. In those instances where the Company relies on offshore suppliers, including for product assembly and manufacture, risks associated with transportation and other natural or human factors may disrupt the flow of product.
Product Cycles. Short product life cycles resulting from rapid changes in technology and consumer preferences and declining product prices characterize the PC industry. Gateway’s internal engineering personnel work closely with PC component suppliers and other technology developers to evaluate the latest developments in PC-related technology. However, Gateway may not have access to or the right to use new technology or may be unable to incorporate such new technology in its products or features in a timely manner. The increasing reliance on the Internet is creating new dynamics in the computer industry, causing an emphasis on speed and connectivity rather than stand-alone computing power. As a new generation of Internet devices and gaming devices is introduced, sales of traditional desktop and other personal computers may be increasingly impacted and Gateway’s products will be subject to competition from consumer electronics companies, telecommunications companies and other major consumer competitors.
Access to Technology. There can be no assurance that Gateway will continue to have access to existing or new third-party technology for use in its products. If Gateway or its suppliers are unable to obtain licenses necessary to use protected technology in Gateway’s products on commercially reasonable terms, Gateway may be forced to market products without certain desirable technological features. Gateway could also incur substantial costs to redesign its products around other parties’ protected technology or to defend patent or copyright infringement actions against Gateway.
E-Commerce. Gateway has developed its e-commerce business in part through investment in existing companies and continued expansion of its e-commerce site offering Gateway™ branded products as well as complementary products from other manufacturers. E-commerce is still a relatively new and emerging distribution channel whose success is dependent on a variety of factors, including its continued acceptance by consumers. Gateway’s success using e-commerce depends on such factors as the satisfactory performance, reliability and availability of Gateway’s web site; the reliability and efficiency of its computer and communications hardware systems; its ability to compete with a growing number of rival e-commerce sites; its ability to evolve, update and improve its services and offerings in response to changing demands; and the consumer demand for its products. Expansion in this area has involved investment in start-up activities and initial operating losses in this portion of Gateway’s business.
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Risks of Minority Investments. Gateway holds and may consider additional minority investments in companies having operations or technology in areas within or adjacent to Gateway’s strategic focus. Many of these investments have been in early stage companies, investment funds or Internet or e-commerce companies where operations are not yet sufficient to establish them as profitable concerns. Certain of these investments are in publicly traded companies whose share prices are highly volatile. Adverse changes in market conditions such as occurred in late 2000 and in 2001, and poor operating results of certain of these underlying investments have resulted and may in the future result in Gateway incurring losses or an inability to recover the original carrying value of its investment.
Risks of Acquisitions, Joint Ventures and Strategic Alliances. Gateway has entered into certain strategic alliances, acquired certain businesses that it believes are complementary to its operations and anticipates making possible acquisitions and entering into possible joint ventures in the future. While Gateway believes it will effectively integrate such businesses, joint ventures, or strategic alliances with its own, Gateway may be unable to successfully do so without losing key employees or business relationships. After incurring substantial costs to launch a retail presence relationship with OfficeMax, Inc., in July 2001 Gateway terminated this retail relationship in accordance with its terms, in part, due to lower than anticipated sales arising from the relationship. In addition, in the case of acquisitions, Gateway may be unable to smoothly integrate the acquired companies’ marketing, production, development, distribution and management systems resulting in the Company’s inability to realize hoped for cost savings and/or sales growth. Gateway’s operating results could be adversely affected by any problems arising during or from such process or the inability to effectively integrate any current or future acquisitions.
Inventory Risks. By distributing directly to its customers, Gateway has been able to avoid the need to maintain high levels of finished goods inventory. This has minimized costs and allows Gateway to respond more quickly to changing customer demands, reducing its exposure to the risk of product obsolescence. A decrease in market demand or an increase in supply, among other factors, could result in higher component inventory levels which could have a negative effect on Gateway’s results of operations.
Customer or Geographic Sales Mix. Gateway’s results of operations differ depending on the product sold, the customer segment and the geographic market involved. As a result, Gateway’s profitability in any fiscal period will depend, in part, on the corresponding mix of customers, products and geographic markets. In the third quarter of 2001, Gateway exited substantially all of its Company-owned international operations.
Item 2. Properties
Gateway occupies leased space of approximately 125,000 square feet in Poway, California for its corporate headquarters, along with approximately 11,000 square feet of storage space. The Company owns space in North Sioux City, South Dakota housing a production facility, customer sales and support center, training center, administration and warehouse space totaling 857,000 square feet of space. The Company also leases facilities in North Sioux City used for customer pick-up, manufacturing and warehouse space.
Gateway owns two facilities with a total of 213,000 square feet of space in Sioux Falls, South Dakota that serve as a base for the sale and fulfillment of orders for add-on PC components, the receipt of returned merchandise and the fulfillment of orders for customer replacement parts. The Company also leases space in Sioux Falls and Lake Forest, California for administrative, remanufacturing and warehouse operations. Gateway owns a facility in Kansas City, Missouri housing a customer sales and support center, and leases space in Lakewood, Colorado for an Information Technology and Support Center, and leases facilities in Hampton, Virginia for manufacturing, customer support, sales, warehouse space, and office space.
As of January 31, 2002 Gateway leases store space for its 277 retail locations throughout the United States and is actively seeking to dispose of leases in approximately 40 locations where Gateway has closed stores.
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Gateway owns a 411,000 square foot facility in Hampton, Virginia that formerly housed manufacturing, customer support, sales, warehouse and office space, a 271,000 square foot facility in Salt Lake City, Utah that formerly housed manufacturing operations, and facilities in Rio Rancho, New Mexico and Colorado Springs, Colorado that formerly housed customer support centers, each of which is being actively marketed for sale. The Company continues to be subject to leases for warehouse, office and distribution facilities in San Diego, Salt Lake City and Lake Forest that are being actively marketed for sublease. Gateway leases space in Lake Forest, California for its business operations, and has a vacant manufacturing building and vacant office buildings in Lake Forest which are being actively marketed for sublease.
The Company exited substantially all of its company-owned international operations outside of North America in 2001, and currently owns a facility in Dublin, Ireland, its former European headquarters, which it plans to sell. The Company has exited substantially all of its European leases, and expects its remaining lease obligations to be settled in 2002. In Asia-Pacific, the Company is in the process of completing the sale of its former manufacturing facility in Malacca, Malaysia, and has exited all of its leases in the region.
Management believes that Gateway’s office, manufacturing, and retail store space will be adequate for its business needs in the foreseeable future.
Item 3. Legal Proceedings
Gateway is a party to various lawsuits and administrative proceedings that arise in the ordinary course of its business. Gateway evaluates such lawsuits and proceedings on a case by case basis, and its policy is to vigorously contest any such claims which it believes are without merit. Gateway’s management believes that the ultimate resolution of any such pending matter will not materially and adversely affect Gateway’s consolidated financial position, operating results or cash flows.
On December 7, 2000, James Burton (“Burton”) filed a purported class action complaint against Gateway, one of its former officers, and one director, in the United States District Court for the Southern District of California for alleged violation of federal securities laws. Since December 2000, six similar cases have been filed in the same court by other plaintiffs. The complaints were amended to allege among other things that the defendants misrepresented Gateway’s financial performance in securities filings and in statements to the public, and purport to be class actions on behalf of purchasers of Gateway’s stock between April 14, 2000 and February 28, 2001 (the “class period”). The complaints seek damages and attorneys’ fees. On December 18, 2000, the Court entered an Order directing counsel for the lead plaintiffs to file a single consolidated complaint within 60 days after the Court’s designation of a “lead plaintiff.” On April 23, 2001, plaintiffs’ counsel filed a Revised Motion to Appoint Perry Capital and Teachers’ Retirement System of Louisiana as Lead Plaintiff and to Approve Plaintiffs’ Choice of Lead Counsel, and this motion was granted by the Court on May 18, 2001. On July 16, 2001, the lead plaintiff filed a consolidated complaint alleging violations of the federal securities laws for the class period against Gateway and two former officers. On September 13, 2001, defendants filed a motion to dismiss. On February 1, 2002, the court entered an order granting defendants’ motion to dismiss, but has allowed the plaintiffs to file an amended complaint within 60 days.
On March 27, 2001, Bruce Eubank (“Eubank”) filed a shareholder derivative suit on behalf of Gateway against its Board of Directors and two of Gateway’s former officers in the Superior Court of the State of California, County of San Diego. The Eubank complaint alleges among other things that the defendants breached their fiduciary duties to Gateway and wasted corporate assets and seeks compensatory and punitive damages, an accounting, injunctive relief, and attorney’s fees. On May 15, 2001, Jacob Scheinhartz (“Scheinhartz”) filed a similar derivative suit in the United States District Court for the Southern District of California. The Company has filed motions seeking dismissal of the Eubank lawsuit. Both of these derivative lawsuits have been voluntarily stayed pending motions to dismiss the consolidated federal class actions.
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The Company’s obligation to indemnify its officers and directors under the aforementioned lawsuits is insured, to the extent of the limits of the applicable insurance policies, subject to potential reservations of rights. The Company intends to vigorously defend these actions, and believes that in the event that it is not fully successful, insurance coverage should be available to defray a portion, or substantially all, of the expense of defending and settling the lawsuits or paying a judgment. However, the Company is unable to predict the ultimate outcome of the litigation. There can be no assurance the Company will be successful in defending the lawsuits or that if unsuccessful, that insurance will be available to pay all or any portion of the expense of the lawsuits. The Company’s consolidated financial statements do not include any adjustments related to these matters.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
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PART II
| Item 5. | Market for Registrant’s Common Equity and Related Stockholder Matters |
Market Information
Gateway common stock is quoted on the New York Stock Exchange under the trading symbol “GTW”. The following table sets forth the quarterly high and low price per share for the Common Stock as quoted at the close of trading on such date in 2001 and 2000:
| High | Low | ||||
| 2001: | |||||
| 1st quarter | $23.69 | $14.86 | |||
| 2nd quarter | $19.50 | $14.65 | |||
| 3rd quarter | $15.95 | $5.45 | |||
| 4th quarter | $10.22 | $4.65 | |||
| 2000: | |||||
| 1st quarter | $73.00 | $53.31 | |||
| 2nd quarter | $61.31 | $46.81 | |||
| 3rd quarter | $70.94 | $48.25 | |||
| 4th quarter | $56.98 | $16.82 |
Holders of Record
As of January 30, 2002, there were 4,681 holders of record of the Common Stock. There were no issued and outstanding shares of the Class A Common Stock as of such date.
Dividends
Gateway management believes the best use of retained earnings is to fund internal growth and for general corporate purposes. As a result, Gateway has not declared any cash dividends on Common Stock since it was first publicly registered and does not anticipate paying any cash dividends on Common Stock in the foreseeable future.
Gateway is obligated to pay dividends on its Series A Convertible Preferred Stock (“Series A Preferred Stock”) at the annual rate of 2.92%, payable quarterly, and on its Series C Redeemable Convertible Preferred Stock (“Series C Preferred Stock”) at the annual rate of 1.5%, payable semi-annually. The Company is precluded from declaring or paying Common Stock dividends unless all such dividends have been paid in full on Series A Preferred Stock and Series C Preferred Stock.
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| Item 6. | Selected Consolidated Financial Data |
The following historical data were derived from the Company’s consolidated financial statements, which have been audited by PricewaterhouseCoopers LLP, independent accountants. This financial data should be read in conjunction with the consolidated financial statements and notes thereto beginning on page 28 of this Report and in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 16 of this Report. The information below is not necessarily indicative of the results of future operations.
| 2001 | 2000 | 1999 | 1998 | 1997 | ||||||||||||
| (in thousands, except per share data) | ||||||||||||||||
| Consolidated Statements of Operations Data: |
||||||||||||||||
| Net sales | $ | 6,079,524 | $ | 9,600,600 | $ | 8,964,900 | $ | 7,703,279 | $ | 6,460,530 | ||||||
| Net income (loss) | $ | (1,033,915 | ) | $ | 241,483 | $ | 427,944 | $ | 346,399 | $ | 109,797 | |||||
| Net income (loss) per share: | ||||||||||||||||
| Basic | $ | (3.20 | ) | $ | 0.75 | $ | 1.36 | $ | 1.11 | $ | 0.36 | |||||
| Diluted | $ | (3.20 | ) | $ | 0.73 | $ | 1.32 | $ | 1.09 | $ | 0.35 | |||||
| Consolidated Balance Sheet Data: | ||||||||||||||||
| Total assets | $ | 2,986,857 | $ | 4,180,645 | $ | 3,954,688 | $ | 2,890,380 | $ | 2,039,271 | ||||||
| Long-term obligations, net of current maturities | $ | - | $ | 2,548 | $ | 2,998 | $ | 3,360 | $ | 7,240 | ||||||
| Series C redeemable convertible preferred stock |
$ | 193,109 | $ | — | $ | — | $ | — | $ | — | ||||||
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| Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion should be read in conjunction with the Consolidated Financial Statements and the related notes that appear elsewhere in this document.
This Report includes forward-looking statements made based on current management expectations pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future performance and actual outcomes may differ materially from what is expressed or forecasted. Factors that could cause future results to differ from the Company’s expectations include the factors described on page 2 of this Report under “Forward-Looking Statements” as well as under “Business – Factors that May Affect Gateway’s Business and Future Results” beginning on page 9 of this Report.
During the fourth quarter of 2000, the Company adopted Securities and Exchange Commission Staff Accounting Bulletin No. 101 (SAB 101), “Revenue Recognition in Financial Statements.” As a result, the Company changed its revenue recognition policy retroactive to January 1, 2000 to recognize revenue upon delivery rather than shipment of products. The cumulative effect of this accounting change was $11.9 million, net of tax in 2000. The pro forma impact of this accounting change on prior periods is not material.
Overview
During 2001, Gateway experienced a significant period of transition. In early 2001, management undertook a strategic review of its business and established the following objectives for the year: simplify the business, reduce the cost structure and return to a path to long-term sustainable profitability. In connection with these objectives, the Company discontinued certain unprofitable revenue streams beginning in the second quarter of 2001 of approximately $200 million quarterly, exited its international company-owned operations in the third quarter and took significant restructuring and other actions, which served to reduce costs and align its operation with its digital technology solutions provider strategy resulting in charges in 2001 totaling $1.1 billion. See Note 15 to the Consolidated Financial Statements included herein for further information. The Company has most recently announced that in furtherance of its cost reduction efforts and alignment of its operations with this strategy, it expects to incur a special charge of between $75 and $100 million in the first quarter of 2002, related to the closure of select Company sites and other restructuring actions, including reductions in staffing.
Outlook
The Company intends to regain sales momentum by investing in its core PC business through the adoption of a more aggressive pricing and marketing strategy in 2002. At the same time, the Company intends to continue to develop and refine its digital technology solutions business as a complement to the more aggressive PC pricing strategy. Based on this strategy, the Company expects to experience a pre-tax loss, before special charges, for the next few quarters while it prices aggressively to regain market share in its core PC business. Notwithstanding the expected loss, the Company believes it will exit 2002 with at least $1.0 billion in cash and marketable securities. This expectation is based on, among other things, a planned reduction of capital expenditures in 2002 to approximately $100 million, the collection of income tax refunds of more than $200 million, the Company’s reduced cost structure resulting from the restructuring activities of 2001 and early 2002 and the net cash outflows associated with restructuring activities. Actual results may vary depending on the Company’s results of operations.
Critical Accounting Policies and Estimates
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses Gateway’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgements, including those related to customer incentives, product returns, bad debts, inventories, investments, intangible assets, income taxes, financing operations, warranty obligations, restructuring costs, retirement benefits, and contingencies and litigation. Management bases its estimates and judgements on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgements about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
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Management believes the following critical accounting policies, among others, affect its more significant judgements and estimates used in the preparation of its consolidated financial statements. Gateway records estimated reductions to revenue for customer incentive offerings. Should a greater proportion of customers redeem incentives than estimated by the Company, additional reductions to revenue may be required. Gateway maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of Gateway’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Gateway provides for the estimated cost of product warranties at the time revenue is recognized. While Gateway engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its component suppliers, Gateway’s warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from Gateway’s estimates, revisions to the estimated warranty liability may be required. Gateway writes down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Gateway holds minority interests in companies having operations or technology in areas within or adjacent to its strategic focus, some of which are in publicly traded companies whose share prices are highly volatile and some of which are in non-publicly traded companies whose value is difficult to determine. Gateway records an investment impairment charge when it believes an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investments that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future. Gateway records a valuation allowance to reduce its deferred tax assets to the amount that it believes is more likely than not to be realized. While Gateway has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event Gateway were to determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. Likewise, should Gateway determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax assets would increase income in the period such determination was made.
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Results of Operations
The following table sets forth, for the periods indicated, certain data derived from the Company’s consolidated income statements (dollars in thousands):
| Increase | Increase | |||||||||||||||
| 2001 | (Decrease) | 2000 | (Decrease) | 1999 | ||||||||||||
| Net sales | $ | 6,079,524 | (37 | %) | $ | 9,600,600 | 7 | % | $ | 8,964,900 | ||||||
| Gross profit | $ | 838,192 | (59 | %) | $ | 2,058,994 | 12 | % | $ | 1,837,222 | ||||||
| Percentage of net sales | 13.8 | % | 21.4 | % | 20.5 | % | ||||||||||
| Selling, general and administrative expenses |
$ | 2,022,122 | 31 | % | $ | 1,547,701 | 25 | % | $ | 1,241,552 | ||||||
| Percentage of net sales | 33.3 | % | 16.1 | % | 13.8 | % | ||||||||||
| Operating income (loss) | $ | (1,183,930 | ) | $ | 511,293 | (14 | %) | $ | 595,670 | |||||||
| Percentage of net sales | (19.5 | %) | 5.3 | % | 6.6 | % | ||||||||||
| Net income (loss) | $ | (1,033,915 | ) | $ | 241,483 | (44 | %) | $ | 427,944 | |||||||
Net Sales
2001 vs. 2000
Gateway’s net sales declined 37% in 2001 from 2000. The Company shipped approximately 3.6 million systems in 2001 compared to 5.0 million systems in 2000, representing a decrease of 28%. Domestic net sales decreased 33% in 2001 from 2000.
The following table summarizes the Company’s net sales for the periods indicated by geographic region (dollars in thousands):
| Increase | ||||||||||||||||
| 2001 | Decrease | 2000 | (Decrease) | 1999 | ||||||||||||
| Net sales: | ||||||||||||||||
| U.S. Consumer | $ | 3,097,375 | (43 | %) | $ | 5,401,016 | 16 | % | $ | 4,660,936 | ||||||
| U.S. Business | 2,430,815 | (14 | %) | 2,836,967 | (6 | %) | 3,020,209 | |||||||||
| Total U.S. | $ | 5,528,190 | (33 | %) | $ | 8,237,983 | 7 | % | $ | 7,681,145 | ||||||
| EMEA | 229,026 | (61 | %) | 586,361 | 5 | % | 556,100 | |||||||||
| Asia Pacific | 322,308 | (58 | %) | 776,256 | 7 | % | 727,655 | |||||||||
| Consolidated | $ | 6,079,524 | (37 | %) | $ | 9,600,600 | 7 | % | $ | 8,964,900 | ||||||
The Company’s net sales were adversely impacted by approximately $200 million per quarter related to a number of strategic actions taken beginning in the second quarter of 2001 to discontinue certain non-profitable revenue streams which included, among other things, the closure of certain retail locations, restructuring international markets, discontinuing lower quality consumer lending, modifying its ISP business model, and exiting certain indirect sales activities. During the third quarter of 2001, the Company exited substantially all of its Company-owned international operations. International net sales were 9% of total Company net sales in 2001.
In the United States, the consumer and business segments represented 51% and 40%, respectively, of total Company net sales in 2001, and with the exit from substantially all of its Company-owned international operations, will represent all of net sales in 2002. In the United States, consumer segment net sales and unit shipments declined 43% and 36%, respectively, in 2001 from 2000. Excluding the impact of the strategic actions mentioned above, domestic consumer net sales declined approximately 34% during 2001 from 2000. The Company continued to experience a decline in consumer demand for PC and PC-related products and services in 2001, which is a continuing trend from the last quarter of 2000. In addition, the Company experienced a significant reduction in demand immediately following the terrorist attacks that took place on September 11, 2001, which had an adverse impact on net sales for the third and fourth quarters of 2001. Management expects that the weak consumer demand in the United States will continue through at least the remainder of 2002, and will continue to result in intensified pricing pressure in the industry. In the business segment in the United States, net sales and unit shipments declined by 14% and 3%, respectively, in 2001 from 2000. The business segment experienced continued growth during 2001 in unit shipments to small and medium business, posting a 4% increase over 2000, while unit shipments to education customers were up slightly over 2000.
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Digital Technology Solutions and Digital Services accounted for $1.2 billion in 2001, or 19% of net sales, compared to $1.9 billion in 2000, or 20% of net sales. Digital Technology Solutions, previously referred to as beyond-the-box revenue including Digital Infrastructure, consists of Internet access and financing solutions, Digital Solutions, consisting of software and peripherals that are common elements of Gateway’s Your:)ware bundles, and Digital Services, consists of extended warranties, learning or training and installation offerings.
In 2001, $726 million of beyond-the-box revenue was sold at the point of sale and $433 million was sold after the point of sale. The decline in beyond-the-box revenue on a year-over-year basis is primarily attributable to the decline in unit shipments as well as the Company’s decision to discontinue certain non-profitable revenue streams mentioned above. During the first quarter of 2001, the Company modified its strategic alliance with America Online, Inc. (AOL) whereby it will convert existing gateway.net customers to the AOL-branded Internet access in order to improve the customer experience and the economic return to the Company for such subscribers. In addition, the Company began to participate earlier in a greater share of recurring income on new prepaid ISP subscribers rather than earning a higher fee for re-selling prepaid ISP subscriptions at the point of sale and participating in the recurring income stream at a later date. The change in the strategic alliance has resulted in the Company reporting substantially less revenue from ISP at the point of sale. This change has the effect of negatively impacting average selling price, as well as the sales mix percentage of beyond-the-box revenue while favorably impacting the gross profit percentage of beyond-the-box items.
As part of the strategic reviews of the Company’s direct sales policy and in response to the decline in consumer demand, the Company curtailed retail expansion plans in 2001 and closed a number of retail locations. The Company exited 2001 with 296 Gateway stores in the United States as compared to 327 at the end of 2000, and no store-within-a-store locations as compared to 463 at the end of 2000. As of January 31, 2002, the Company had 277 stores in the United States.
Average selling price (ASP), which includes PC and non-PC products and services sold at the point of sale per unit, was $1,527 in the fourth quarter of 2001, up from $1,460 in the third quarter of 2001. This increase is significantly better than the earlier 2001 sequential quarterly declines experienced by the Company which is due, in large part, to a richer system mix and lower discounting in the fourth quarter of 2001. The Company did not report ASP prior to 2001.
Average unit price (AUP) was $1,690 compared to $1,911 in 2000, a decrease of 12%. The Company experienced an aggressive pricing environment triggered by some large competitors beginning in the fourth quarter of 2000, which resulted in AUP declines in the consumer segment. Management expects that the pricing environment will continue to be challenging for 2002.
2000 vs. 1999
Gateway’s net sales growth was 7% in 2000 over 1999. The Company shipped approximately 5.0 million systems in 2000 compared to 4.7 million systems in 1999, representing an increase of 7%. Domestic and international sales grew 7% and 6%, respectively, in 2000 over 1999.
In the United States, the consumer and business segments represented 56% and 30%, respectively, of total Company sales in 2000. Consumer segment net sales and unit shipments grew 16% and 12%, respectively, in 2000 over 1999. Consumer net sales were strong the first three quarters of 2000 driven by new marketing initiatives, continued retail expansion and sales of beyond-the-box products and services in addition to PCs. In the fourth quarter, the consumer segment experienced a decline in both net sales and unit shipments of 1% and 9%, respectively, compared to the fourth quarter of 1999 due to a substantial decline in consumer demand for PC and PC-related products and services.
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Beyond-the-box revenue including software and peripheral sales, Internet access and portal income, financing, extended warranty and training revenue accounted for $1.9 billion in 2000 sales compared to $800 million in 1999, or an increase of 150%. Beyond-the-box revenue in 2000 was driven in part by an expansion in Internet access and portal income through the alliance with AOL and successful delivery of training programs in the store channel as well as on the Internet.
In connection with its continued retail expansion in the United States, the Company opened 93 retail stores in 2000 versus 83 in 1999, as well as 463 store-within-a-store locations as part of a strategic alliance with a retail partner.
The business segment experienced a decline in net sales of 6% and unit shipments by 4% in 2000 over 1999. The segment was reorganized in the second half of 2000 in light of its declining performance to focus on small and medium businesses, government and education sectors, and this reorganization and related initiatives led to double-digit business sales gains at the store level in the fourth quarter of 2000.
Average unit price (AUP) was essentially flat in 2000 compared to 1999. The continued diversification of the Company’s revenue stream through beyond-the-box initiatives offset declining PC prices overall in 2000. The Company experienced an aggressive pricing environment triggered by some large competitors in the fourth quarter of 2000, which resulted in AUP declines in the consumer segment during the quarter.
During 2000, Europe, Middle East and Africa (“EMEA”) net sales and units increased 5% and 21%, respectively, over 1999. The Asia Pacific region net sales increased 7% and units 17% in 2000 over 1999. These increases were principally due to expansion of the number of store-within-a-store outlets.
Gross profit
2001 vs. 2000
Gross profit in 2001 declined to $0.8 billion, a decrease of approximately 59% from 2000. As a percentage of sales, gross profit for 2001 decreased to 13.8% from 21.4% in 2000. The decline in 2001 is due in large part to the losses experienced in the first quarter of 2001 on the Company’s consumer financing portfolio and the costs associated with restructuring decisions during the third quarter of 2001 which included, among other things, the exit of substantially all of its Company-owned international operations and the closure and consolidation of manufacturing facilities, and increased pricing pressures throughout 2001.
The Company’s consumer financing operations are reported as net sales in the case of interest and fee income and cost of goods sold in the case of service fees and finance receivable losses. On February 16, 2001, the Company sold approximately $500 million of finance receivables, consisting of higher rated credits, to its loan-servicing partner at book value. Later in the first quarter of 2001, the Company’s remaining consumer financing operations experienced an increase to the provision for loan losses on financing receivables, resulting in a $75 million operating loss. In addition, while continuing to provide customer financing, the Company made the decision to sell the substantial balance of its remaining portfolio. As a result of that decision, the Company recorded an additional charge of $100 million in the first quarter of 2001 to reduce the carrying value of those receivables to their estimated net realizable value. See Other Income (loss), net below for discussion of other impacts from the consumer loan portfolio. Excluding the effects of the consumer financing portfolio on gross profit and the restructuring costs and other special charges of $116 million and $51 million, in 2001 and 2000, respectively, gross profit was $1.13 billion in 2001, or 18.6% of net sales, compared to $2.1 billion or 22% of net sales in 2000. Excluding the effects of the consumer financing portfolio and restructuring costs, the year-over-year comparisons of gross profit percentage are impacted primarily by the competitive pricing environment noted above, the decision to accelerate the sale of international inventory, product line transition costs in connection with the Company’s move to a more simplified hardware product line, as well as additional costs associated with the consolidation and closure of three manufacturing facilities. For 2002, the Company has ceased new direct consumer financing activities, relying primarily on third-party partners.
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2000 vs. 1999
Gross profit in 2000 rose to $2.1 billion, an increase of approximately 12% from 1999. As a percentage of sales, gross profit for 2000 increased to 21.4% from 20.5% in 1999. Year-over-year improved margins were driven principally by the continued diversification of the revenue stream from the sale of non-PC services and products and active supplier management.
The Company’s gross finance receivables increased from $299 million at the end of 1999 to $779 million at December 31, 2000. The Company continually assesses the allowance for losses on a regular basis with corresponding adjustments made based upon management’s periodic review of historical experience, the nature and volume of the portfolio, adverse situations that may affect the customer’s ability to repay and general economic conditions. The Company significantly increased its allowance during the course of 2000 from $3.6 million at December 31, 1999 to $75 million at December 31, 2000 primarily due to the increased participation of the Company in finance receivables and the expansion of the consumer finance program to higher risk categories.
Selling, General and Administrative Expenses
2001 vs. 2000
Selling, general and administrative expenses (SG&A) totaled $2.0 billion in 2001 compared to $1.5 billion in 2000. During 2001, the Company approved restructuring plans which, among other things, have led to the closure of substantially all of its Company-owned international operations, reduction of its workforce, closure of certain store locations, consolidation of facilities, redefinition of its information technology strategy, and the exit from certain other activities. Pre-tax charges of $759 million were recorded to SG&A to provide for these actions and other related items. During 2000, the Company recorded special charges totaling $43 million, including the impairment of goodwill, severance costs and asset write-downs. See Note 15 to the Consolidated Financial Statements included herein for further information.
Excluding the restructuring and other special charges noted above, SG&A expense would have been $1.3 billion or 20.8% of net sales in 2001 compared to the $1.5 billion or 15.7% of net sales in 2000. This decline in SG&A expense in 2001 compared to 2000 is the result of a combination of the restructuring decisions made in 2001 and variable cost declines associated with lower sales volume, as well as other cost reduction efforts. The increase in SG&A as a percentage of net sales is due, primarily, to the de-leveraging of expenses during the time frame of significant revenue reductions as described above, and to incremental costs resulting from the execution of the Company’s restructuring plans in 2001.
In July 2001, the Company announced that it was accelerating the implementation of its strategy that involved transforming the Company from a traditional manufacturer of PCs to a leading provider of personalized technology solutions by better leveraging Gateway’s existing retail footprint, its brand position and its beyond-the-box solutions leadership. This acceleration consolidated the Company’s U.S. Consumer and Business operating units into one sales organization and included the formation of a new solutions group. As part of this shift, Gateway is turning its U.S. retail locations into local technology resource centers, serving as hubs for cross-functional sales, service and marketing teams that will provide customers with unparalleled personalization and local service and support. In August 2001, the Company announced plans to further align its operations and cost structure with this strategy including, among other things, the consolidation and closure of certain manufacturing and call center operations in the United States and the closure of substantially all of its Company-owned international operations.
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2000 vs. 1999
SG&A expenses totaled $1.5 billion in 2000 compared to $1.2 billion in 1999. In 2000, the Company continued to open retail stores, added sales personnel in other channels, experienced an increased depreciation charge due to the capitalization of systems infrastructure, and increased marketing in all segments. As a percentage of net sales, SG&A expenses were 16.1% in 2000, up from 13.8% in 1999.
Operating Income (Loss)
2001 vs. 2000
Operating loss for 2001 totaled $1.2 billion compared to operating income of $511.3 million in 2000. The operating loss in 2001 resulted prin