Gateway-AOL alliance may change desktop rules

The deal, announced yesterday, creates a tight partnership between the two companies. Together, eventually, the two will try to sell consumers all their home computing needs--broadband Internet service, set-top boxes decked with AOL software, PCs, standard AOL service, and third-party products.

Companies are positioning themselves to lead the brave new market for "information appliances" and, at the same time, they're trying to corner as much business as they can now by offering cohesive bundles that are more attractive, and less expensive, than anything the competition can provide.

It's a struggle that could have wide-ranging implications for software and hardware makers in the next few years. The agreement's ramifications may mean trouble for Microsoft efforts to establish a foothold in the information-appliance market and also for its underachieving MSN Internet access service.

Under terms of the alliance, PC maker Gateway has agreed to market information appliances such as email readers and Internet TV set-tops for the "AOL Anywhere" strategy, an approach that echoes Microsoft's "Windows Everywhere" tactic.

AOL will also become the de facto Internet service provider (ISP) for Gateway customers. Its flagship service will be marketed alongside Gateway.net, Gateway's Internet access service, on all Gateway computers. Gateway.net will be managed by AOL, but it will be used as a more bare-bones option for users.

An Internet appliance, generally speaking, is a relatively low-cost device that does one or a few things well, such as read email. It's a nascent market that analysts expect to explode in the next few years.

But while the growth potential is attractive, it's also fraught with risks that Gateway doesn't want to take alone. For one, nobody is sure what kinds of non-PC devices people will wind up using, or what kind of software will power them, meaning there could be many expensive product flops in the years to come. As for AOL, it isn't used to designing hardware products. The two are a good match, analysts said.

"Gateway needs a service provider for low-cost Internet appliances, and AOL's confidence in Gateway, given the other PC makers they could've invested in," is probably due to whatever technology Amiga is developing, surmised Richard Doherty, president of consulting firm Envisioneering Group.

Like many PC companies, Gateway is trying to devise a strategy to tap the growing market for Net appliances. The company's wholly owned Amiga subsidiary is working on software for various incarnations of these devices.

But while AOL and Microsoft duke it out in the Net access market, Gateway could walk out a winner if it finds a way to support both sides.

Because these devices are also supposed to be cheaper than PCs, that means slimmer profit margins, so many observers have suggested that hardware companies will have to hook up with service providers to make money on appliances.

Gateway and AOL seem to be the first to take that advice to heart, but others are sure to follow.

Microsoft on the offensive
Microsoft, for one, is laying down lots of cash to make sure it's a player in this market. Among other deals, Microsoft spent $5 billion to make sure AT&T would use cable set-tops with Microsoft technology, and took a stake in Thomson Multimedia, makers of TVs and other consumer electronics items. Thomson is now getting ready to offer shares in an initial public offering. Additionally, the company's WebTV technology is being built in to satellite receivers from Echostar, and are on the market now.

In September, Microsoft announced plans to work on a "Web Companion" device powered by Windows CE that would offer email and Internet surfing only in conjunction with its MSN service. Unlike WebTV, the device has a built-in or stand-alone monitor instead of viewing content on a TV.

But there's no guarantee that any of these devices will sell any better than handheld PC companion devices built around Microsoft technology. So far, Palm Computing has a lock on the handheld market.

And unlike the PC market, Microsoft may not have the heft it needs--not yet, anyway--to persuade PC makers to go along with its plans for the information appliance market.

"AOL is in a unique position to annoint content providers, and then bring consumers to these new devices," said Eric Schmitt, an analyst with Forrester Research.

The deal could affect the relationship between Microsoft and Gateway, analysts said, because Microsoft has set-top and communications ambitions that conflict with AOL's plans.

"There is?the potential the AOL relationship [with Gateway] could strain the company's relationship with Microsoft," U.S. Bancorp Piper Jaffray analyst Ashok Kumar said in a report.

More customers
For AOL, the deal represents a way for the company to get first crack at a large number of consumers. Deal-making has paid off before for AOL, which saw its subscriber rate jump after Microsoft agreed to feature an AOL icon on its Windows desktop.

The desktop icon as a method for signing up customers, however, has seemingly been replaced by the "PC-ISP" deals that swept the country this summer. Consumer PC sales topped expectations, largely because of rebate offers tied to PC sales. CompuServe, which AOL owns, saw subscriptions jump after it began to give customers $400 rebates.

Calculations show that the deal could amount to big numbers. Gateway shipped 1.234 million units in the strong third quarter, mostly to consumers and small businesses. If AOL signed up an improbable, yet conceptually possible, 1 million of these customers at its traditional $21.95 monthly rate, the first-year revenue generated by connectivity alone would come to $263 million. For four quarters of PC sales, the hypothetical total rises to $1.1 billion.

AOL will not likely see these types of leaps, but the popularity of PC-ISP deals strongly indicate that customers will be generated. AOL and Gateway will also see increased profits.

"We believe the AOL agreement will add about 7 cents to fiscal 2000 earnings-per-share but more importantly will be much more accretive over time and increase Gateway's exposure to Internet-related business opportunities, including Internet appliances," BancBoston Robertson Stephens analyst Dan Niles said in a report. Niles upgraded Gateway stock today to a "buy" rating because of the deal.

Investors cheered the alliance. Gateway defied the market, rising 10 to close at 62, while IBM, Compaq, Dell, Hewlett-Packard, and Micron were all down. AOL was also up 4.25, closing at 122.25.