Consumers should love the cheap PC model being pushed by eMachines Inc.
Unfortunately, investors have reasons for doubt.
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Anyone reading ZDNet probably knows about eMachines by now. You wouldn't be reaching too far to say eMachines has extended the PC revolution to the millions of U.S. households that hadn't bought a PC until now. The hype over the sub-$500 PC phenomenon has made eMachines the PC industry's new darling, and a very eagerly awaited initial public offering.
eMachines made its first formal IPO filing yesterday with the U.S. Securities and Exchange Commission. When eMachines actually goes public, it'll draw a lot of attention, and understandably so.
CEO Stephen A. Dukker did a lot of things right when he created eMachines. For what he's trying to accomplish, he might be doing everything right. Costs stay low because eMachines relies entirely on its Korean shareholders (who together own more than 56 percent of the company) for cheap manufacturing overseas. Selling through retailers gets eMachines in front of first-time buyer, and the price is so cheap that eMachines buyers don't expect as much as purchasers of Compaq or Hewlett-Packard.
Should the eMachines way of doing business become the industry standard -- and that just might happen if the current trend continues, considering the company became the third largest retail PC company in just nine months of existence -- profits on PC hardware will be gone, vanished, missing in action.
Owners of PC stocks have learned to expect gross margin percentages in the low 20s or better. Contrast that with eMachines; according to its IPO prospectus, the company saw a gross profit of 3.6 percent in the first half of this year. And that fell to 2.9 percent as the company sold more units in the June quarter. Sounds like a company that would fit nicely a portfolio of grocery store stocks.
Hardware isn't the main thrust of eMachines, though. If its ideas catch on, investing in a PC stock won't be much different from investing in shares of an Internet service provider. Compaq, Dell and Gateway offer ISP access to build long-lasting customer relationships that sell more hardware, while eMachines seems to be offering hardware to build an immediate customer relationship that turns into an ISP account.
Perhaps that's exaggerating, but not by much. If Dell.net or Gateway.net stopped producing revenue tomorrow, their PC parents would take negligible hits on the bottom line. Not so for eMachines: "Our future success depends in part on our ability to sell Internet access services to our PC buyers ... Our business would be significantly harmed if our PC buyers who elect to receive an ISP rebate and enter into long-term contracts for Internet access services fail to honor their commitments ... Because we operate our business on narrow margins, any change in our expected net revenues from Internet access service monthly payments or e-commerce could adversely affect our business."
ISP revenue has the advantage of being predicable, even with the industry's average customer churn rate of 4 percent a month (according to market research firm IDC). And eMachines believes its subscriber turnover will be less because it's targeting first-time computer buyers who are too ignorant to know they can get no-charge Internet service for several months by jumping from one "Get a Free Month!" ISP to another. Or even forever, through programs like AltaVista's FreeAccess. I remember Dukker telling an audience at an investment conference it would take eMachines buyers 18 months on average to realize they how easily accessible free Internet service can be. By that time, eMachines would have the customer locked in.
Unfortunately, even if eMachines keeps all its PC buyers as Internet access customers, there's one problem: the ISP business stinks. To this day, America Online doesn't generate earnings from the Internet access side of its business, but rather from the advertising and e-commerce shoveled through AOL's intricate layers of content.
eMachines has plans to offer some of the same thing, but unless Dukker plans to become the president of a large content company, the ads and commerce revenue won't be much. Perhaps eMachines does have large content plans up its sleeve, but that begs the question: Why should an investor buy into eMachines when there are other skilled, established content players out there?
And that's really the problem posed by eMachines: if it carries out its current plans, it won't be a pure play on anything. You've got hardware-almost-at-cost leading to Internet access leading to e-commerce and whatever else the company pulls out of its sleeve. eMachines won't roll out the eMachines.net ISP until the fourth quarter, so if the company goes public before the end of this year, IPO buyers won't have the benefit of seeing the real eMachines business model at work.
Granted, that wouldn't be the first time IPO buyers dive blindly into a stock. But for investors accustomed to the more easily discernible businesses of the traditional PC business, eMachines has to be a tough sell.
Market indices in the afternoon continued today's rebound from their recent slide. Going into the final two hours of Wednesday's trading, the Nasdaq Composite Index was up 28.78 to 2768.13, the S&P 500 higher by 10.52 to 1330.93, and the Dow Jones Industrial Average up 104.48 to 10933.76. 22GO>