Gateway Incorporated is a major U.S. marketer of personal computers and related products and services, which targets both to consumers and businesses. Additionally, it is one of the top two manufacturers of consumer PCs in the United States. After a slowdown in the economy in 2000, Gateway had a 14 percent decline in year-end annual operating income and posted a $25 million operating loss in the fourth quarter of 2000. The strategic objectives of the new senior executive team and CEO (Ted Waitt) are to: (1) simplify Gateway’s business, (2) reduce the company’s cost structure, and (3) return to a path of long-term, sustainable profitability.
Their goal is to normalize business and operate at a level that will drive healthy shareholder returns through a sustainable long-term business model. Essentially, in order to increase profits and preserve market growth, Gateway must make critical decisions regarding the delivery of their products and services in a value-driven market. The firm’s key alternatives will examine whether or not to continue with the current business model-which includes expanded presence in OfficeMax stores and the cost effectiveness of the Gateway Country Stores-or whether to adopt a modified business model that balances the contributions of both traditional and electronic stores.
Personal computers are the largest sector of the computer hardware industry. The personal computer market experienced an average growth in worldwide PC shipments of more than 20 percent between 1991 and 1995 due to increased affordability and better performance. Then, after a 26 percent sales increase in 1995, annual growth trended downward to approximately 13 percent in 1998. In 1999, worldwide shipments increased 23 percent due in part to Internet-driven demand and customer interest in upgrades.
PC manufacturers have sought to offset declining gross profit margins due to lowered system prices by broadening their revenue stream beyond PCs, commonly called “beyond-the-box” revenues. These offerings including warranty service, product integration and installation services, Internet access, customer financing, consulting and training, and other products and services. These added services, historically, have generated gross margins two to three times higher than PC gross margins.
Because the PC industry generates a commodity-like product, it is expected that barriers to entry and exit would be low, potential entrants would be low, and the threat of substitute products would be high. Essentially, the PC market is designed to incorporate the elements of perfect competition, but has been guided by two or three leading firms that have differentiated themselves via value-added products and services. However, the elements of industry-achieved economies of scale, low start-up costs, and a buyer-controlled market make exit and entry into the market feasible for manufacturers and distributors. Further, research indicates that market positioning affects the pricing and profitability of PC manufacturers. In general, business clients tend to purchase higher-end PCs (in terms of pricing), which generate higher gross margins than those sold to individual consumers, who tend to purchase on a lower price point.
PC manufacturers recognize that their fundamental production-distribution business model also represents a potential source of differentiation and competitive advantage. Among industry leaders there are two main production and distribution business models: “build-to-stock/reseller,” and “build-to-order/sell direct”. The “build-to-stock/reseller” model involves the mass production of PCs for sale to and through a network of resellers to businesses and consumers. Resellers include value-added resellers, distributors, and retailers. Value added resellers (VARS) specialize in selling to a particular market segment and offer specialized services, such as complete PC hardware and software systems or special expertise in an application area.
The “build-to-order/sell direct” model involves the customized production of PCs to customer specifications and direct shipment to the buyer. The computer is not produced until the order has been placed. This pull marketing representation is a more economically efficient production and distribution model for PCs because it reduces idle inventory at the distribution centers. “Build-to-order/sell direct” also reduces the need to clear out overstock of less demanded equipment. Furthermore, selling direct eliminates retailer selling and general and administrative expenses, which increases PC prices. This style of purchasing is particularly appealing to more tech-savvy consumers who are knowledgeable of price differences among brands.
As more people gain access to the Internet, growth prospects of Internet sales of personal computers and technical products are expected to increase. Additionally, as technologically-innovative improvements are introduced to computers and media accessories, PC users will have a desire to capture such innovations that can satisfy their leisure, personal, and business needs. Key success factors in the PC industry align with those in other industries of perfect competition and commodity products. They include (1) maintaining competitive pricing, (2) aspiring to be the low cost producer, (3) and differentiating the value proposition of products and services.
Personal computers and “beyond-the-box products” offer a wide variety of styles, features, and custom configurations. However, the customer base is segmented into only two broad categories-consumers and businesses. Retail stores and the Internet account for the majority of sales in the United States and around the world. Business customers-including small, medium, and large companies, educational institutions, and government entities-buy more PCs than consumers (households and individuals).
In 1999, worldwide business computer purchases accounted for 70 percent of total PC shipments, falling only slightly from 1998 to 2000 and remaining at over 62% of total shipments. Similarly, in the United States, 66 percent of total PC shipments were to business clients, falling only slightly to 60% by 2000 and expected to increase again in 2001 to 64%. In 1998, the non-U.S. market had 73 percent of their shipments allocated to business customers and only 27 percent to individual consumers, rising closer to the other market averages by 2000 with 63% of shipments allocated to businesses and 37% to consumers (see details in Exhibit 1).
Higher consumer shipments in the United States are due to Americans generally having more disposable incomes, as disposable income levels across all markets generally motivate PC purchases. The variety of system configurations, “beyond-the-box” options, and accessories offered by PC manufacturers address unmet needs of consumers on a timely, technologically-innovated platform.
PCs represent the largest sector of the computer hardware industry in terms of both units sold and revenue. Of all the PC hardware revenues, desktop computers represent approximately 61 percent, notebooks and portable PCs account for 28 percent, and PC servers are about 11 percent. The U.S. is the largest single geographical PC market, representing 35 to 40 percent of worldwide PC unit volume.
The U.S. PC industry posted moderate unit volume gains for the year 2000. The U.S. had a 10 percent gain in unit sales in 2000, compared with a sales growth of 14.5 worldwide. The PC industry was hurt by a sluggish fourth quarter in 2000, when worldwide PC shipments increased just 10 percent and U.S. shipments increased only 6.4 percent. PC sales in the first quarter of 2001 continued the decline from the fourth quarter of 2000, and 2001 shipments are predicted to be 11 percent in the U.S. market, slightly below 2000 levels.
Additionally, the average system price for PCs decreased substantially between 1998 and 2000, falling from $1,877 in 1998 to $1,709 in 1999 (down 9 percent), and finally down to $1,609 in 2000 (down 9.5 percent). However, the largest price decline has been in desktops, where the average price fell 12 percent in 1999, 7 percent in 2000, and an expected 9.6 percent in 2001. As disposable incomes increase in the United States, PC purchases are expected to increase. Likewise, technological innovations steer the value-added options available to satisfy the needs of individual consumers and business clients.
Compaq, Dell, Hewlett-Packard and IBM are the four big competitors. These companies represent 38 percent PC shipment worldwide and 51.3 percent in U.S. market in 2000, while Gateway only account for 3.8 percent and 8.7 percent, respectively (see market share in details in Exhibit 2). Compaq is the biggest competitor in the worldwide market and Dell is the largest competitor in the U.S. market.
PC manufacturers compete on the basis of price, technology availability, performance, quality, reliability, service and support. It is important to find innovative ways to differentiate their products and their total offerings. In recent years, PC manufacturers increasingly emphasize on beyond-the-box offerings and adjusting their fundamental production-distribution business model. Each of the large manufacturers tends to focus on one of the two major models. Compaq, Hewlett-Packard and IBM employ the “build-to-stock/reseller” business model. Dell and Gateway use the “build-to-order/sell direct” business model.
Gateway and Dell both pioneered the “build-to-order/sell direct” model and have incorporated this model since 1980s. Dell began to distribute its PCs through retailers such as Wal-Mart, Staples, Sam’s Club and Best Buy stores in 16 states in 1990 through 1993. Start from 1995, however, they both recognized the potential of offering customers the ability to custom configure, order and pay for a PC via the Internet a s an integral part of their business model in 1995. They are virtually identical in terms of their sales and operating income as recently as 1996 (see the comparison in Exhibit 3.
Gateway and Dell began to differentiate themselves from 1997. Gateway broad its sell-direct initiative by adding company-owned and operated Gateway Country Store to its telephone and Internet sales practice and became the only PC manufacturer to do so. Dell put greater emphasis on its direct-sales, build-to-order business model during the same time period. There were significant differences between their sales and operating incomes since then (see Exhibit 3). As of 2000, Dell’s net revenue is $25,265 million, almost 5 times as that in 1996.
The operating income of Dell in 2000 is $2,300 million, account for 9.1% of its net sales and the dollar amount of operating income is more than 6 times as that in 1996. On the other hand, Gateway’s net revenue in 2000 is only $9601 million, and the operating income is only $509 million, which account for 5.3% of the net revenue (see details in Exhibit 4). Compare to 1996, Dell’s operating income increases 511%, while Gateway’s only increase 42%.
PC manufacturers compete on the basis of price, technology availability, performance, quality, reliability, service, and support. Barriers to entry in the computer sales market are high due to high initial capital investment in the computer sales market. There is already a glut in the market with well established companies such as industry leaders, Compaq and Dell. For many the PC is now considered a commodity, making it more challenging to offer a differentiated product. Hence, a potential new entrant into the market would need something distinctive to set their company apart and weather the initial investment.
Gateway, Inc. was founded in 1985 as a computer-parts distributor. However, by 2000, the firm had evolved into the second largest custom manufacturer and direct marketer of personal computers (PCs), falling just behind Dell Computer Company and securing more than 20 percent of total market share in the United States consumer PC market. In 2000, Gateway, Inc. reported an operating income of $511 million on net sales of $9.6 billion and 5.1 million units, up from 4.7 million units shipped in 1999. Further, the company has shipped over 21.6 million PCs over the firm’s lifetime through 2000.
In 1993, Gateway, Inc. made its first expansion into an international market by entering Europe via a production, sales, and service facility constructed in Ireland. By 2000, the newly coined segment, “Gateway Europe,” had operations and physical locations in most Western European countries. In 1995, the company expanded to the Asia Pacific region and within five years “Gateway Asia Pacific” had a manufacturing operation in Malaysia, with sales and support facilities in Singapore, Malaysia, Australia, New Zealand, and Japan. In 1999, Gateway entered the Canadian market with product, service, and support options for buyers; and, in 1999 and 2000, international sales comprised 14 percent of total company sale.
Determinants of Strategic Options
Gateway develops, manufactures, markets, and supports a broad line of desktops, laptops, servers, and workstations. Gateway incorporates the “beyond-the-box” services and focuses on delivering value to customers. In 2000, such “beyond-the-box” services comprised approximately 20 percent of total sales, up from 9 percent of company sales in 1999. This increased emphasis on “beyond-the-box” products and services provides insight on components of the firm’s future business strategy.
Historically, Gateway’s distribution strategy, including specific channels and the mix of channels, has distinguished the firm from competitors. The company sells its products and services to PC customers, primarily, through three complementary distribution channels, which include telephone sales, company website, and Gateway Country stores. Telephone sales marked the original sales and distribution method for Gateway, Inc. In 1995, the firm entered the World Wide Web community by developing a web site that consumers could use to gain product information. Then, in April 1996, Gateway became the first major PC manufacturer to provide the technology for consumers to customize, order, and pay for a personal computer via an e-commerce portal. And, by 2000, Gateway Country Stores accounted for approximately $8 million of annual Gateway sales.
Immediately following entrance into the e-commerce market, Gateway opened two Gateway Country Store locations in the United States, followed by additional “brick and mortar” locations in France and Germany in 1994 and later in Japan, the United Kingdom, Sweden, and Australia. By the end of 2000, ten stores were operational in Canada, with 327 in the United States and approximately 360 worldwide. Company data estimated that in 1999, 75 percent of the U.S. population was located within a 30-minute driving commute from a Gateway Country Store.
This statistic increased to 85 percent by 2000. Exhibit 5 illustrates the unit growth of Gateway Country Stores from 1996 to 2000. Essentially, the Country Store concept distinguishes Gateway because it incorporates and emphasizes information dissemination, product demonstration and servicing, customer relationship building, and training by Gateway personnel in a familiar setting. Gateway Country Stores typically occupy 4,000 to 8,000 square feet and are typically staffed with up to 15 company-trained personnel, technical specialists, and customer service representatives.
In 1999, Gateway formally introduced its Gateway Business Solution centers, which were located within Gateway Country Stores and provided specialized training to small business and home office customers. Immediately following the inception of Business Solution centers, Gateway also added approximately 300 dedicated business sales representatives across the Country Store locations to address the technology needs of both small and medium-sized business customers. By 2000, the U.S. Country Stores accounted for approximately 6,000 classroom seats across locations that offered training on general PC usage, popular third-party software, Internet usage, and networking services.
To align with its focus on the complementary mix of distribution channel, Gateway announced an alliance with OfficeMax in February 2000. OfficeMax, which is a major office products retailer in the United States, agreed to replace its existing computer department with a Gateway “store-within-a-store” that would occupy approximately 400 square feet near the store entrance and be staffed with Gateway customer service representatives. Under this alliance, Gateway would make an initial investment of $50 million in OfficeMax convertible preferred stock and pay OfficeMax rent income and costs associated with leasehold improvements necessary to align with the Gateway Country Store model. By the end of 2000, Gateway had 463 stores in OfficeMax locations, and firm’s focus is to be present in 1,000 OfficeMax stores by the end of the first quarter in 2001
To simplify its business, Gateway began reducing the number of components used to build Gateway PCs, which reduced product variations from 2 million to 1,000. Further, while Gateway continued to offer “beyond-the-box” products and services, it also committed its focus on selling “one computer, one customer at a time.” Finally, in the third quarter of 2001, management elected to discontinue company-owned manufacturing, sales, and service operations outside North America. This strategic effort is expected to reduce Gateway’s labor force by 3,500 employees (approximately 18% of total employees), and technical and support services for customers outside of North America will be contracted through third-party suppliers.
Gateway is the third largest PC manufacturer in the U.S. and the sixth largest in the world, which lends credibility to their current business model. Gateway has used a simple strategy of direct sales of PCs built to customers’ orders. Two key advantages of direct sales is that expensive inventory does not build up in the channel and lose value before it can be sold and new products can be introduced without having to clear out the old inventory in the channel. Also the Gateway model establishes a direct relationship with the end customer, which provides information about customer preferences and concerns, unlike the indirect vendors whose channel partners generally do not disclose even the customer’s identity. Finally, customers often pay for the final product via the internet or telephone before the vendor pays suppliers for the parts that go into the PC, so that Gateway operates on a negative cash conversion.
An important aspect of the current Gateway model is that it emphasizes relationship selling. By using dedicated sales employees this also enables Gateway to enhance the company’s image. Gateway’s direct approach allows consumers to gain more experience and confidence in selecting PCs. If a customer feels comfortable selecting a computer at the Gateway store with the assistance of a knowledge sales person, they are likely to become a repeat buyer within the store, or they may even have built enough confidence to purchase online from home.
Conclusively, the current model has consistently generated positive profits, a trend that will likely continue as the number of small businesses and home-offices increase. However, historically, the bulk of Gateway sales have been from individual consumers, which does not align with the growing global market. Seemingly, this aspect of the model limits Gateway’s market to reach the value needs of a specific market segment, and Gateway’s consumer focus does not allow for them to successfully compete in the corporate business market, which accounts for over 60 percent of worldwide shipments. (See Exhibit 1).
A second alternative is to maintain the existing electronic portal, proceed with the OfficeMax expansion plan proposed for fourth quarter 2001, and to close all Gateway Country Store locations. Obvious advantages are that Gateway significantly reduces the operating expenses associated with a company-owned, free-standing store (utilities, insurance and maintenance). Additionally, Gateway does not have to fund a continuous, costly media campaign once they establish brand association with OfficeMax’s print and television media. A further option with this alternative is that Gateway could choose to staff OfficeMax locations with either Gateway employees or independent contractors (i.e., OfficeMax employees or other sales representatives).
In the partnership environment, Gateway can achieve low production and coordination costs by maintaining an employee base. However, because Gateway differentiates itself on limited product offerings and committed after-the-sale service, a staff of independent contractors could feasibly align with the firm’s strategic objectives. And, while maintaining employees or independent contractors will require SG;A expenses to continue, Gateway should be able to limit such costs by staffing fewer representatives at the OfficeMax locations (i.e., three or four as opposed to fifteen).
Of course, proceeding with partnership expansion will still cost the firm $50 million in committed leasehold improvements, but this is minimal compared to the SG;A costs of operating 327 stores at an average SG;A expense of $1.5 to $2 million dollars annually (327 X $1.5MM = $490.5 million annually). Accordingly, under Alternative II, Gateway would maintain an Internet site that would allow customers to order services and products online.
A final alternative is to maintain the existing electronic portal, proceed with the OfficeMax expansion plan proposed for fourth quarter 2001, and to close select Gateway Country Store locations. The advantages and disadvantages of this alternative are the same as outlined in Alternative II, with the exception that Alternative III gives recognition to the significant portion of sales generated by the Country Store locations, which was approximately 27% of total sales in 2000, see Exhibit 6.
It is recommended that Gateway Incorporated can achieve a successful “bricks and clicks” production and distribution mix by selecting Alternative III. Additionally, since “beyond-the-box” products generate profit margins two to three times greater than PCs alone, Gateway should not completely abandon this profitable market, which accounted for 20% of total sales in 2000. However, to offset the costs of maintaining traditional “bricks and mortar” locations, Gateway should consider outsourcing the production of “beyond-the-box” products and services with companies that have focused expertise in these areas (i.e., local and regional Internet Service Providers, manufacturers of computer accessories).