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Gateway makes bid for rival eMachines

The struggling company sees in eMachines' retail success story an opportunity to expand its PC market share and add new distribution channels for consumer electronics gear.

Gateway plans to acquire rival eMachines in a bid to regain its footing in the PC game and broaden the distribution of its Gateway-branded consumer electronics devices at retail.

The Poway, Calif.-based company plans to purchase privately held eMachines for $30 million in cash and 50 million shares of stock. Based on Gateway's closing price of $4.09 per share Thursday, the total value of the deal would be approximately $234.5 million.

The companies' combined PC businesses would constitute the third-largest PC manufacturer in the United States, Gateway said, and rank it eighth in the world. The deal is subject to regulatory approval and is expected to close in six to eight weeks.

By making a bid for eMachines, Gateway is hoping to combine the best of two worlds, creating a much larger PC business and giving itself additional sales channels for consumer electronics, such as its Gateway televisions, both inside and outside the United States.

The move could allow Gateway to double its annual PC volume from about 2 million to about 4 million units and position itself as a "very strong No. 3" to Hewlett-Packard and Dell, Ted Waitt, Gateway's CEO, told CNET in an interview Friday.

eMachines has been one of the fastest-growing PC companies in the United States. Last quarter it posted a higher unit shipment growth rate than any of the other top manufacturers in the United States. It grew unit shipments almost 21 percent year over year to 498,000 units, which moved it back into the top five manufacturers in the U.S. market, according to IDC.

eMachines also operates with a unique business model, designed to help keep its costs low. It only builds enough PCs to satisfy orders from retailers. It also aims to sell all of those PCs by the end of each quarter. Meanwhile, it does not accept returns or provide price protection to retailers against future price drops, two measures that could also cut into profits.

"If you look at some of the synergies of this combination, we're going to (be able to) build a model that has multiple brands, selling across multiple multiple geographies," Waitt said.

Under the agreement, Wayne Inouye, eMachines' CEO, would become CEO of Gateway, and Roderick Sherwood would remain as Gateway's chief financial officer. Waitt, Gateway's founder, would remain as chairman of the board.

Gateway's bid for eMachines also says something about the PC market. While unit sales reached a new high in 2003, the market was hostile to PC makers' revenue because of falling prices. PC makers shipped a record 152.6 million desktops, notebooks and servers last year but saw their collective revenue shrink by $51 billion to $175 billion, when compared to 2000, according to IDC.

Although the market appears to be improving, manufacturers will likely continue to consolidate, because it's difficult to turn a profit in the PC business, said Roger Kay, an analyst at IDC.

"Companies will either merge or have to get out of the business," Kay said. "The economics are kind of grinding away at the industry. Everybody's still hurting."

The market has been a particularly rough place for Gateway. During the fourth quarter, Gateway sold only 526,000 PCs, a 6 percent sequential decrease and a 27 percent decline from a year ago. Meanwhile, eMachines has been growing. The PC maker has expanded its model lines to include notebooks and also offers the latest processors from Advanced Micro Devices, whereas Gateway has sold only Intel-based PCs for the last several years.

Gateway said the merged PC businesses would generate several billion dollars in revenue annually. During 2003, their combined revenue totaled $4.5 billion. Alone, eMachines generated about $1.1 billion in revenue and kept selling, general and administrative expenses to "midsingle digits" as a percentage of that revenue, Gateway said. The low expenses helped eMachines profit while mainly selling low-price desktop PCs. eMachines desktop prices currently start at $449, before rebates.

The upsides
With the greater heft that would result if the merger is approved, Gateway expects to return to sustained profitability in 2005, in part because of the ability of the larger PC business to gain higher discounts on components, the company said.

A merger would also give Gateway a better grip on the retail market for electronics devices in the United States. The company plans to use eMachines' relationships with retailers to distribute its Gateway-branded devices outside Gateway stores.

Last year, Gateway embarked on a strategy designed to remake itself as a consumer-electronics brand. The strategy, which includes televisions, digital cameras, home-networking gear and music players, has helped the company increase its non-PC revenue. During the fourth quarter of 2003, consumer-electronics or non-PC revenue totaled $268 million, a 12 percent sequential increase from the third quarter and a 39 percent jump from the same quarter a year ago.

The eMachines deal could help Gateway negotiate agreements to let it sell products such as its plasma televisions at retail stores, Waitt said.

In addition, Gateway plans to adopt elements of eMachines' business practices. The company said it expects to adopt eMachines techniques to create low-price PC lines for the government and education markets.

While questions about the deal remain--such as whether Gateway will be able to maintain or grow the unit volumes of both companies and how many changes the company will make after the sale--Kay said the eMachines buy makes sense for Gateway.

"I think it's basically a good deal," Kay said. "My question would have been, 'What's going to happen to PC volumes?' Their assumption is that they're going to double. Our experience with Compaq and HP was that that didn't exactly happen--although HP did manage to maintain its market share at retail with two different brands."

In a conference call with analysts, Gateway officials said they will unveil more details, as the deal moves forward.

Gateway's initial plan is to sell eMachines PCs only at retail stores, while continuing to sell its Gateway-branded PCs directly to customers via phone and the Web--and at Gateway stores.

It's too soon to say whether eMachines desktops and notebooks will also show up at Gateway stores. Instead, the company is likely to keep the two brands fairly separate, Waitt said.