January 30, 2004 1:07 PM PST

For eMachines, a gateway to the future

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news analysis In announcing its plan to acquire tiny eMachines, the much larger Gateway is acknowledging its own deteriorating performance in the PC marketplace.

Although Gateway employs many more people and generates much more revenue--largely because it sells other items, such as consumer electronics--its share of the PC market has slipped below that of eMachines.

Where Gateway has struggled to compete against Hewlett-Packard and Dell, eMachines has been successful, largely because it focused on one niche: low-cost desktop PCs sold through retailers such as Costco.

News.context

What's new:
Gateway plans to buy fellow PC maker eMachines for about $230 million in stock and cash.

Bottom line:
Even fortified by eMachines, a bigger Gateway will still have to prove that it's better off. To succeed in the months ahead, analysts say, the combined company will have to tap the energy of new management talent and identify niches that will yield the greatest returns.

More stories on this topic

It is on retail shelves that Gateway is looking to gain ground, with a deal it announced Friday to acquire eMachines for about $230 million in stock and cash.

Despite rough times in the PC market during the past few years, eMachines has posted profits for nine consecutive quarters, according to the privately held company. Last year's sales surged 40 percent to top $1 billion, with 2 million computers shipped.

"We've become the fastest-growing, most efficient company in the PC market today," said Ed Fisher, the company's senior vice president of global sales. And eMachines has done so with just 139 employees, compared with the 7,500 that Gateway employs, even after several rounds of layoffs.

Gateway CEO Ted Waitt sees the incorporation of eMachines creating a "very strong No. 3" in the PC market, behind heavyweights HP and Dell. But even fortified by eMachines, a bigger Gateway will still have to prove that it's better off. To succeed in the months ahead, analysts say, the combined company will have to tap the energy of new management talent and identify niches that will yield the greatest returns.

eMachines faded from the headlines after becoming a private company at the end of 2001. Over the same period, however, the company boosted its fortunes significantly. Free from the scrutiny and pressures of Wall Street, the company changed the way it did business, focusing on finding a way to make its niche profitable.

The company started building its PCs to meet the requirements of retailers, but at the same time, it required firm commitments from the stores for how many PCs they wanted, with no returns accepted.

In return, the stores got from eMachines the models they needed at cut-rate prices.

"The retailers love them," said Stephen Baker, an analyst at the NPD Group. "They deliver what they say they are going to deliver. We used to say that if eMachines didn't exist, Wal-Mart and Best Buy and Circuit City would have to invent them."

eMachines made a brief foray into selling its machines directly, via the Internet, but it quickly retreated, using its Web site instead to direct customers to retail stores.

The company's stature only increased when HP bought Compaq Computer. "Everyone recognized they had to have an alternative to HP-Compaq" in the retail sector, Baker said.

Back from the brink
The turnaround is more remarkable, considering that the company was written off as all but dead when PC sales tanked a few years ago.

eMachines saw its sales surge during the late 1990s. Rebates of $400 from Internet service providers MSN and America Online allowed eMachines to offer consumers a new PC nearly for free.

But the company got stung by the end of those rebates and by reliability problems, along with a misguided foray into the Internet services market.

In late 2001, the company's shareholders agreed to its acquisition by one of the company's directors in a buyout that took eMachines private in a deal worth about $161 million.

Rather than fade into oblivion, like so many other PC makers of the previous 20 years, eMachines found itself at the start of a turnaround. The company was able to boost its share of the U.S. PC market from 2.1 percent in the first quarter of 2002 to 3.4 percent by the end of last year, rising from ninth to fourth in terms of market share, based on units sold. During the same period, Gateway's share of the U.S. market dipped from nearly 6 percent to just below eMachines', also at about 3.4 percent, for the last quarter of 2003, according to IDC.

Despite its success, eMachines faced challenges for the future, some of which led it into Gateway's arms. One of the most pressing issues was where to get the money needed to continue the company's expansion into notebook computers and overseas markets.

"Clearly, eMachines had been struggling with how to bring capital into the company," IDC analyst Roger Kay said. "They had even talked about going public."

A return to the public markets could have brought more cash to the company and its investors. However, the PC maker had already experienced the fickle demands of Wall Street, particularly a desire for sales growth that proved difficult to achieve while trying to also make money.

"We have been looking at several different alternatives," Fisher said. "A larger capital structure is absolutely required to support your growth."

Although the company was profitable, analysts doubt that eMachines was making much money, likely posting margins of just 2 percent or 3 percent. "They had to work really hard to make $20 million or $30 million (a year)," Baker said. "That's hard work."

Also, the company's niche in low-end desktops could become less lucrative, as more of the market shifts to notebooks and high-end desktops, such as entertainment PCs that run Microsoft's Windows XP Media Center software.

Kay notes that Gateway was able to acquire eMachines for just $30 million in cash, along with about $200 million in Gateway stock. "You can assume they were not hugely profitable, because Gateway was able to buy them for so cheap."

Scratching a niche
Joining forces with Gateway melds eMachines' expertise in selling low-cost machines profitably with Gateway's skills in creating advanced products. However, analysts say that after the purchase, eMachines could lose some of the focus that led to its success.

Baker said that, besides leaders HP and Dell, the PC companies that have managed to survive have found some sort of specialty.

"A company that is focused in the PC market is going to be more successful," Baker said, pointing to Alienware, a maker of high-end PCs for game players; notebook specialist Toshiba; and Macintosh maker Apple Computer. "Dell and HP aside, everybody is now a niche player."

While the move could help give Gateway some added muscle with retailers, Baker doubts that Gateway will be helped much in terms of adding scale to its PC business, which will still be dwarfed by HP and Dell. "Another 2 million units doesn't get them any kind of scale against Dell or HP," Baker said. "That horse has left the barn."

Gateway is also acquiring new management talent in Wayne Inouye, the veteran retailer who has served as eMachines' CEO since February 2001, when he replaced founding Chief Executive Stephen Dukker. Inouye will take over for Waitt as chief executive of the merged company, with Waitt staying on as chairman.

"The fact that Gateway is getting new management will also please investors," said Michelle Gutierrez, an analyst at SoundView Technology Group. "People are tired of waiting around for a turnaround under the existing management."

Gateway has launched a number of restructuring efforts, since Waitt returned as chief executive in 2001, but none has had spectacular results. The company's latest realignment has been a move toward consumer electronics, as it seeks to stem steep losses with its PC business.

"We were hoping for a big pop in the fourth quarter. But their PC market share declined on a quarter-to-quarter basis by 7.5 percent, while the market overall grew 14 percent," Gutierrez said.

CNET News.com's Dawn Kawamoto contributed to this report.

 

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