Last modified: October 8, 1999 5:00 AM PDT
How can giveaways pay off?
The answer is unclear even to those companies that have staked their future on these confounding business models. And if their calculations prove wrong, they could become victims of their own success by falling behind consumer demand.
Typically, shoppers who get free PCs agree to subscribe to an Internet service provider for three years or to be deluged with a constant stream of advertisements in exchange for their computers. But hundreds of thousands have concluded that those are small concessions because they would have purchased Internet access anyway, and they are already barraged with advertising on other media.
Internet access providers have been swept up in the deep-discount craze as well. CompuServe, for example, is paying $400 to customers who sign up for three years of its service.
In the midst of this consumer nirvana, analysts and others in the industry are questioning the business acumen of companies that appear to be giving away the store, literally and figuratively.
PC start-ups such as Emachines, which sells computers that cost practically nothing when purchased with the CompuServe subscription, and "free" ISPs like NetZero have become overnight celebrities in consumer marketing circles. FreeMac says 500,000 people have applied to take advantage of the company's free iMac offer, true to its name.
Not bad for a trend that began only months ago--February 8, to be exact--when then-unknown Free PC announced the seemingly absurd intention of giving away 10,000 desktop computers.
There is just one problem with this business model: profits. Or, more accurate, a lack thereof.
A close look at the numbers shows that the companies at best net a few hundred dollars in gross profit per customer. And even that relatively paltry sum is spread out over the three-year ISP contracts that provide the PC makers with alternative revenues designed to offset the giveaways.
That calculation is based on the cost of the computer itself and a monthly Internet access payment by the customer of $20 to $30. In most cases, the companies providing the free PCs are banking on additional revenue from sales of upgrades or by bombarding customers with advertisements. But those sources have proved more of a trickle than a flood.
"This is not a high-margin area of computer manufacture," said Ganesh Ramakrishnan, chief executive at Gobi, a company that offers computers with three years of Internet access for $25.99 a month.
Others are more blunt in expressing their pessimism. "We think that this business model is very questionable," said Van Baker, a Dataquest analyst who recently completed a study dissecting the free-PC companies' costs and revenues. "Under the assumptions of the economic model today, it's a money loser."
PC makers have been forced to continually lower the bar on prices to satiate cost-conscious consumers, who realize that low-end, low-cost machines are plenty powerful for email, Web browsing, and video games--often the main reasons computers are purchased.
The shift in the market has been dramatic. Three years ago the average price for a PC was $1,800. In August, sales for computers priced under $600 made up 47 percent of all desktop computers sold by retailers, according to a recent report by research firm Infobeads. And for the first time, the majority of PCs sold cost less than $800.
As prices have declined, some manufacturers have resorted to bundling an ISP service with the PC to attract buyers. Similar trends have occurred in other industries as competition forced prices down: Years ago, cellular phone companies began to essentially subsidize the hardware in return for a long-term commitment from the customer to use a particular carrier.
Do the math
Under most "free" PC deals, the customer gets a computer for nothing, or very little after a rebate, but must sign a three-year ISP contract. In a variation of this theme, customers buy a PC but get several months, and often a year or more, of free or discounted ISP service.
Under the first plan, which is far more prevalent, the monthly cost to the consumer is between $20 and $30. For a 36-month contract this amounts to between $720 and $1,080. Microworkz, DirectWeb, and others are among those offering such deals.
Service fees can also be added. Gobi, for instance, charges $29.99 for an initial processing fee, $25.99 for monthly service, and $60 for shipping and handling. In all, Gobi takes in about $1,000 from the customer, although it also can charge for upgrades, the company said.
(Under other offers, such as those from Free-PC or FreeMac, the consumer must agree to accept advertising. Free-PC gives away its Internet access. FreeMac customers must sign up for ISP service from EarthLink and qualify for a First USA credit card, the company said.)
Industry research firm Dataquest estimates that the companies pay $500 to $660 for the PCs and that Internet access adds close to another $16 per month, or $575 during the three-year period.
According to Dataquest, the average total cost to the manufacturer is $1,075 to $1,235, while revenue from the customer ranges from $720 to $1,080. This creates a margin of $255 to $500.
The numbers do not account for other revenue that may be derived from the customer, such as by selling additional hardware. Nor do they reflect other business costs to the company, such as rent, employee salaries, customer service, or taxes.
As a result, most of these companies are banking on other sources of revenue--and this is where things gets murkier still.
Gobi, for example, relies on "a number of revenue streams, including sales of hardware and software upgrades and accessories, revenues from strategic partnerships, as well as typical e-commerce revenues," Ramakrishnan said without offering specifics.
Advertising, however, has not proven to be a deep source of revenues. Other than America Online, even the most successful ISPs have been hard-pressed to make more than $1 per month per subscriber from advertising and other marketing devices, analysts say.
DirectWeb chief executive Dennis Cline has said his company, which offers PCs with Internet service, will act as an agency to refer customers to other merchants and will offer benefits such as an online credit card. "This will allow us to get into transactional revenue," Cline has said.
"Forget about the traditional PC model...If I recovered just cost on the box, I'm happy," said Rick Latman, founder of Microworkz, which has offered various low-cost combinations. The company's next product: a $199 device called the iToaster that comes with unlimited free ISP service.
This build-it-and-they-will-come strategy hasn't impressed many analysts. "E-commerce for the moment is extraordinarily vague," said Roger Kay, an analyst at International Data Corporation. Although he thinks that it could be viable in some instances, Kay said, "the issue is really that it's unproven."
In addition, "the problem with these [free-PC companies] is that they grossly underestimate support costs," Dataquest's Baker said. "This is important. A big part of this market is first-time users who require a lot of handholding."
Microworkz as a poster child
The travails of Microworkz, a pioneer in the free-PC movement, highlight the issues facing similar start-ups. Latman recently resigned as Microworkz's president, ending a tenure that was marked by a lawsuit from ISP partner EarthLink Network and numerous customer complaints.
According to a statement from the Better Business Bureau in Microworkz's home state, "This company has an unsatisfactory business record. Specifically, a high volume of complaints and a pattern of being slow to respond to customer complaints that were brought to their attention." Complaints are centered on "nondelivery of products ordered."
"This could happen to anyone in the industry when you grow this fast," a Microworkz spokesperson said. "I can't think of another company in this sector that's grown this fast."
Microworkz is far from alone in its troubles. Enchilada, which had been giving away computers with paid Net service subscriptions, stopped accepting orders in July. Since that time, a notice on the company's Web site states that Enchilada is experiencing "technical difficulties."
Large manufacturers have pounced on these incidents to underscore the dangers of a deal that seems too good to be true. "You're selling your soul. This means no support or limited support," said Mike Ritter, director of the consumer products group at Gateway.
At rival Dell, Carl Everett, head of the company's personal systems group, agreed. "These are 36-month experiments...That's a long time for somebody to hang on," he said.
One reason these companies seem to be sprouting up is that "the world is awash with capital," Everett said. These companies are losing money in an effort to build market share and gain investors, he speculated. If they can go public, they may be able to grow their way to profitability.
Despite their skepticism, the leading PC companies have been forced to adopt some of their new competitors' tactics or risk an erosion of market share.
Dell and Gateway, for instance, give a year's worth of Internet service to customers who purchase certain packages. In Dell's case, the company absorbs the cost, said Paul Bell, senior vice president of the home products group. ISP connections are bought at a wholesale price and in general are accounted for like other components or software that go into a PC, he said.
ISP executives note, however, that this wholesale service can be expensive too.
EarthLink CFO Grayson Hoberg, whose company provides ISP service for several manufacturers, said he recently saw a contract that required a computer manufacturer to pay UUNet more than $19 per customer per month to handle bandwidth and customer support, leaving essentially no room for profit by the manufacturer-branded ISP service.
Considering their size, Gateway and Dell likely pay far less for wholesale ISP services than smaller companies. Still, it is an additional expense.
Even if the companies are paying $8 per customer per month--Dataquest's low figure--that comes to $96 in added cost. This is roughly equivalent to the cost of doubling the memory on low-end PCs, putting in a much larger hard drive, or giving away an additional 433-MHz Celeron processor.
Hewlett-Packard, IBM, and Compaq Computer are shifting these expenses onto their ISP partners. Those deals, nonetheless, come with costs as well.
The solution? The usual: maintain the positive brand and user experience, expand market share, and watch the bottom line. "This is a brutally competitive market," Bell said. "A lot of companies aren't making money."
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