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THE DAY AHEAD: Analyst ambushes eMachines well before IPO

It's not that often that a Wall Street analyst pummels a company before it even goes public. But that's essentially what USB PiperJaffray analyst Ashok Kumar did with eMachines Inc.

Kumar, in a research note this week, said eMachines has all the makings of another Crazy Eddie, a computer retailer that was hot for awhile and crumbled like a house of cards because of shaky fundamentals.



eMachines: House of cards?



"EMachines has acquired significant mind- and market-share," Kumar told ZDII. "But they've built a business model where there's very little room for error."

What Kumar said about eMachines isn't revolutionary -- in fact ZDII has pointed out the fundamental flaws. What is noteworthy is how a sell-side analyst is flagging an IPO before it even sets a price range. Kumar has been known for his calls, entertaining writing and being right. The guy does his homework.

But there is something worth noting. The offering of eMachines (Proposed ticker: EEEE), which doesn't even have a price range yet, is being underwritten by Credit Suisse First Boston , BancBoston Robertson Stephens, Hambrecht & Quist and Salomon Smith Barney. USB Piper Jaffray isn't getting any part of the underwriting pie. That either makes Kumar's report more objective or sour grapes.

Kumar told ZDII he's just reporting the facts since eMachines could impact the companies he covers. Kumar follows Dell (Nasdaq: DELL) and Compaq (NYSE: CPQ).

Kumar had been much more generous to eMachines in previous reports and even hosted a conference call last year featuring CEO Steve Dukker. Kumar began to go sour on eMachines when companies like Compaq entered its market. Kumar, among the first following the eMachines story, has tracked the company since it first appeared this time last year.

"While the company has sold over a million units since its inception last November, it has not even remotely created a business model that is sustainable," wrote Kumar. "In the sub-$600 market, which represents a third of retail sales, Compaq has made a strong comeback."

It's hard to argue with Kumar's points about eMachines.

For starters, eMachines is a joint project between Trigem, a Korean PC maker, and Korean Data Systems (KDS). Although eMachines gets components cheap enough to compete, it also is a conduit to service Trigem's debt, according to Kumar.

Since cost of credit is high in Korea, eMachines tries to maintain its cash conversion cycle under 28 days, and provides a 2 percent discount to resellers for payment within 3 days. The company's IPO should alleviate the problem.

And that's just the beginning.

Execution is a problem. Kumar said his sources indicate that eMachines shipped 100,000 PCs back to Trigem due to soft demand and forecasting errors. "That represents about 20% of its planned quarterly run rate," said Kumar. "Also, last quarter eMachines provided an average of $7 million in price protection across every account. With the Korean parent companies assuming all the trade and credit risk, eMachines is pushing the boundaries of FASB approved accounting."

Another sticking point is eMachines' rebates. The company offers a rebate on its models to lure consumers. The bet here is that half of the consumers never bother to cash in the rebate and boost eMachines' returns. The bet was paying off, but Best Buy and other chains are printing out rebates on receipts and now there's a 90 percent redemption rate, according to Kumar. Some original equipment manufacturers are also offering instant rebates. You can bet there'll be nearly a 100 percent redemption rate for those instant rebates. "Retail chains need to be cognizant that they could be left holding the bag long after eMachines is gone," said Kumar.

Other issues cited by Kumar:

  • The field is getting crowded. EMachines had a nice start but may have a bad finish. Compaq and other branded PC vendors will soon offer sub-$600 models and they already dominate the higher price points. Kumar said eMachines doesn't have an answer. "With the redemption rates on its rebates set to explode, eMachines is making a futile attempt to expand its audience beyond the low-cost PC buyer," he said.

  • Being an Internet service provider won't help. EMachines is packing America Online (NYSE: AOL) with its PCs and AOL will offer rebates on the service. That's nice, but ISPs are offering free services. Kumar said the revenue stream from eMachines as an ISP is "highly suspect."

  • Lawsuits, lawsuits, lawsuits. Both Apple Computer (Nasdaq: AAPL) and Compaq are suing eMachines for copying designs. For a company on razor-thin margins, there's no room for legal costs. "We believe that Compaq especially will not be inclined to settle," said Kumar. "As such, we expect them to begin the legal equivalent of a proctology exam known as 'discovery'. Discovery usually comprises about 80% of the total cost of these lawsuits. We believe eMachines does not have the resources to weather the storms."