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Professors Frances X. Frei and Youngme Moon and Research Associate Hanna Rodriguez-Farrar prepared this case. HBS cases are developed
solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or
ineffective management.

Copyright © 2000 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be
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photocopying, recording, or otherwise—without the permission of Harvard School.

F R A N C E S X . F R E I

Y O U N G M E M O O N

Gateway: Moving Beyond the Box

Todd Bradley, executive vice president and head of Gateway’s Global Operations, was meeting at
the San Diego headquarters in the spring of 2000 with the heads of the company’s three distribution
channels: Direct (i.e., telephone), Internet (i.e., Gateway.com), and Bricks & Mortar (i.e., Gateway
Country Stores). As he exited the Coronado conference room, Bradley recalled how as the increasing
importance of each channel was touted the most vehement disagreements were between Ken
Stickevers and Keith Martin, the heads of Gateway.com and Gateway Country Stores, respectively.

Stickevers had maintained that Gateway should be focusing its energies on moving more
customers to the web. The fastest-growing channel in terms of percent growth, Gateway.com
accounted for roughly 10 percent of the company’s sales. Moreover, the costs associated with the
channel were about half those of the other channels. “We need to go after additional discounting
aggressively … to try to move people out of stores and phones and onto our website,” Stickevers had
insisted. “Look at Dell. It has committed its whole company mentality and focus to the Web, and it’s
been enormously successful for them. What’s our equivalent to that? How can we make that happen
for us?”

“Sure, the Web is growing fast and there are some real cost efficiencies there,” Martin conceded,

But our stores will do more than 50 percent of our consumer business this year. That’s huge.
More important, the Country Stores give us a way to differentiate ourselves from Dell. The
kinds of customers we attract to our stores are not the kinds of customers who are going to
purchase at Gateway.com or Dell.com. The 75 percent of people out there who still buy
computers in a retail environment, those are the people we need to go after.

Both arguments made sense, Bradley reflected, but bigger issues loomed. Recently Gateway had
publicly unveiled its new “hexagon” strategy, designed to augment the company’s PC hardware
sales with five different revenue streams: software and peripherals; service and training; Internet
access; portal/content; and financing (see Figure A).

601-038 Gateway: Moving Beyond the Box

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Figure A Gateway’s Hexagon Strategy

Source: Company information.

In short, Gateway was telling the world that it no longer wanted to be regarded as a PC hardware
company. The $103 billion PC market, observed Jeff Weitzen, the company’s 43-year old CEO, was
“Brutal and not getting any easier.” Under the hexagon strategy, the company would compete in the
$240 billion “PC solutions market,” which entailed providing a host of services ranging from Internet
access and content to computer training. Gateway’s stated goal was to generate a whopping 40
percent of its profits from non-PC (“non-systems”) revenue by 2001. According to Bradley, the new
strategy was wholly consistent with the company’s founding philosophy:

We’ve always looked at more than just the selling transaction. It’s the buying experience
and the ownership experience that’s important to us. Our goal has always been to develop
long-term relationships with customers so that we can go back to them and offer them other
things.

Still, Bradley had to admit, the move was nothing less than radical. The fifth-largest PC
manufacturer in the world, Gateway derived nearly 90 percent of its revenue from sales of its built-
to-order computer systems. To transform Gateway into a full-scale “solutions provider” in just a few
years would clearly be challenging.

There were some within the company, Bradley knew, who feared that Gateway was trying to
reinvent itself as an Internet-services powerhouse too quickly. Companies such as FreePC,
eMachines, and Microworkz, had experimented with different pieces of the “hexagon,” typically
bundling cheap hardware, financing, and Internet access in high-profile marketing campaigns, but
had failed to demonstrate that they could turn a profit. This had raised concerns that Gateway was
embracing an unproven business model. Although he tried not to let the naysayers dampen his
enthusiasm for the new strategy, Bradley himself wondered at times: “Is this company doing the
right thing? If so, then how do we move from where we are today to where we want to be in two
years? More specifically, how can we leverage our three distribution channels in order to market this
new portfolio of applications most effectively?”

Gateway: Moving Beyond the Box 601-038

3

Company Background

In 1985 college dropout Ted Waitt had found himself working phone sales in the back room of a
Des Moines, Iowa, retail computer store. There he had made the simple, yet startling, discovery that
in a 20-minute phone call he could get a customer to make a $3,000 computer purchase and put the
transaction on a credit card. For him, this was the “aha!” moment that entrepreneurs dream about.

The more Waitt thought about it, the more excited he became. A telephone-based computer retail
business eliminated not only retail distribution costs and markups (which could add more than 10
percent to the wholesale prices) but also the need for finished goods inventory and showrooms. It
could be based anywhere, even his father’s cattle farm. Most important, if he could get customers to
prepay purchases it could be launched with an empty bank account, which indeed was the status of
his finances at the time.

Fellow salesman Michael Hammond signed on to help Waitt launch a business out of his family’s
Sioux City, Iowa farmhouse and Waitt’s older brother Norman joined soon thereafter. After initially
selling add-on equipment by mail, the company switched to selling built-to-order computers at prices
at least 10 percent below those of the competition. Rapid growth forced a move to more spacious
(but hardly upscale, as employees literally had to sidestep cow manure in the halls) quarters in Sioux
City’s Livestock Exchange Building.

In 1987 the renamed Gateway 2000 earned revenues of $1.5 million. A year later sales had
rocketed to $12 million. In growing the company Waitt was mindful of several key things he had
learned from his retail experience. He knew that prospective customers needed to feel that they were
purchasing a PC from a trustworthy source and that PC customers tended (1) to be price sensitive,
many willing to spend hours poring through the pages of publications such as Computer Shopper for
the best deal, and (2) particularly those willing to buy through the mail or via telephone, to be a select
and sophisticated lot that cared about technical specifications, quality, and support. Waitt’s goal was
thus to establish Gateway 2000 as a trustworthy company that offered built-to-order computers at a
bargain, that is, high-end quality for low-end prices. Aware that he was selling against IBM clone-
makers with questionable reputations, Waitt decided to position Gateway 2000 as bunch of plain folk
on whom people could depend. This occasioned a rather idiosyncratic marketing campaign that
employed whimsical ads featuring the Waitt family’s cattle herd and the Sioux City water tower
rather than the product. “Computers from Iowa?” the tagline read. Later ads featured buffalo,
double-door saloons, and characters such as Robin Hood and the company’s built-to-order PCs were
shipped in boxes decorated in the black-and-white pattern of Holstein cattle.

Its unconventional nature notwithstanding, the marketing campaign seemed to be working. In
1991 Inc. Magazine named Gateway 2000 the fastest-growing private company in the nation, with $626
million in annual sales and 1,300 employees. “It’s going to sound a little hokey,” Stickevers
submitted:

But I think a large part of our success has been our midwestern values. We started out in Sioux
City and the people who worked for us there really cared. They got excited about the
company and just poured their hearts and souls into it. We created this great culture and our
customers responded to that.

If you ask Ted what this company is about, he’ll tell you that we’ve done two things really
well. We had a great core idea, but then we surrounded it with great service and a great
marketing strategy that positioned us as a kind of David to everyone’s Goliath, and it worked.

601-038 Gateway: Moving Beyond the Box

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When the company went public in 1993, the chain-smoking, Diet Coke-guzzling, pony-tailed, 30-
year-old founder of Gateway 2000 was still in charge and worth $800 million. Gateway 2000 had
shipped more than 1.5 million PCs and had revenues of $1.7 billion and a market capitalization of
$1.4 billion. Moreover, its homespun image had enabled the company to distinguish itself from the
larger pack of mail-order companies.

By 1999 Gateway was second only to Dell in direct distribution of PCs. With more than $8 billion
in revenues, market capitalization in excess of $18 billion, and some 20 million customers, it was the
fifth-largest PC manufacturer in the world. (Exhibit 1 details Gateway’s financial performance.)

Whereas large corporate accounts were Dell’s core customer segment, home consumers were
Gateway’s primary target market. (Exhibits 2 and 3 break down Gateway’s and Dell’s overall market
share by customer segment.)

Direct and Internet Channels

Most manufacturers rarely “touched” end customers, but both Dell and Gateway exploited the
telephone- and Internet-based sales distribution model to create direct relationships with their
customers.

The Telephone Channel

Customers who used the telephone, the original distribution channel for Gateway 2000
computers, were greeted by an emissary and routed to the appropriate salesperson. In 1999,
Gateway replaced these emissaries with an automated voice-response system designed to save
money and improve channel efficiency.

Sales representatives helped customers assemble computer systems customized to their specific
needs. Although its compensation plan rewarded reps for selling high margin products, Gateway’s
sales training emphasized the importance of serving customers rather than simply maximizing the
dollar value of a given transaction. Bradley attributed the company’s success with the home
consumer market largely to this approach. “The thing that has made us different,” he maintained, “Is
that our sales process has focused on understanding what you want to use the technology for. Our
focus has always been: ‘How do we build the right system for you?’”

Gateway discovered its marketing approach to be even more critical as the average home
consumer’s needs began to change. Observed Jay Sperco, head of Gateway’s telephone sales:

The people who originally bought Gateway computers really knew their stuff. They were
willing to buy over the phone because our people could talk the talk. Nowadays computers
have become much more a commodity purchase and so there are a lot of people who call us
who don’t know the difference between gigahertz and megahertz. So we’ve had to work hard
to make sure our sales force can speak to both sets of consumers.

The telephone sales group comprised reps who handled inbound calls and reps who made
outbound calls specifically focused on upselling existing customers. Sales reps were expected to sell
$150,000 to $160,000 worth of merchandise in each of the company’s 24 annual sales cycles. As
computer profit margins shrank, sales reps found themselves spending increasing amounts of time
selling products “beyond the box,” that is, software, add-on peripherals, financing, and extended
warranties.

Gateway: Moving Beyond the Box 601-038

5

Gateway.com

Gateway and Dell adopted the Internet as a distribution channel in 1996. Customers who visited
Gateway.com could learn about products and configure and purchase customized computer systems
without recourse to the telephone. They could choose memory and monitor size, software,
peripherals, service programs, ISP subscriptions, training modules, and accessories and track orders,
obtain technical support, and e-mail questions.

Gateway.com employed 100 online support personnel in Kansas City to provide sales processing
and follow up, technical support, and answer e-mail. The Kansas City staff was also responsible for
contacting the 10 to 20 percent of customers whose configurations were “kicked back” for reasons of
being “unbuildable.” Virtually all kicked back orders ultimately resulted in a sale.

A large percentage of Gateway’s customers used both the telephone and website channels. Said
Stickevers of the potential for channel conflict:

We really don’t worry too much about that. Our philosophy is we want to capture them
within the Gateway family. If they need to come to the Web to look for information, but want
additional assurance on the phones, that’s okay. We’d rather sell them a PC and capture them
for a lifetime … than lose them to Dell or Compaq or someone else. Of course, ideally, we’d
prefer it if we could keep them at the website and convert them right then and there.

The Box

Gateway spent approximately $115 to acquire each of its PC buyers. A purchased PC (termed
“the box”) was typically custom-built, loaded with specified software, and shipped directly to a
customer.1 The average unit price (AUP) of a computer purchased through Gateway was $1,845 in
1999, although the company estimated that the typical customer spent a total of about $6,000 over five
years on hardware, software, Internet access, e-commerce transactions, and other online expenses.

In 1999 systems revenues accounted for almost 90 percent of total revenue. Although unit sales
had increased throughout the 1990s, Gateway’s growth paled in comparison to that of its direct
marketing rival Dell. By the late 1990s Dell had become the poster child of the industry, its success
casting a shadow over Gateway’s every accomplishment. Between 1996 and 1998, Gateway’s sales
rose from $5 billion to $7.5 billion, Dell’s from $5 billion to $12.3 billion. Moreover, Gateway’s net
margin fell even as Dell’s rose. (Exhibit 4 details Dell’s financial performance.)

Gateway had other problems as well. Fierce competition in the PC business had driven prices and
profits down. (Exhibit 5 details U.S. consumer PC sales.) Gateway responded by chasing large
corporate accounts, but found that it lacked the expanded sales team needed to get a foot in the doors
of major corporate clients. Gateway also began to have trouble attracting top executive and
engineering talent to its Sioux City, Iowa headquarters. It even had a Y2K problem: its name,
Gateway 2000, was on the verge of becoming obsolete.

Deciding that some radical changes were in order, Waitt, never one to be accused of complacency,
vowed to rethink Gateway’s entire business model top to bottom. Nothing was to be held sacred, not

1 Gateway departed from its built-to-order approach for the first time in February 2000. To hit a lower price point, its Solo
1100 laptop computers aimed at the consumer market were non-custom and stockpiled in inventory. The Solo 3300, another
portable computer made available only in a limited number of configurations, followed. Nor did Gateway rule out the
possibility of expanding its non-customized offerings to keep prices down on specific machines.

601-038 Gateway: Moving Beyond the Box

6

the name, the strategy, the products, the alliances, the location, nor top management. The result? A
complete makeover of just about every aspect of Gateway’s operations.

Holy Cow!

A New Corporate Image

In 1998 Gateway dropped the “2000” from its name and the trademark Holstein cow from TV and
print ads in an effort to broaden the company’s appeal to consumers and attract more corporate
customers.

A New Location

Also in 1998 Gateway moved into new administrative headquarters in San Diego, California. The
move from Sioux City, where Waitt’s family had raised cattle for five generations, was risky. Some
feared that Gateway might be perceived to be turning its back on the folksy, midwestern culture and
marketing that had defined the company and helped make it a brand name. But according to Waitt,
the company had no choice if it wanted to attract the kinds of engineers and executives needed to
boost its technical expertise.

New Top Management

Gateway also reshaped its executive staff with a number of new hires. Boasted Waitt: “We went
through an organizational change in 1998 like no company our size has ever gone through. Ten of
our top 14 people were hired in 1998.”2 Among the many new hires who came from outside the PC
industry was AT&T veteran Jeff Weitzen, who joined the company in early 1998 and was later
anointed CEO by Waitt. The immediate introduction of innovative marketing initiatives, such as
Gateway Country Stores and Gateway’s Your:)Ware program, suggested that the goal of the new
management team was to push the company’s business model beyond simple computer assembly.

A New Distribution Outlet

Perhaps Gateway’s most controversial move was the opening, in 1997, of a number of Gateway
retail stores. Explained Martin:

The stores really started with the idea that some people, both new and repeat buyers, want
to “kick the tires” before buying a PC. They want to touch and feel the products and get a
different level of service than you can achieve through the direct channel.

We’re not interested in building a typical computer retail outlet. We want the client to walk
out of the store and feel different than having walked out of an electronic superstore across the
street. Whether they buy something or not, we want them to feel different.

At about 5,000 square feet, the stores were roughly half the size of a typical computer store. They
showcased only Gateway products and carried no inventory. Customers could try out products, ask

2 “New Home, New CEO, Gateway is MOO and Improved,” Fortune, December 20, 1999.

Gateway: Moving Beyond the Box 601-038

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questions in a face-to-face environment, and obtain support for their purchases. Purchases could be
made at in-store kiosks, with the assistance of a salesperson if needed. The stores were also intended
to reduce the hassle factor for returns and repairs and even incorporated classrooms for customer
education.

Given that Gateway had been built on the premise that customers could be induced to migrate
away from the retail channel to the direct channel, the opening of the Country Stores raised some
eyebrows. Critics noted that the launch came just as other PC makers, which, they emphasized, had
not fared well in retail, were scrambling to move to the more cost-efficient Internet channel. Tandy
Corporation, for example, had recently sold its unprofitable Incredible Universe and Computer City
stores. Although Gateway was avoiding one of the major risks of the retail format by eliminating
inventory, building a retail chain was nevertheless hugely expensive. The cost to operate a Gateway
store ranged from $750,000 to $1.5 million per year. Moreover, the stores’ operating margins were
likely to be lower than the company’s historical average.

Its many skeptics notwithstanding, Gateway forged ahead. Its goal was to have 80 percent of the
U.S. population within a 30-minute drive of a Gateway Country store by the end of the year 2000. By
early 2000 the company had opened 260 stores and at least 60 more were planned. Concurrently,
Gateway tested a “store-within-a-store” concept at 35 OfficeMax locations, with the plan of
establishing mini-Gateway Country Stores in most of OfficeMax’s 1,000 stores nationwide.

Gradually, Gateway’s retail efforts began to bear fruit. The stores were drawing considerable
traffic (on the order of 1,000 to 1,500 potential customers per week), and although cannibalization of
existing Gateway sales was a concern, company research found that less than 10 percent of Country
Store customers were registered Gateway buyers and 60 percent of its customers liked having access
to multiple channels when making a purchase decision.

Most important, despite the growing popularity of sub-$1,000 PCs, Gateway found that the
average price of a PC bought at a Country Store was about $1,925, higher than for either of its direct
channels. Gateway was able to achieve this AUP despite 40 percent of Country Store customers
being first-time computer buyers, “because of the attached products around it, not necessarily the
core system,” Martin explained.

When we talk about the average unit price at Gateway we’re talking about the total
transaction, not the system price. So what happens in a store environment, because it’s a richer
environment, we have a much higher “attach” rate of other products and services to the base
systems.

An example of this was training. Whereas few web or telephone customers signed up for
Gateway training sessions, about 60 percent of store customers did so when they purchased a
computer system. Training was provided in two venues. Online training took the form of a set of
disks or access to an Internet site. Classroom training in topics such as getting started on the Internet,
desktop publishing, and digital imaging, was provided by instructors. Gateway had 4,000 training
seats in its stores by the end of 1999 and charged about $75 per course.

Gateway Country Stores also proved to be an opportunity to reach out to small business
customers. “ Solution Centers” installed in each store were run by specially-trained business
sales representatives. “When you’re dealing with a Fortune 1000 company,” explained Martin, “you
don’t need to bring them into a store environment to show them the products and services, but when
you’re dealing with small businesses you do. We have more than 200 Solution Centers.
None of our competitors have that.”

601-038 Gateway: Moving Beyond the Box

8

Finally, Gateway added to each store a number of outbound sales representatives responsible not
only for calling on local businesses, but also for attempting to forge partnerships with local value-
added resellers (VARs) that bundled PCs with software developed for specific industries and
professions. No-name “white boxes,” traditionally sold by VARs accounted for about 30 percent of
the small- and medium-sized business market. Gateway was trying, by building PCs to VARs’ orders
and offering an attractive discount, to become the first PC company to crack the white box market.

The opening of the Gateway Country Stores added a third distinct channel to be managed.
(Exhibit 6 reports traffic figures for each of the channels.)

The Your:)Ware Program

In mid-1998 Gateway unveiled its second major initiative targeted at the home market. Its
Your:)Ware granted customers to trade-in two- to four-year-old Gateway computers (at blue book
value) towards the purchase of a new Gateway machine. To qualify for the trade-in program
customers had to sign up for one of the following options.

Software and/or peripheral bundles. Customers could purchase selected third-party
software and hardware add-ons from Gateway. The attach rate of peripheral and
software sales was the highest among the various components of the Your:)Ware
program, reaching 65 percent during some quarters.

A financing option. Customers could finance computer purchases through Gateway
for as little as $19 monthly. Applications for fixed-rate loans were available online
and processed almost immediately. By the end of the program’s first year Gateway
had originated $1 billion in financing. Total financing in 1999, with more than 50
percent of the Gateway products sold being financed, was $2 billion. Financing was
provided through partnerships with MBNA, Associates Corporation, and Household
. Gateway both collected a bounty for and shared in the income generated by
each loan.

Internet access through Gateway.net. Customers who signed up for Internet access
through Gateway.net had the ISP software preloaded into their systems, eliminating
configuration problems. Sign-up options varied in terms of length of commitment
and price. Subscription rates averaged $16 per month; churn rate was about 4.3
percent per quarter. Gateway sales representatives earned $5 for each subscriber
they signed and the company paid UUNet approximately $7.50 per month to provide
back-end infrastructure support. Roughly two support calls per year per customer
cost Gateway $25 each. Gateway.net was enormously successful, with an attach rate
of nearly 50 percent by late 1999. With more than one million subscribers,
Gateway.net was one of the nation’s largest and fastest-growing ISPs.

Service warranties. Although Gateway provided a free three-year limited warranty
with every computer, its extended warranty program was the second most popular
component of the Your:)Ware program. A three-year extended warranty cost about
$150.

Gateway’s Your:)Ware program was immensely popular from the outset. Its attach rate, that is,
the percent of Gateway customers who signed up for it, was 60 percent by the end of the first year.
Many customers, moreover, signed up for more than one component of the program.

Gateway: Moving Beyond the Box 601-038

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Although it knew how many customers had signed up for Your:)Ware, Gateway had no idea how
many would eventually decide to trade in their old computers for new ones. With the two-year
anniversary of the program approaching the first trade-ins were due any day. Would Gateway
suddenly be deluged with obsolete equipment, and if it was, what would the trade-ins do to its
bottom line? The program guaranteed buyers blue-book value, which the company estimated to be
between $400 and $500 for a $2,000 computer. Lacking a way to predict trade-in volume, Gateway
was unable to estimate accurately how much the program would eventually cost.

There was also concern that consumers, unaware of how quickly the value of computers declined,
might be unpleasantly surprised to learn how low the trade-in value was. “I think we have some
work to do to get people ready for what their PCs are going to be worth,” Bradley opined. “No
matter how much work we’ve done to get people’s heads around that, the day the letter comes with
the number it’s never going to be what they expect.”

Finally, the company had no idea what it would do with the returned computers. In the absence
of a healthy market for used PC hardware, options included selling them to a third-party vendor or
donating them to charity.

Moving Further Beyond the Box

By the end of 1999, non-systems revenues already had an annual run rate in excess of $1 billion.
(Exhibit 7 breaks down the revenue streams generated by systems, Exhibit 8 the revenue streams
generated by non-systems.) About 50 percent of non-systems income was recurring. These non-
systems revenues derived from financing, service warranties, training, and Gateway’s ISP deals. It
also included the following.

Software and Peripherals

In 1999 Gateway secured a 20 percent stake in NECX Direct, an online computer-products retailer.
With more than 30,000 SKUs, NECX quickly became the power behind Gateway’s online accessory
store, SpotShop.com. As Stickevers pointed out, Gateway’s stake in NECX was real in terms of
revenue, but virtual in terms of inventory. “We’ve been able to leverage all of our existing
infrastructure. We didn’t have to build anything from scratch. We didn’t have to set up warehouses
or anything like that. What we did was basically attach an interface. So the costs associated with this
have been minimal.”

Portal/Content

In 1999 Gateway announced a major alliance with AOL. AOL was to invest more than $800
million in Gateway …